Invest in A Syndication | Passive Investor Tips

by Christopher Levarek

“Fool me once, shame on - shame on you. Fool me - you can't get fooled again.”

- George W. Bush

I remember when I got started in real estate. Every deal I looked at seemed to work on paper. You just plugged in the purchase price and projected rents and all of the sudden the properties were generating income. Real estate was easy! Why wasn’t everyone doing this I thought?

Here’s the thing, on paper, any deal can be penciled to look good. Most new investors stumble on their first investment or deal for this reason. Expenses are missed, renovations are under forecasted and numbers are inflated to the newbie. Why do I mention this?

Well, because syndication groups also make these mistakes, especially the newer ones, as they overpromise and under deliver. At times, whether intentionally or unintentionally, the numbers are far too optimistic. So here are three quick and easy methods for you, the potential limited partner or passive investor looking to invest in a syndication, to check to ensure it’s a good deal :

Exit Cap Rate

A quick and easy check to an investment deal, is for an investor to look at the exit cap rate. Remember, the cap rate is simply a percentage that indicates what the property is being sold for in a given market. An investment is bought at certain cap rate and sold at another cap rate. Cap rate has an inverse relationship with price as it equals Net Operating Income / Purchase price.

All this to say, if you are entering an investment, you really want to see the exit cap rate number be around the entry cap rate for a conservative approach.

If the exit cap rate number is say 200 basis points, or 2 %, lower then the entry cap rate, you should look at if this is realistic. This would mean you are truly driving the price up for the life of the deal due to value-add or the initial purchase price was simply an amazing bargain. Is it possible? Yes. Is it likely? Not in the majority of cases.

So, TIP #1, verify if the exit cap rate is within 50 basis points higher or lower of the entry cap rate or .5% up or down. If it is not, ask why.

Projected Rents

Another easy number to verify on a deal, is the projected rents. In a syndication, especially value-add, the business plan should have some target rents the team is trying to hit. These should be achieve in year 2-3 after renovations have been made or management of the asset improved. Your job as the investor or limited partner is to ensure these aren’t made up numbers.

Trust me this isn’t as hard as you think! Here is how to do it.

Take the project rents for a value-add completed unit in year 3 for the type of asset you are investing into. Now with that number in mind, pretend you are a renter for the asset class. If it’s an apartment, go hunt for an apartment of similar type size and function in the market. Are you seeing similar numbers for comparable units? If not, what is different between your investment offering and the listed unit’s property? Amenities, square footage, furnishings, etc?

This can be achieved with almost any asset class, but obviously can be easier with residential, multifamily or vacation rentals. You are simply verifying projections against existing comparable rents. Still, the investor can also ask local forums such as BiggerPockets or call a property manager/broker in the area to verify projections as well.

Tip #2, Verify projected rents are comparable to existing properties. If they are not, ask why.

Rent Bumps and Market Appreciation

This one is similar to tip #2, however it can be much easier to spot. So according to a business plan, rents get increased to make their way up to the year 3-5 projected rents in a syndication. Yet, how are those rent increases or “rent bumps” occurring? Are they incremental, a few units at a time or are they property wide?

If you see the 5 year proforma in the underwriting or offering memorandum of an offering and the rent bumps are increasing by over 10% a year, this could be a red flag depending on the project. Just imagine, you are the renter, and you get a 10% hike in one year on your rent, would you stick around without good reason?

Now imagine how occupancy would look if everyone got a 10% hike in year one. Do you think occupancy would drop? Of course it would! People will always move out if rental rates increase, especially if it’s at 10%. If it doesn’t on the underwriting, this is a correlating red flag!

Or, in similar fashion, if the same 5 year proforma shows market appreciation, how much the property appreciates, of say 10% increase per year, is that realistic? Are there many markets where a property appreciates 10% in a year? Let me answer that for you, no there are not. Is it possible? Yes of course, however the more realistic or conservative number used is typically 2-3%. Anything higher should be cause for asking the syndication group as to why market appreciation is expected to be so high.

So, TIP #3, ensure that rent bumps and annual market appreciation are under 3-5%. If they are not, ask why.

In Final

….And that’s it! Those three tips will save you a lot of grief without much time. Of course, there are numerous other items you can check but the exit cap rate, projected rents and rental/appreciation increase rates are some of the more important.

Knowing and verifying these can ensure you invest in the right project for your investment strategy. Happy Investing!