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How to Evaluate a Real Estate Syndication Deal

How to Evaluate a Real Estate Syndication Deal - Best advices!

Real estate syndications have emerged as an attractive opportunity to generate passive income and build long-term wealth. However, evaluating these investments can be complex for those unfamiliar with the terminology and evaluation process. This is part two of a three-part beginner’s guide for investing in real estate syndications. In this article, we will show you how to evaluate a deal, from understanding important terminology to conducting a detailed evaluation of deals and sponsors.

 

 

[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]

Are you thinking about investing in a real estate syndication but don’t know how to get started?

In this three-part series, we’ll walk you through what you need to know to start investing in real estate syndications.

In Part 1, we covered the requirements for investing in syndication, the types of real estate that are funded by syndications, and how to find syndication opportunities.

In part 2 (this article), we’ll cover how to evaluate these opportunities.

In part 3, we will cover the steps for making your first syndication investment.

[Note: If you want to be notified about future syndication opportunities, CLICK HERE to join our list]

 

Important terminology

Here’s some important terminology related to evaluating a real estate syndication deal. 

Due Diligence: The process of conducting thorough research and analysis on a real estate syndication project before making an investment. It includes evaluating financials, legal documents, market conditions, and the sponsor’s track record.

Preferred Return: A specified rate of return that limited partners receive before general partners receive a share of the profits. It is often expressed as a percentage of the invested capital.

Waterfall Structure: A distribution framework that outlines how profits are allocated among the general partners and limited partners based on predetermined thresholds or tiers.

Capital Stack: The hierarchy of capital sources and their order of priority in the event of liquidation or cash flow distribution. It includes senior debt, mezzanine debt, preferred equity, and common equity.

Equity Multiple (EM): A measure of the potential return on investment in a real estate syndication. It represents how many times the initial investment is expected to be returned over the investment period.

Average Annual Return (AAR): Also known as Annualized Return, is the average rate of return on an investment over a specific period. It calculates the average yearly gain or loss, considering both capital appreciation and income generated.

Internal Rate of Return (IRR): A metric that calculates the annualized rate of return that an investor can expect from an investment, taking into account the timing and magnitude of cash flows.

Property Appreciation: An increase in the value of a real estate property over time due to market conditions, improvements, or other factors.

Exit Strategy: A plan that outlines how and when the real estate syndication investment will be sold or liquidated to generate profits for the investors.

 

How to evaluate syndication opportunities

When evaluating syndications, we like to break it down into three major parts: evaluating the deal sponsor (also referred to as the General Partner), evaluating the deal itself and evaluating the deal structure.

 

Evaluating the deal sponsor

Let’s start with the deal sponsor because it doesn’t matter how great a deal is, if you have someone who is dishonest or doesn’t know what they’re doing.

Whenever you invest in someone else’s deal, you have something called “counterparty risk.” 

This is the risk of relying on someone else to make you money.

When you hand that money to someone else, there’s a risk that they use that money for another purpose. These are your scams and ponzi schemes. This is a nightmare scenario for investors and while it’s hard to quantify how often this happens, it’s probably not too infrequent. 

So you can see that the deal itself is completely irrelevant when you’re dealing with someone who is dishonest. This is why vetting the deal sponsor is critically important.

To assess someone’s integrity or honesty, there are a number of things you can do. You can seek references from other investors or industry professionals. You can look for testimonials or reviews of the GP’s previous syndications. You can also evaluate their reputation for ethical business practices.

Once you find an honest operator, what else do you want to look at when evaluating a deal sponsor?

You will want to consider their track record or how they performed on past deals. When evaluating past performance, it’s important to evaluate their success in managing similar types of properties.

When analyzing a GP’s track record, it’s important to take into consideration their success during challenging times, not just good times. Anybody can look like a pro when their track record only consists of investments during a hot market. Remember that real estate prices appreciated every year between 2011-2022.

This makes it challenging to evaluate deal sponsors. If you bought a property anytime during this time period, without doing anything special, you enjoyed a considerable amount of market appreciation. So it’s important to tease out whether the majority of a deal sponsor’s success was due to a good market or their ability to consistently make great investments.

Experience investing through downturns is another important consideration. Since the last major downturn was in 2008 (excluding the more recent COVID downturn), there probably aren’t a lot of deal sponsors out there who have that long of a track record investing in real estate.

