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Updated over 1 year ago, 03/23/2023
Reasons why syndication fails: stories
Hello,
I would be interested in starting a thread where more experienced investors can share their real life experience as to why a syndicated deal they participated in (or not) ended up failing, and by failing I mean not even returning the original capital to the limited partners. I am new to this and I am mostly reading about success stories, so I'm trying to look at the other side of the fence and learn from past failures. Some example of what I am just speculating (since I have no experience) could be failure stories:
- The property was over leveraged
- A larger than expected market downturn caused the economic vacancy to skyrocket, and the debt service couldn't be covered
- The sponsor failed to execute the plan of improving the NOI (why?)
- The mortgage on the property was an interest-only one in order to make the COC reasonable, although by the time the IO period was over, a sell strategy didn't materialize and the increased mortgage wasn't sustainable
- The sponsor was a scam (how?)
- The mortgage was too short and by the time the balloon payment was due, a sell strategy didn't materialize, maybe because the exit cap rate in underwriting was aggressively too low
- After stabilizing the property, it was refinanced in order to partially cash out investors, however the refinance was too aggressive and the NOI ended up not sustaining it?
Thanks!
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#4 Multi-Family and Apartment Investing Contributor
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This is a good story on a subject of failed syndication. It is basically a "how NOT to" syndicate:
https://www.sec.gov/litigation/litreleases/2017/lr23806.htm
There was one that I was asked to participate in that went belly up and all investors lost their investment. It was presented to me by a friend who had a relative who was purchasing an apartment complex in a small town with a military base. The prospectus was top notch and I could see why some folks invested in it. However, the reputation of the syndicator was questionable. My friend bought a share and I did not. The main syndicator used income from the investment to support his lifestyle, going as far as buying a Porsche with those funds. My friend was giddy that he bought the Porsche. I asked him why was he so proud of his relative using HIS funds to buy a Porsche. When there was a downsizing at the base, there wasn't enough reserve funds to keep the property and it went to the bank, leaving every investor with a complete and total loss, including the relative of the syndicator. By the time it was foreclosed on, the syndicator had already moved on and started another business.
I'm interested in these stories too. Thanks for asking this question and I hope there are more responses!
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A little off topic... The most important things that good syndicators have to loose are their investors, their reputation, and their self-respect. That's why I invest with people and the property is secondary.
I think @Mike Dymski brings up a good point.
This industry, like all real estate, has its ups and downs. My take, from seeing members on BP sharing their bad experiences and talking with other investors who haven't been as successful in syndication and they would have liked, it was either tied to poor Sponsor selection or offering selection. It's vitally important to know who you are working with, and have the history of the players involved. I see former players from the 2000's coming back to the industry under different business names, and some of their prior work was less than stellar. It's important to have the advice and perspective of an industry old-timer, in my opinion.
Thank you for the valuable responses so far! It seems that the quality of the sponsor can make a massive difference in the outcome of the investment, and that sounds very reasonable and logical.
It would still be interesting to know some projects that fell because the execution of the deal didn't quite match the underwriting assumptions, learning a few gotchas from real stories could be very valuable.
Thanks again!
I read that link also that Nick B. posted.
First off there is no such thing as GUARANTEED returns or a PROMISE of a certain amount. Run like hell from those people or companies. There are risks in any syndication investment just like stocks or anything else. An investor has to look at the project, the property, and the sponsor and see if it meets their risk level for time lines to exit, expected return, and amount for minimum invested.
Is the syndicator expanding too fast? Are they selective in projects or buying marginal stuff just to keep growing and taking fees?
I have seen some syndicators call marginal areas good ones. Their numbers have also been way off. An investor should do their own research to validate what the sponsor is claiming in reference to the current and future expectations of an asset.
- Joel Owens
- Podcast Guest on Show #47
Gianluca,
Some good comments here and like @Joel Owens additional points. All investments have a certain degree of risk as mentioned, nothing guaranteed...but you want to be in the best possible position to win and weather through challenges. You definitely want to start w/the people involved. See vetting sponsors - top 10 tips link below I culled from my experiences as an insider and investor.
At a high level, its the market, deal and team that drives overall value. Delve into these areas.
1) Market (jobs/pop) growing well above natl avgs and projected to continue
2) Deal - value creation (value add deals only) with a simple business plan that makes sense; and most importantly assumptions are conservative across the board. For example: I like to see the sponsor provide analysis to stress test the deal by showing me what happens to returns when occupancy, rents don't meet forecast under different scenarios.
3) Team has experience in all aspects of the niche and has tenure over the last downturn (review track record).
The blog link below goes much more in depth on above and more - top 10 tips to vetting a sponsor
Gianluca,
When I was looking for syndications to invest in, I had similar questions as you have. It is surprisingly hard to find failure stories and the reasons for failure because very few people publicly admit to failure.
I see certain amount of exuberance in the recent offerings I have come across. The prudent thing I recommend is to choose a syndicator whose integrity is unquestionable and who underwrites conservatively. Do not go by the promise of high returns in the offering documents.
