Real estate syndications and funds have grown significantly in popularity over the past decade. The JOBS Act of 2013, the ubiquity of social media, and the rising tide of real estate values have set the stage. It’s resulted in a whole lot of investors making a whole lot of money.
And it’s also created an opportunity for newbies and great promoters to pose as great syndicators/operators while enjoying the rising tide. But we all know what happens when the tide goes out. Warren Buffett tells us we’ll see who’s skinny dipping.
I’m writing to help you avoid being a victim of a skinny dipper’s blunders. And to help you make sure you know what you’re getting into. It’s a long-term commitment, and I want to be sure you count the costs before writing a check. So let’s take a look at seven more downsides to taking this plunge.
Before I do, here is a list of the risks and downsides I covered in my company blog post:
Overheated market: Commercial real estate is at an all-time high.
Syndicators make money even if investors don’t: Just like stockbrokers make fees.
Over-alignment: It is hard to explain here… but it is possible to discourage the syndicator and motivate them to walk away when things get tough.
Loss of control: Are you a control freak? Don’t send your money to a real estate syndicator or fund manager.
Dilution from over-raising: Some operators raise capital to pay investor returns for a while. This can bite investors in multiple ways if things go south.
A rising tide makes even newrus look good: Newrus = new investors calling themselves gurus. They look great right now. But watch out.
Risky debt: Leverage can accelerate your wealth. Or quicken your destruction. Do you know how to evaluate the risks?
Skin in the game: Syndicators act differently when their cash is invested alongside yours.
Key man (or woman) risk: What happens if your star gets hit by a bus?
By the way, why is it always a bus? What about a car? Or a patty wagon? (Do they still have patty wagons?)
Anyway, here are seven more downsides to investing in syndications…
#1: The liquidity tax
Think of a spectrum. On one end, you have stocks, bonds, and mutual funds. You’ll never know the fund managers, and there is a lack of clarity between revenue increases on the ground and dividends in your pocket. You may be subject to the mood on Wall Street, a war in the Middle East, or a CEO scandal. But you’ll have liquidity. You can cash in whenever you need or want to.
On the other end of the spectrum is commercial real estate. You can get to know the syndicator, and the returns are often predictable. There is a clear line connecting rents and operating expenses to your bank account. But you won’t have liquidity. You won’t get access to your funds until the investment term is up.
I call this the liquidity tax. While real estate may pay you a higher, more predictable return without the emotional roller coaster of Wall Street’s casinos, this “tax” will be attached to your investment. While concessions often allow you to access your funds, there is no guarantee. And it won’t be an easy process like the stock market.
This is a long-term commitment. A marriage. But it may be a marriage to someone who is hard to get to know…
#2: Due diligence is tricky
There is a massive amount of information and almost endless analysis available on public companies and mutual funds. And there are standard boxes that most of them check and publish.
Not so with private real estate offerings. These offerings are generally exempt from SEC registration. And since they are relatively tiny compared to public company market caps, there is little to no analysis available. You need to dig deep to get an accurate picture of their company and deals.
Here’s the problem: as an individual passive investor, do you really have the knowledge, resources, and time to do this due diligence? From what I’ve seen, most don’t. I’ve spoken to over a thousand prospective investors in the past several years, and I’ve only met a small handful who do.
Here’s a resource for you if you decide to perform due diligence. My friend, Brian Burke, has written an excellent BiggerPockets book called The Hands-Off Investor. This book will give you details on how to vet syndicators and deals. I have spoken to investors who were invigorated from the detailed material…and others were discouraged when they realized how much is required to thoroughly perform due diligence.
If this is a marriage…it is worth it to know who you’re marrying. And to know how much will be required from you…
#3: High minimum investments, high bar, and detailed investment process
Kids (18 and up at least) can buy stocks on Robinhood for a few bucks in a few minutes. Day traders enter and exit small trades daily. But investing in syndications involves a heavy commitment. Many start at $50,000. Some $100,000 or much higher.
And most syndication investments will require you to be accredited. This is an SEC construct meant to protect smaller or inexperienced investors from getting taken. It requires investors to either (a) have $1 million in net worth (not including their primary residence) or (b) make $200k annually, or $300k if filing jointly.
