Why should a busy professional invest in real estate? What are the benefits and the risks of investing in a syndication? How do you evaluate a deal right now and how to vet operators? What are standard fees that real estate syndicators charge? Our anonymous guest shares her knowledge to us.
Tell us a little bit about you.
I started investing passively about a year ago, I’m a physician, and work in the oncology space. I’ve always had an interest in commercial real estate. I had a few family members who had purchased small shopping centers so I had some familiarity, at least on the property management side. I started learning about commercial real estate, and the various asset classes and passive investing probably about a year ago. I became a consumer of real estate knowledge and in my spare time while I was cooking, commuting, traveling, I started listening to commercial real estate podcasts, including your podcast. I started reading several books, a few fantastic books that I recommend are: The Hands-Off Investor by Brian Burke and Passive Investing Made Simple by Anthony Vicino and Dan Krueger. They give great overviews of real estate and passive investing.
Why should a busy professional invest in real estate in general? What is a syndication?
Real estate has many benefits, unlike crypto or stocks, it’s a hard tangible asset and it’s generally stable and less volatile. So, there will always be some value in the land and the building itself and you can use leverage or debt to purchase it. For example, if you purchase a property and borrow 75% of the property’s cost, and the property value increases 25%, you’ve essentially doubled your money. You’re basically borrowing money to generate income and grow your wealth.
Real estate is also great for an investor who has a long-term horizon, it’s a long-term game because real estate tends to appreciate over time and so, if you hold on to a property for many years, you gradually grow your wealth over time. In addition to the market’s appreciation, you can also force appreciation on a property by making some repairs or improvements and you can also reduce expenses, that will help you increase value and income. Given our high inflationary environment, another major benefit of real estate is that it can be a hedge against inflation because property values tend to increase over time, especially in an inflationary environment. Leaving money in the bank can sometimes cause it to lose value when there’s inflation.
Another point that everyone always emphasizes about real estate is that it has major tax benefits. I am by no means a tax professional, I work in oncology but in broad strokes, there are several tax advantages, such as writing off the depreciation, which is the wear and tear of a building and it’s over a specified period of time. So, it’s possible to receive positive cash flow even if you have a tax loss. Another benefit in terms of investing in real estate is that it can actually just become a new skill, just like anything else. I’m a firm believer in what really sets apart successful people is a growth mindset and the ability to master new skills over time and expand your knowledge. Adam Grant, an organizational psychologist, said that the highest form of self-confidence is believing in your ability to learn. Learning about real estate has been an exciting journey and it also has helped elucidate various economic factors which helps you keep yourself updated on the latest trends in the overall economy.
A syndication is just a group of investors who pooled their money together to buy a real estate asset. As a busy professional, you would be a passive investor or a limited partner and you provide some of the capital to purchase a property. Then, the sponsor, who’s also known as an operator or a general partner, provides their time, experience and network to buy, operate and eventually sell the property. It’s a fully passive investment.
Why did you start to learn about real estate investing versus other forms of investing?
I always had an interest in real estate, there are so many benefits to real estate. Also, having that exposure early on, having family members who had invested in real estate certainly piqued my interest, but being a busy professional, I never had the time to learn about real estate until I decided that I wanted to learn about it and invest any spare time I had into learning this new skill. Once I became this consumer of knowledge and started listening to podcasts while I was commuting or traveling, that’s what piqued my interest and the more I learned, the more I wanted to learn about real estate.
What are the benefits and the risks that you have learned of investing in a syndication?
The major benefit is that it’s a completely passive investment for the busy professional. Another advantage is the ability to diversify geographically, as well as across asset classes. You can invest in a self-storage facility in North Carolina, and you can also invest in a 200-unit apartment building in Minnesota, so you can invest anywhere in the US and you have no geographic limitations. Another benefit is that you can invest smaller amounts of money. The minimum investment is around 100,000, just to give you some perspective, the average purchase price, for a small commercial real estate deal tends to be in the millions. Also, you save a lot of time because, as a busy professional, time with our greatest asset, you could spend countless hours looking for a property and trying to determine if it will cash flow, or you could just leave it to the experts to handle the work.
