What do you syndicators do in down markets?

Question

Just curious - I've never been part of a syndication either as an investor or the syndicator. We own our own stuff directly, and thus can simply ride out long down cycles (as long as we are not over-leveraged) and continue to collect the rent.

These syndication deals which have expiration dates seem inherently risky to me - I guess you got free equity for putting the deal together so there's no downside for yourself. But how do you convince investors that their best move is a locked in time period of X years?

Nobody can predict where the market or economy will be in 5 years - if everything goes to hell right at your scheduled sale/exit then that would be the worst possible investment move - the right move would be to hold on, let the property keep paying for itself, and ride out the cycle.

So again, I don't see how syndication deals hedge against this possibility, unless they have some built in clause that says "we won't sell in a down market." Is that how they are actually structured?

Brian Burke · Answer

@Chris Reeves you are absolutely right--a syndication, or any investment, whether real estate or not, would be risky if it had an exact fixed term.  It's just a bad idea.  So what do syndicators do?  And how do you as a passive investor protect yourself against this risk?

The first question has no single answer. Every investment sponsor is different.  Some employ a very linear strategy, in that they always operate with the same strategy in the same asset class with the same geographical focus. They don't have the insight to forecast markets, lack respect for downside (because they haven't been around long enough to have experienced it), and underwrite to the best-case scenario.  Others change their strategy and/or asset class or geographic focus in response to economic indicators.

As to the second question, your self defense is in your sponsor selection.  Due diligence on the sponsor is one of the most important components of a syndicated investment decision.

While I can't speak for what other sponsors do, I can directly answer your question relative to my own personal experience.  I don't have fixed exit dates. An investment is a living, breathing, fluid process and our job as the sponsor is to pay attention to prevailing conditions. I tend to acquire multifamily property in markets with a compelling growth story (of course the future is uncertain but it pays to begin in the right direction), improve the property to bump the income in the front side of the investment, then monitor for the optimal exit point.  I can model out for ten years and see which year will yield the highest IRR and forecast a sale in that year, but when conditions change (and they will) I can sell early or hold longer.  Because of where we are in the cycle, I'll typically write my offerings with a ten year hold, but the strategy of "buy, reposition, and watch for the optimal exit" does not change. The ten year term just ensures that I don't get backed up against a wall, as I would if I wrote it as a three year hold.  Extension options available at my discretion provide additional insurance.  Thus, I can implement a three-year plan but have a twelve year sunset.

Finally, I would be remiss if I didn't address your statement that "you got free equity for putting the deal together so there's no downside for yourself."  I think that statement accurately portrays the thought process of some investment sponsors and underscores why sponsor selection is so important. The passive investor has to weed out sponsors with that attitude (which is easier said than done).

I had one property that I acquired in 2008...it was in receivership and I paid half of what the previous owner paid.  It was a great deal, or so it appeared.  It started off tracking exactly along with projections but then the Great Financial Collapse sucked the wind out of the world, and out of my property.  This property was hit especially hard, dropping from 95% occupancy to 60%.  It got to the point where the property's income covered the operating expenses, but not the debt service.  As a result, I funded the $15,000 monthly debt service out of my own pocket for over three years.  I was faced with a double-downside.  A big financial hit personally (to the tune of $15K/mo), or a hit to my excellent track record (which facilitates my livelihood) and a loss to my investors.  Ultimately I put more money into supporting that deal than my investors did to acquire it.  But on the other side, we got to sell in better conditions and my investors not only got their money back, but even managed to make a profit, and I recouped all that I put in.  So...there can definitely be downsides to being an investment sponsor.  Making investments in real estate, whether with your own money or funded by investors, must be approached with the utmost care, planning, and contingency plans.

Jay Hinrichs · Answer

@Chris Reeves  Not at all my area of expertise.. however I have been around a few syndicators over the years.. and the general partner usually has some pretty good discretion in the event the sunset and subsequent sale is not optimal.

And I imagine the sponsor could just go back to the investors for a vote to see what they want to do.

I have seen though fixed debt get called in the last GFC... with owners that were on 5 year call notes ... having their notes called because the bank was not in a position to roll it over.. Or the bank got taken over and all of a sudden your dealing with a successor in interest like Rialto... Many big boys bit the dust because of the lack of liquidity in the market and they could not refinance.. thinking Opus... Here in Oregon Ken Harter ( largest owner of assisted living facilities in the US).. He then became the largest BK in the history of this state.

Many of the folks syndicating today only started after the GFC.. someone Like Brian would be a guy who worked on both sides of that disastrous economic climate and as he stated to save his rep and client base he had to feed the deals.. those that did not feed them lost them. those that did suffer that pain came out the other end much stronger.  you talk about loyal clients ....

Sponsor experience and wherewithal and liquidity are important factors in these deals in my mind..

Joel Owens · Answer

About the longest commercial debt tends to be 10 years. Most asset classes cycle every 10 years or sooner. Not all asset classes cycle at the same time.

There are generally 2 types of syndications. Stabilized and value add.

Stabilized is a set return to the investors and buying at a certain cap rate. The hope is to time the cycle where you get rent increases and cap rate compression. Then you can sell off in 3 to 5 years for a premium.