Syndications also require a more detailed investment process than most stock investments these days. In addition to verifying accreditation, investors are required to sign subscription agreements confirming they’ve read a lengthy PPM (Private Placement Memorandum) stating they understand many of the ways they could get burned, plus other provisions. There are usually multiple calls and webinars involved, and if you agree with my point above about due diligence, it may include site visits to see what you’re investing in.
Staying with the marriage theme, this spouse may encounter “issues” that are tough to resolve…
#4: Potential of multiple state tax returns
One benefit of syndications is the fact that you get a K-1, a partnership return. This means the depreciation losses from the property pass through to you. It also means you may be required to file in multiple states where your syndication invests.
Most investors find it’s not a severe or overly costly problem, but it is a hassle, and you should know this going in. Yesterday, I met with an investor in over 30 syndications in multiple states. Like me, he files about five or six state returns, including in his state. These returns typically cost $50 to $100 per state.
But there is another issue with K-1s…
#5: K-1s are typically not timely
This marriage analogy could get me in trouble here. Ever have a spouse that runs late? If you invest in syndications, you will probably link up with a syndicator whose K-1 is late as well. These often lengthy returns are technically due on March 15th, but many syndicators get them out in late March or early April.
Most investors don’t complain since they file extensions anyway. But if you’re the early filing type, you need to know that your late K-1 will probably set you back.
I’ve been an entrepreneur since 1993, and I’ve extended my return these 28 years, so I didn’t think of this as a downside. But last year, a few investors who typically filed in March had a bit of angst over this issue.
#6: All your eggs in one—or a few—baskets
As we discussed, the high minimums result in heavy concentration for a regular investor. I can buy a share of Apple for under $200. The typical syndication (at $50,000) has a minimum of 250 times as high (though some have a much higher minimum). This means more eggs in one basket if you want to invest. The opportunity for diversification is, therefore, quite limited for most.
In my mind, this means a higher due diligence bar on real estate syndications. But as I mentioned above, due diligence can be more difficult for private syndications than public stocks, making this situation even more challenging.
#7: It’s hard to fire the manager
The press abounds with stories of public CEOs who are fired for various good and bad reasons every year. CEOs are under constant scrutiny for their comments, actions, personal lives, and financial performance.
Last week, I met with a prominent public company CEO whose career ended in a board room disagreement. He said he was ready to retire and seemed happy about the situation. But this reminded me of the level of accountability and scrutiny these public CEOs undergo day-in and day-out.
If you’ve invested in a syndication, think about this: how would you know if the execs at your syndicator are cheating on the books? Or if they are mismanaging the properties? Or if they’re refinancing with risky debt? Or doing any of a hundred other things that could hurt or destroy your investment?
And if you could figure it out, could you fire them? Not likely. The syndication PPM provides details on removing management for cause, but I can tell you this will probably be quite difficult. And there will probably not be a Board in place to fire them either.
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So…why would anyone invest in a syndication?
So you have a significant allocation in an unregulated, illiquid investment with a hard-to-diligence and tough-to-hold accountable syndicator who is nearly impossible to fire. Why would anyone do this?
There are a lot of good reasons. I could write a short book about this topic, but that is well beyond the scope of this post.
I can tell you that most of the Forbes 400 wealthiest Americans utilize commercial real estate to maintain their wealth. Many of them made their fortunes in this arena as well.
Unfortunately, these investments have been historically unattainable to the average investor—until recently. Recent changes to syndication legislation and SEC policies have opened the door for millions of investors to participate in commercial real estate.
Investors in syndications are participating in hard assets that provide…
Predictable cash flow
Meaningful principal paydown, and
Nearly unparalleled tax benefits
These investments stand apart from those offered through stock market casinos. These investors aren’t worried about…
The turbulent moods on Wall Street
Rumors of war in the Middle East
A recent CEO scandal, or
The latest tweet by Elon Musk
An increasing number of investors are turning to syndicated commercial real estate to protect their assets, grow their wealth, and reduce their taxes. If you decide to take this path, you should take steps to overcome the disadvantages outlined in these posts.
So what about you? What risks and downsides have you discovered investing in syndicated deals and funds? What have you done to mitigate them?