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Originally posted by @Manish Bahety:
Gianluca,
When I was looking for syndications to invest in, I had similar questions as you have. It is surprisingly hard to find failure stories and the reasons for failure because very few people publicly admit to failure.
I see certain amount of exuberance in the recent offerings I have come across. The prudent thing I recommend is to choose a syndicator whose integrity is unquestionable and who underwrites conservatively. Do not go by the promise of high returns in the offering documents.
Hey Manish. The real estate market has experienced one of it's best runs in history. In addition, the commercial market, particularly apartments, self storage, and mobile home parks held up well during the last recession. Fannie Mae had less than a 1% default rate in it's multifamily program. There are certainly many failures...they have just not been as prevalent in recent history. Every cycle is different though and the next one will create new stories. There are ways to help mitigate both market and sponsor risk and they involve work and diligence. We all work way too hard and have too much on the line to throw our money away and the good sponsors take that very seriously.
Good points @Mike Dymski. The default rate on MF loans vs single family was 1% vs 5% nationwide at the 2008 downturn. Eliminate over exuberant / speculative markets live Vagas, Phoenix and Miami and it was more like nil. I was reviewing yesterday a syndication prospectus on self storage and mobile home parks. The operator of the self storage has like 40 yrs experience but in the prospectus there was an adverse event that prompted several properties to go under during the last financial crisis. When I inquired about this it was not due to poorly managed properties or over leveraged properties, simply laws were in place at the time that prevented market specialists (like property managers of CBMS) where the loans are in the hands of investors and their hands were tied. There were no rules in place to enable the specialist to work w/the property owner and investor of the note. Loans were coming due on 5, 7, 10 year notes during that crisis (credit markets were frozen) and essentially little opportunity to get refinancing / workouts. Cash calls w/investors were challenging to get alignment to pay cash and pay off the loans as they were coming due. Lots of property owners in these niches lost properties during the financial crisis, investors lost money and I'm sure many because of frozen credit markets and laws on the books. Since 2013, those laws have been changed to help prevent a repeat performance.
@John B. , great question! Sometimes you can learn more from the failures than the successes, especially when we've been in such a long bull market and success seems easy. On a side note, Paul Moore has a great podcast called "How to Lose Money" where he interviews people on their worst deals and moments. It's worth a listen!
@Mike Dymski nailed it though - invest in the people first, and the deal second. The right people can salvage a bad deal. The wrong people will make a disaster out of even a great deal.
I have one direct personal experience to share with you: Back in 2005, when the single family market was hot, I was working as an engineer, and I had zero real estate experience. I lost probably 80% of what I invested. It wasn't a true syndication, but the principle is the same. This company was selling shares "pre-IPO" and supposedly using the money to develop single family houses on golf courses, etc. My boss invested in it, and I went in largely on the back of his due diligence (he went to their offices, met with the principals, etc.). The real allure was getting a deal on shares that would supposedly triple when they went public. As it turned out, the company had built some properties, but nowhere near as many as they said, they over valued what they had built, and the majority of the money they were bringing in was going to pay fake dividends and for the lavish lifestyles of the principals. I started to smell a rat, but just prior to me asking for my money back the SEC swooped in, shut them down, and took 4 years to seize and liquidate what assets actually existed.
With that said, as a buyer of apartment complexes having looked at many hundreds of deals over the last 6 years, here are some of the reasons for failure I have seen:
1. Partner infighting. Partnerships are like marriage: easy to get into, hard and expensive to get out of. When the partners start having problems, so do the property and investors. Make sure any partners you are investing with have a good track record together.
2. Undercapitalization. This one is way too common. People buy (and in the scope of your question syndicate) apartments and under estimate how much capital they will need to renovate and/or sustain the property. Cash gets tight so they start putting off repairs. Existing good tenants start to leave, and lower quality tenants start to come in. Collections go down further and cash gets even more scarce. The property can go into a death spiral from which it never recovers. So if you're looking at a syndication, make sure they are raising enough capital up front to fully cover renovations and reserves!
3. Underestimating how bad of an area the property is in. Unless you are in the path of growth or gentrification, you can't make a property better than the neighborhood it's in. Crime and vandalism will hold the property back, or at the minimum, people won't be able to afford the higher rents needed to get a good return on what was spent.
4. Banking on market growth to hit proforma. Markets have a tendency to shift quicker than anyone imagines. You want to work with a sponsor that is creating most of the value/returns by bringing a property up to its full potential where the market is today. Any market growth on top of that is a bonus. At the end of this bull market, whenever that is, there are going to be a lot of failed syndications when strong market growth is no longer carrying everyone forward!
I hope that helps!
Andrew
That's some good information. About the company where you invested...my opinion is that there are advantages to investing in a particular deal, an LLC that only exists to own one particular property, rather than an open-ended fund. It just seems easier to analyze one property, and keep track of the operations of one property, while with the second choice, it's too easy for the sponsors to turn it into some sort of Ponzi scheme. Even if the sponsors had no bad intentions initially, if things get rough, they could start taking in new investors and paying out their money as dividends. Sure, you can cook the books on a single property too, but it just seems that it would be easier for an investor to catch some funny business if they are looking at the monthly or quarterly financial statements.