Why is experience investing during downturns important? Because you are probably more conservative in your deal analysis. You learn how to stay out of trouble when the economy tanks like it did in 2008 and property values plummeted.

One last thing we like to evaluate is effective communication and transparency. Ultimately, you want to look for sponsors who provide regular updates, promptly respond to inquiries, and maintain open lines of communication with investors. The last thing you want is someone who doesn’t respond to your questions and leaves you in the dark about the performance of your investment. Strong communication builds trust and fosters a healthy partnership.

 

Evaluating syndication deals

The first step to evaluating syndication deals is to clearly define your objectives.

In other words, what are your risk tolerance, financial goals, and long-term vision for success?

Are you focused on investing in residential or commercial properties? Are you targeting specific markets or are you looking to diversify across regions?

Are you looking for cashflow or appreciation? Some deals will only give you cashflow and zero equity. Other deals will have little or no cashflow and the return is primarily based on property appreciation.

Once you define your investment objectives, you can easily weed out the investments that don’t meet your objectives.

The next step is to evaluate the deal itself. Many rush to the investment metrics, like IRR and equity multiple. But before doing so, it’s important to evaluate the market and property location. 

Real estate is all about location, location, location, so it makes sense to carefully evaluate the market. 

You want to dive into market trends, economic indicators, population growth, employment opportunities, and factors influencing property values and rental demand. Consider the location, neighborhood development, and overall market stability. 

You want to ask questions like: Is the market experiencing growth or decline? Are there economic drivers, such as job opportunities, population growth, or infrastructure development? What is the demand for rental properties in the area?

We like to invest in the “path of progress.” These are areas that are up and coming, where the City is putting dollars towards improvements. This allows you to take advantage of market appreciation.

The next thing is to dive into the numbers. You want to scrutinize financial statements, including income, expenses, occupancy rates, and historical data. Assess the physical condition of the property, potential renovation needs, and associated costs. Verify the accuracy of projections and estimates provided by the syndication.

You then want to think about the potential risks of the investment. You want to analyze economic factors, market volatility, regulatory changes, and environmental risks. 

For example, when evaluating environmental risks, such as flooding or natural disasters, you want to think about the impact on insurance rates. Florida, for example, has seen insurance rates skyrocket due to recent hurricanes. 

 

Evaluate the syndication deal structure

The last step is to carefully evaluate the deal structure. 

This step can be pretty confusing if you don’t understand the terms thrown around by deal sponsors. You’ll want to understand terms like capital stack and waterfall structure. You’ll also want to learn the common metrics used to describe the opportunity, terms like cash-on-cash return, IRR, and equity multiple.

Let’s start out with the capital stack. The capital stack refers to the hierarchy of funding sources in a real estate syndication deal. It represents the different layers of capital investment and their order of priority in terms of repayment and distribution of profits. The typical components of a capital stack include:

  1. a) Senior Debt: This is the first layer of financing and usually involves traditional bank loans or commercial mortgages. Senior debt holders have priority in repayment and are secured by the property’s assets.
    1. b) Mezzanine Debt: Mezzanine financing sits between senior debt and equity. It typically involves higher interest rates and can be used to bridge the gap between the senior debt and the equity portion of the capital stack.
      1. c) Equity: Equity investors provide the remaining capital needed for the syndication deal. They have a higher risk profile but also enjoy potential higher returns. Equity investors participate in the profits and losses of the project, typically through ownership shares or membership units. There can be preferred equity vs. common equity. Preferred equity is synonymous with preferred return, where preferred equity owners are higher on the capital stack than common equity owners.

Understanding the capital stack helps you assess the risk exposure at each layer and evaluate the potential returns relative to the associated risks. For example, some deals do not have mezzanine debt. So that means as an equity investor, you are next in line after senior debt to get your money back and share in the profits of a deal. 

The waterfall structure outlines how profits are distributed among the syndication participants. It defines the order in which cash flows are allocated, ensuring that investors receive their returns according to predetermined priorities. The waterfall structure typically consists of two main components:

  1. a) Preferred Returns: Preferred returns (also known as preferred equity as described above) represent a specific rate of return that is paid to investors before any profits are distributed to other participants. It acts as a safeguard to provide investors with a predictable income stream and protect their capital.
    1. b) Profit Split: Once the preferred returns have been satisfied, the remaining profits are typically divided between the syndication sponsor (general partner) and the investors (limited partners) based on a predetermined split. This split can be structured in various ways, such as a percentage-based split or a hurdle rate arrangement.