As far as risks, you are essentially putting your faith in the sponsor to execute a business plan and you want to feel comfortable with them controlling your money, lack of control is another downside because as a passive investor, you’re giving up control of the investment to the sponsor. Another risk is that you have no liquidity and your investment is locked in during the duration of the deal which is also called the hold period, which is the amount of time that the asset will be owned so your capital can be locked in between three to 10 years, so sometimes a five-year plan can turn into a 10-year plan if the market conditions are not optimal during the time of sale. Another major risk is the potential for the loss of your capital, and no one wants to lose their money but it can and has happened, that’s why it’s so important to screen the sponsor.
How do you vet an operator with the knowledge that you have gained over the last year?
Talk to them, try to meet them on a zoom call or ideally in person, listen to what they are saying and ask yourself: are they listening to you and interested in learning about you, what is their track record, do they have experience in this particular asset class?
Another good question to ask the operator is, are they co investing in the deal and if so, how much? In general, I have tried to measure their character, do they seem overly confident or do they have a more conservative mindset, are they dodging your questions or are they being open and transparent and that gives you a sense of how trustworthy they are. A way to evaluate this is to understand if they’ve encountered challenges or failures or how they’ve handled underperforming deals and what they learned from the experience because everyone has failures, so transparency is the key.
The most important question to ask yourself is what does your intuition tell you about the sponsor? Women tend to be incredibly intuitive and we’re very attuned to what our gut is telling us so at the end of the day, you should listen to your gut regarding a sponsor. You can also do background checks or Google them as well. Lastly, you should do due diligence on the deal itself, review the properties and locations and understand how they analyze the deal. Look at their projections for returns, are their numbers too positive? Do they seem to be over promising in terms of their returns, or are their returns much higher than average? Those are good questions to ask yourself.
Knowing the answers to their questions requires you knowing the business so you can understand if they are advanced in their responses, or if they’re just a newbie, and I have seen this and a couple of people that are being investigated by the SEC. What are some of the red flags to look out for in an operator?
A couple of points are the level of experience that comes through, if they’re dodging questions, look for their ability to communicate effectively and if they have inconsistent messaging, those could be signs that they’re not trustworthy. Another potential red flag is if they’re not detail oriented or if they charge very high fees compared to other syndicators. I always inquire about the fee structure, there are various fees like the acquisition fee or the asset management fee and they should be within a certain range. Another point for due diligence is to always review the documentation, like the subscription and operating agreements carefully before you sign anything.
What is the standard fee from acquisition all the way to exit fees, adding all of the percentages up and on average as well?
Asset management fees are usually anywhere between one and 2%, acquisition fees can be anywhere between one and 3%, the disposition fee is typically anywhere between one and 2% and the construction fee is typically around 5%. So, probably up to 10%.
How do you evaluate a deal right now?
I review fundamentals like the properties themselves and the location. I ask these questions to myself: what type of properties are they, are they class A or Class B? What about the location, is it an area of population growth or is there job growth because those markets tend to appreciate? Is the sponsor adding value, how are they adding value, are they improving the operational efficiency to increase income, how much leverage are they using and what is the interest rate, is it a fixed or floating interest rate? I always evaluate the return metrics that they share.
And there’s some basic terminology that you’ll hear in syndication deals that’s good to understand. One term that you’ll often hear is the internal rate of return, or the IRR, this is the total time adjusted returns of an investment. Many deals are usually somewhere in between the 15 to 18% range. Another is the cash-on-cash return, this is the annualized return relative to the initial amount invested. If you invest $100,000, and you receive an annual distribution of $10,000, then you have a cash-on-cash return of 10%. Then, the equity multiple is the total amount of distributions received divided by the amount of the initial investment. So, if you invest 100,000, and then you get a total return of 200,000, then the equity multiple is 2x because you’ve doubled your money. The equity split is the ratio of equity that goes to a sponsor versus a passive investor, for example, in an 80-20 split, the passive investors get 80% of the return and the sponsors get 20% of the returns. The last term that’s important to understand is the preferred return, this is the claim on profits provided to investors, for example, the passive investors receive, let’s say, a six to 8% return on their investment before the sponsors share any of the returns.