Edmonton Real Estate Investors Association Message Board › 8 Mistakes to Avoid in Real Estate Syndications
Syndicating (or pooling) of your money with others to buy larger commercial real estate projects is a great idea - if executed well . It is a proven path for wealth creation - if bought at the right price and managed well. Not all real estate classes are created equal - and not all operators are equal either - and this recession is a case in point.
There are eight typical mistakes in real estate syndication projects that you must avoid ! What are they ?
1. Overpriced Assets sold to innocent investors at a huge premium.
Often an asset is purchased by the syndicator, and then sold to the "innocent" public for a lift up from a low of 20% to several 100% on some land deals. This used to be OK in a very strong market. Let's use an office or retail syndication as an example: An office tower or larger retail center is bought for $10M which was perhaps fair market value in 2006 or 2007 or 2008. It carries a 70% LTV mortgage, say $7M. $6M is now raised .. $1M in cost for commissions and for other soft costs like marketing and legal expenses, and $5M to syndicate the asset for $12M. OK if it cash-flows and maybe can be exited in 5 years for $15M ... however roll forward to 2009 and with rising office vacancies and higher CAP rate demands by banks this asset today is now worth $9M .. down only 10% .. in some cases perhaps down 20% to $8M. Deduct the $6.5M mortgage (now paid down a bit) and you see equity of $1.5M .. a 75% drop in equity from $6M raised !!
There are some private REITs out there or some office syndicators that pretend the world still looks like 2008 with low CAP rates and flat values. HELLO. Let's assume the asset was bought in 2006. Roll forward to 2011: the 5 year mortgage is now due. It is now maybe $6M. The asset is worth $8M. Most lenders today would not lend 70% on a retail or office tower. Maybe 60 to 65%. Thus, a $5M mortgage can be obtained .. $1M short in a relatively normal market. A recipe for bankruptcy .. and in any case huge investor losses despite a minor correction of value of only 10% to 20%.
Thus: check the true asset value if you intend to invest .. and do not accept their excuses for uplifting the building value because there isn't any ! Then hopefully you can co-invest with one of the many ethical syndicators out there !
2. Inexperienced Operator with NO OPERATING TRACK RECORD.
Many a syndicator has had some success raising funds, sometimes for flow-through tax deals or other parties. They make a commission only. Hey, let's open up a syndication firm they say. Buy an asset and manage it and take commission and an operating profit. Big mistake in many cases as it takes years to understand how to buy, even more years how to buy well and not overpay .. and even more years to manage an asset well .. especially in a more normal less heated economy !
Thus: check their track record and depth of knowledge in the asset space they operate !
3. Excessive Fees - usually upfront - independent of project success !
Some syndicators charge in excess of 10% commission. 10% seems to be the norm but is still high as it has to be made up through asset performance which takes a few years. Also an annual asset management should probably not exceed 0.5% on the asset value or 2% of the cash invested ... otherwise it is too rigged towards the syndicator and not the investor. It has to be win/win !
Thus: Lower is better !
4. Unrealistic ROIs using unrealistic assumptions
A common trick is to use unachievable future values of condos or land prices as a high ROI is easily achievable on a spreadsheet or in an ad. However this is now a lower demand world caused by more cautious and financially less wealthy baby boomers.
Although housing has shown feeble signs of recovery, this economy has been a wake-up call to investors who thought they could ride a never-ending real-estate bubble for condo projects, land sub-divisions or international real estate in hot markets like Costa Rica, Mexico or Belize. Then there's commercial and office real estate, where many institutional investors have recently taken enormous losses.
Thus: are these future values achievable in the timelines advertised ?
5. False sense of security
Syndication firms often use terms such as "asset backed" or " up to 18%+ interest on our mortgages" or "secured by a mortgage" .. but in many cases these mortgages are in 2nd or 3rd position and exceed by far the value of the underlying real estate. In construction or land development projects the investors money is often in 2nd or sometimes in 3rd position behind an expensive first position .. hardly security but a sham ! Don't call it a mortgage if it is indeed equity or investment dollars.
Thus: security not in 1st position or exceeding going in prices, based on future speculative possible prices is not security .. it is false advertising !
6. Executives that were charged .. by the Alberta or BC Security Commissions or are embroiled in lawsuits with their current or previous investors.
Thus: check out the project and the people behind the project. What did they do before they did this venture ?
7. Big ads promising huge returns .. usually paid for with your own money as an expense to the business.
Thus: look for soft costs besides (huge) commissions too .. 2.5 % - 3.5 % of money raised is reasonable .. more is not !
8. Not taking ownership of the asset although promised by their marketing. Ensure that the investors actually own the asset ! Frequently .. and I invested in 3 such deals .. with two syndicators that shall remain unnamed to protect the guilty .. the asset is not held by the investment group but by a side company and the money is lent to them. It is now almost impossible to trace the money trail .. especially if this shadow company also co-owns many other assets with many mortgages. Thus, one collapsed and unrelated project can derail your project too !
In summary: it has to be win/win !
Are the operator’s profits aligned with yours, the investors i.e. usually at the end on exit? Or are they lining their pockets upfront regardless of asset performance ?
There are quite a few scams out there .. and many were in the news lately .. but even more exist that just exploit the legal loopholes .. but there are many honest folks too. Use these eight guidelines to distinguish between the honest and the dishonest operators .. and you too can successfully and profitably co-own a larger piece of real estate or a pool of hard assets with others !
Thomas Beyer, President
Don't wait to invest in real estate - Invest in real estate and wait ! ™
Edited by Thomas Beyer on Nov 10, 2009 8:45 PM