Understanding the waterfall structure allows you to assess how profits will be distributed, the level of preferred returns offered, and the potential for additional profits based on the profit split arrangement.

Now let’s transition to the common metrics that are used to describe the opportunity. These metrics help investors assess the investment’s performance and compare different opportunities.

Let’s start out with equity multiple. To calculate the EM, you divide the total distributions or profits received by the investor by the initial equity investment. For example, if an investor initially invests $100,000 and receives a total of $200,000 in distributions over the investment period, the equity multiple would be 2. This means that the investor received twice the amount of their initial investment.

To calculate the average annual return, you divide the total return on investment by the number of years the investment was held and express it as a percentage. For example, if an investment generates a total return of $50,000 over a five-year period, the average annual return would be 10% ($50,000 divided by 5 years).

The last metric, IRR is a bit more complicated to explain. It’s a measure of the profitability of an investment over time. It tells you how much money you can expect to make on average each year from your investment in a real estate syndication.

Imagine you invest in a syndication project, and you contribute a certain amount of money upfront. Over the years, you receive cash flow distributions from the project, which could be rental income or profit from property sales. At the end of the investment period, you may also receive a lump sum when the property is sold.

The IRR takes into account both the timing and the amount of these cash flows. It calculates the average annual rate of return that you would earn on your investment, considering the initial cash investment and the future cash flows.

For example, let’s say you invest $100,000 in a real estate syndication and receive annual cash flow distributions of $10,000 for five years. After the fifth year, you sell the property and receive an additional $50,000. The IRR would give you a single percentage number that represents the average annual return on your investment over the holding period.

When comparing different opportunities, you might be tempted to favor investments with higher EM, AAR and IRR. However, it’s essential to consider other factors such as the investment duration, risk profile, and the specific market conditions surrounding each syndication when choosing among different opportunities. At the end of the day, it doesn’t matter how high the projected return is for a property that has a very high-risk profile. 

 

Conclusion

Congratulations! You have acquired the knowledge and tools necessary to evaluate real estate syndications and embark on the journey of creating an additional source of income. By understanding essential terminology, conducting thorough deal analysis, and evaluating sponsors diligently, you can make informed investment decisions. Remember to focus on market analysis, due diligence, risk assessment, and partnership with reputable sponsors. With careful evaluation and comprehensive understanding, you are ready to seize the opportunities presented by real estate syndications. So, step confidently into the world of real estate investment and unlock the path to financial success!


Do you want to learn how to creatively fund your real estate portfolio and achieve financial freedom? Join the conversation! Follow our Semi-Retired MD Facebook page and join our Doctors (for MDs or DOs only) or Professionals group!

Semi-Retired M.D. and its owners, presenters, and employees are not in the business of providing personal, financial, tax, legal or investment advice and specifically disclaims any liability, loss or risk, which is incurred as a consequence, either directly or indirectly, by the use of any of the information contained in this blog. Semi-Retired M.D., its website, this blog and any online tools, if any, do NOT provide ANY legal, accounting, securities, investment, tax or other professional services advice and are not intended to be a substitute for meeting with professional advisors. If legal advice or other expert assistance is required, the services of competent, licensed and certified professionals should be sought. In addition, Semi-Retired M.D. does not endorse ANY specific investments, investment strategies, advisors, or financial service firms.

Do you want to learn how to creatively fund your real estate portfolio and achieve financial freedom? Join the conversation! Follow our Semi-Retired MD  Facebook page and join our Doctors or Professionals  group!

Semi-Retired M.D. and its owners, presenters, and employees are not in the business of providing personal, financial, tax, legal or investment advice and specifically disclaims any liability, loss or risk, which is incurred as a consequence, either directly or indirectly, by the use of any of the information contained in this blog. Semi-Retired M.D., its website, this blog and any online tools, if any, do NOT provide ANY legal, accounting, securities, investment, tax or other professional services advice and are not intended to be a substitute for meeting with professional advisors. If legal advice or other expert assistance is required, the services of competent, licensed and certified professionals should be sought. In addition, Semi-Retired M.D. does not endorse ANY specific investments, investment strategies, advisors, or financial service firms.

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