Value add is maybe getting something 50% occupied at a 6 cap on existing income but by 90% occupancy you have a 10 cap that you sell in the market for a 7. Your debt service is so low to the cash flow it produces that even a refi at a higher rate will not impact the property that negatively.

If you have a 10 cap and debt goes from 4.6 to 6 it's not good but not the end of the world. If you bought at a 5.5 cap to just give dividends to your passive investors and you need to refi at a 6 then you can run into issues. Each cycle hits a peak and then a decline. Sometimes you can buy something at a 6 cap fully stable with under market rents and increase rents and decrease costs to get an 8 or 8.5 cap etc.

The syndicator you are planning on investing with needs to plan out exits and return of capital to the investors.

I think a lot of stuff people are nuts paying those prices for things. There are still good deals you just have to hunt for them and act fast.

Ben Leybovich · Answer

At this point in the cycle, anything less than 10-year horizon is just stupid - that's one thing. And the other is that now we have to discount the hell out of things :)

Carlos Flores · Answer

I've never seen a fixed disposition date, and would never write a deal that way.

One way to hedge is to ensure the debt's maturity date far exceeds the anticipated hold period.  For example, a 10 or 12 year Fannie on a 5 year deal.  On the flip side, you'll pay a prepayment penalty (yield maintenance) to exit early or the note will have to be assumed (which shrinks the buyer pool). Everything has a trade off in this business.

Jeff Greenberg · Answer

Our deals have a window that we are aiming for, but the descretion as to when is still up to the sponsor. We would, of course, take into consideration the needs and desires of the investors.  We also have the option to refinance if the timing is bad.  This is the case in commercial deals in general, not just syndicated deals.

Trevor Ewen · Answer

@Chris Reeves

One of the great advantages of syndication is that it usually exposes an investor to a class of real estate they had no access to prior. That being said, putting all your eggs in one basket is super risky, no matter what the investment. For instance, many Americans (prior crisis, but some still) pour the vast amount of their net worth into a primary residence: Risky.

Some people invest only in domestic blue chip companies: Risky. Some people thinks stocks are too volatile and only invest in bonds: Risky. Perma-bears love precious metals, and try to stay primarily in these physical goods: Risky.

I think a diverse and balanced approach is your wisest path toward financial health and asset protection. If you are riding on a single syndication to fund your retirement, then I think you are in classically risky territory. If you can think of them as part of the broader strategy, it's very likely that 20% will have a rough(er) outcome (just based on a simple Pareto estimation). The trick is to view it as a part but not the entirety of the portfolio. Just my two cents.

Account Closed · Answer

Excellent advice, I will surely use it.

In the syndication deals I've seen offerings on, none had sure-fire sale dates. Many of them noted that it was a 5-7 year play but I don't recall seeing a date where everyone would get cashed out. I'm not speaking from experience since I've never done one. But it sounds foolish to state early on that there will be a sale date, just like your Coca Cola example.

Regarding buying at insane cap rates, sadly in the Bay Area, it's all at <4% ish. But there are always forced appreciation deals

Account Closed · Answer

I'm curious to see the responses here. I have been doing all of my deals on my own (mainly buy and hold 4plexes in the SF Bay Area) but as I am growing I have a few friends and family interested in investing with me as partners. This is leading me to look at larger commercial apartment buildings and I've been studying on the topic of syndication.

The scariest part of syndication (at least for commercial property) is being forced to sell/refinance due to the fact that most commercial loans are structured as balloons. Like @Chris Reeves states, there is usually an expiration date or possibly a balloon date coming and the worst possible scenario would be having to sell or refinance in a down market.

I'm curious to hear what others have done.

Chris Reeves · Answer

First, I say go for it in terms of buying apartment buildings. I can't tell you what to do with partners - we play only with our own capital and have never taken on investors. I'm not saying that's right for everyone but it keeps our motives pure. I can tell you the way we deal with this risk is to:

1 - Not buy at insane cap rates on small spreads

2 - Be quite conservative in terms of leverage. My family's been in this game quite a while and have thus seen disgustingly ugly financial crises. We are not as aggressive as some other people and I'm sure we're not as successful as some others. On the other hand we've never gone bust - even during times when we've lost 30% of a tenant base and had to drop rents 20% in addition. And that's because we were conservative with leverage and never bought at the top of a market.

3 - Maintain a *lot* of liquidity in other investments so we can feed the properties if necessary, and like you said pay off the notes if refinancing is not available.

4 - Never bite off more than we can chew. In the early days that meant not buying more property than could be saved/fed in case of market disaster with salaried income from day jobs - no matter how tempting the deal. Now that we are bigger it means not buying any one deal that could take down the portfolio if things go south - no 2nd mortgages to buy other deals. And we only do no recourse financing.

I realize this is easy for me to say - for someone starting out in the game with not a lot of capital and nothing to lose then maybe aggressive leverage and syndication makes sense.

Syndication could make sense even if you *do* have a lot of capital - but the idea of a locked in sale date just seems insane to me. It's like asking your friends to all buy a share of Coca Cola stock together and saying "But we are going to sell on January 25th 2021 no matter what the price of the share on that date."

What do you syndicators do in down markets?

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