7 Warning Signs a Passive Real Estate Investment Could Lead to Trouble
A May 23, 2023 article in the Wall Street Journal featured a high-profile foreclosure on a Houston apartment complex in which investors lost their entire investment. It is a tragic tale from which we can gain valuable insights.
The article did not present enough facts for a full diagnosis of the problems, but there was enough information to surmise a number of factors, discussed below, that led to the end result. So, when evaluating a passive investment opportunity, do not ignore these seven signs of potential trouble.
(Click the arrows below to expand each section.)
1. The General Partner (“GP”) Team Lacks Proper Experience
Not every GP began their career in real estate, investments, or business management. That might be okay, but the GP team should be well-rounded enough to have that experience, plus financial acumen. You want a solid GP team that can handle unforeseen deviations from the business plan with well-reasoned, decisive action.
2. The GP Team Lacks Incentives
It is common for syndicators to invest some of their own money in a deal, so look for some skin in the game and a track record of investing alongside limited partners.
The typical GP compensation model in a real estate syndication is comprised of an acquisition fee up front, recurring asset management fees, and a share of the profits. Fees are not correlated to performance. It is the share of the profits that aligns the GP’s interests with the interests of the limited partners (passive investors) because the GP will make money when the LPs make money. The profit split, therefore, should be the largest component of the GP’s compensation.
A good way of protecting investors’ capital and aligning the GP’s and investors’ interests is through a profit split that includes a preferred return to investors, a catch-up, and a clawback. These features work together to ensure the GP will receive the bulk of its profit share on the back end and no more than what it is due.
3. Questionable Business Plan Assumptions
Be wary of forecasted rent growth that looks like 2021 (a rare, exceptional year), and pay attention to the projected timeline for unit improvements and associated rent increases – it takes time to execute a value-add strategy and raise rents while maintaining occupancy levels. Question a flat or lower cap rate at sale v. purchase because that implies the real estate market will get stronger over time. And make sure the financial forecasts take realistic inflation expectations into account, particularly for property taxes and insurance.
4. The GP Does Not Understand or is Being Evasive about Debt Risk
It should be clear what assumptions the GP is making about debt such as the interest rate, whether the rate is fixed or floating, and prepayment penalties. And if the loan will need to be refinanced during the hold period, what assumptions is the GP making about the refinancing and why?
The pace and extent of the Fed’s 2022 interest rate hikes has put a lot of GPs on their heels and has not been kind to their passive investors. Floating rate loans require “rate cap” insurance to prevent the interest rate from escalating beyond a certain point. This year, many operators facing expiring rate caps are requesting additional funds from investors because the cost of a new rate cap has risen dramatically along with interest rates. Other operators refinancing maturing loans are confronted with more expensive debt, which leads to less cash flow for investors.
5. Too Little or No Cash Reserves
Things go wrong – it’s part of business just as it is in other parts of life. Does the capital raise adequately reserve for the unexpected? There should also be some allocation of funds to working capital – a cash management tool to ensure there is always money in the bank to pay predictable expenses.
6. Poor Property Management
Property management is essential to the success of a real estate deal – I cannot stress this enough. If the GP team is self-managing, then it must have experienced leasing and maintenance staff with a track record of success. Otherwise, the GP team needs to go through an extensive vetting process to select the right property manager based on number of units, property class, and neighborhood, among other factors. It is also the GP team’s responsibility to set expectations for the property manager, to monitor the property manager’s performance through reports and recurring meetings, and to hold the property manager accountable for performance.
7. Lack of Transparency
Nothing breeds mistrust more than hiding the truth behind a veil. Talk to the GP team before you invest. Are they being candid when answering your questions or are they dodging them? If they don’t know the answer, are they honestly admitting to it and then getting back to you later with the answer, or do you sense they are “faking it?”
The GP team should be clear on how it will communicate with investors and how frequently investors will receive investment reports. Also ask if the GP will be issuing annual financial statements audited by a reputable public accounting firm. They cost money, but the assurance they provide to investors is worth it.
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