Risks Involved in Private Real Estate Funds and Syndications
Source of Returns: Real Estate Syndications / Funds have three potential components of return:
- Cash flow the properties generate from rental activity
- The value added by the developer/sponsor
- The market changes in price.
Cash flow from rental activity is the source of return with the lowest risk and fastest distribution to partners. Value added by the sponsor (renovation, better tenants) and market change in price take longer to distribute and often require the sponsor to refinance or sell the property.
Liquidity Risk: The investor in a real estate syndication or private fund should earn a premium for this being a private investment. Unlike a publicly traded Real Estate Investment Trust (REIT), the investment can’t be sold at the current market value at any time. The fund or syndication prospectus should define the hold period. Five years is a good starting point with a wide range of distributions on either side. Single project syndications related to development / redevelopment should repay faster. Lower risk profile transactions (high quality building, high quality tenants, high price) tend to have longer hold periods.
Management Risk: These transactions are typically with a smaller/entrepreneurial business. Evaluating the management’s experience in managing similar property types, developments, and geographic experience matters. The deal by deal syndication opportunities can be similar to investing directly into a small business. How detailed are they in providing past return information on all projects and not just picking their best performing ones? How did they treat their partners in a project that went wrong?
Development Risk: The higher risk / higher return opportunities often include a value add component. It could be complete ground-up development or buying a property for a turnaround. Many of the institutional investors will sell an asset when it’s due to renovation and releasing and shift that risk on to an entrepreneur who can give the asset more focus.
If the investment is made directly with the entrepreneur, the limited partner typically has a phone call with the general partner/management team to go through a question and answer session. This could also be taken care of by an allocator such as a crowdsourced platform or through a wealth management shop.
You will usually want to ask for both experience and financial disclosure from the General Partner in a development transaction. How much are they co-investing in the transaction? How many similar properties have they brought to market? If something goes wrong, additional capital calls will quickly dilute the project’s return.
Property Type: A specific transaction syndication or a real estate fund exposes the investor to property type risk. Industrial, Office, Retail, Multifamily, Self Storage, Cell Towers, Data Centers, and Hospitality all have their own set of risks. Typically a sponsor will specialize in one property type and perform well in that type of property, but as an investor you may want to spread your risk around in a couple of property types.
Investment Type: Is this a debt or equity investment? Equity investments have more upside with a greater risk of loss. Debt funds/debt investments have their upside capped in exchange for a better outcome in the event of an unsuccessful investment. Distressed debt funds are a specialized hybrid of the two.
Tenant Risk (office/retail/industrial): What is their tenant mix? How long are the leases? Are there any credit tenants? How well does the General Partner understand this in a deal?
Capital Deployment (specific to funds): Can the fund execute on it’s goal? If you are looking at a transaction specific syndication, the deal is already under contract and either it closes with your money or it doesn’t close and you get your funds out of escrow. A real estate fund can require committing capital capital for properties/deals not yet found. When are you asked to commit capital as an investor? When are you asked to contribute to that capital? What is the window for the investor to do something with that capital or return it? What is the risk of management “stretching” for deals just to keep the capital under management?
Aligned Interest (the sponsor’s investment and fees): How much is the sponsor investing in the deal or fund? How do they get paid? Are they taking significant fees out of the transaction in addition to their share of the profits? I prefer transaction structures that pay the sponsors a management fee that allows them to operate the business, then pays very well when a transaction or fund is successful. Success means the limited partners earned what they were promised or more in a deal.