One advantage, I suppose, to investing in a group that plans to have many properties, is the ability to diversify in case there is a problem with one.
I'd be curious to hear anyone else's thoughts.
Thank you very much for your lengthy and valuable reply! And also thank you for introducing me to that podcast, I just took a look at the past episodes and it looks like it's going to be a gold mine of experience!
"How to Lose Money" by Paul Moore. Haven't started listening yet since I just learned about it last night, but the episode list seems so juicy!
I bought a note where I was offered 9% cashflow and 50/50 split of the property. I found out the guy never paid the taxes and I had to take it over via deed in lieu. Should I asked around my peer group I would have heard that this guy did this all the time.
Originally posted by @David S.:
There was one that I was asked to participate in that went belly up and all investors lost their investment. It was presented to me by a friend who had a relative who was purchasing an apartment complex in a small town with a military base. The prospectus was top notch and I could see why some folks invested in it. However, the reputation of the syndicator was questionable. My friend bought a share and I did not. The main syndicator used income from the investment to support his lifestyle, going as far as buying a Porsche with those funds. My friend was giddy that he bought the Porsche. I asked him why was he so proud of his relative using HIS funds to buy a Porsche. When there was a downsizing at the base, there wasn't enough reserve funds to keep the property and it went to the bank, leaving every investor with a complete and total loss, including the relative of the syndicator. By the time it was foreclosed on, the syndicator had already moved on and started another business.
Wow, that is straight up securities fraud. Total misappropriation of funds. Did anyone litigate?
Originally posted by @Lane Kawaoka:
I bought a note where I was offered 9% cashflow and 50/50 split of the property. I found out the guy never paid the taxes and I had to take it over via deed in lieu. Should I asked around my peer group I would have heard that this guy did this all the time.
Agreed on peer group. I think its always important to call around and ask about the sponsor and management.
As an attorney on a lot of these deals, I've seen some weird stuff as well. Here goes:
1) Humans: No matter how perfect the deal is, the property is only a part of the equation. The sponsor/management team is so important--not just to save the deal, but to be rational, good business partners. I once saw a husband + wife + business partner team blow up because the husband passed away. The business partner, for whatever reason (some suspect she had an affair with the husband), went around to get all the investors to sue the wife. Doesn't even matter if its a family-family team--emotions can often defy rationality, and when that happens, things go sideways.
2) Undercapitalized & Poor leveraging strategy: They didn't raise enough. They couldnt get another loan. They didn't prepare for the possibility of a downturn. Don't be caught unprepared. Always prepare for the worst scenario.
3) Lack of experience: If its a beginning syndicator who isn't pulling together a team of more experienced folks or coaches or mentors, there's a higher risk of failure.
3) Lack of formality/Lack of Deal Structure: Handshake agreements or, my favorite, the "I pulled this template off Google and edited it myself". When there are no documents, there is no signed document to point to and say "you agreed to this" when an investor comes in the future demanding this or that. Similarly, I've seen some folks draft up their own stuff. Sometimes its not clear what the investment structure actually is (and it doesnt help if the sponsor is deceased), or they screwed up their structure and sponsor/investors are no longer economically aligned to perform.
I found a video you might like, Gianluca. No real examples but it's a general overview of why syndications fail and how to avoid them.
http://www.valuehoundacademy.com/public/VIDEO-TRAINING-The-4-Biggest-Mistakes-New-Syndicators-Make-and-How-to-Avoid-Them.cfm
I'm just adding my two cents here in light of the recent downturns in the market with the increasing interest rates. The three syndications I am in right now, two are doing okay and the the other is doing great.
The two multifamily deals I am in are having a cash crunch from their bridge debt due to rates, and will need to raise funds to remain solvent if and when they get fixed debt. They are in great markets (Houston & Austin) and the operators are doing a great job getting occupancy into the 95% range so there is potential to refinance out in 90 days. It's just a little nerve wrecking because I lived through 2008 and I'm somewhat shocked that neither syndication didn't buy extended rate caps. Glad they did buy the shorrt term rate caps. Each deal is expected to be held for 5 years.
The last syndication I am in is a homerun. It's a land development deal in Mustang Ridge near Austin. It is doing well, the city is giving us great work when it comes to utilities. The interest rate on the debt is mostly fixed it seems. The great thing is the exit is in three years.
Quote from @Rob Birch:
I'm just adding my two cents here in light of the recent downturns in the market with the increasing interest rates. The three syndications I am in right now, two are doing okay and the the other is doing great.
The two multifamily deals I am in are having a cash crunch from their bridge debt due to rates, and will need to raise funds to remain solvent if and when they get fixed debt. They are in great markets (Houston & Austin) and the operators are doing a great job getting occupancy into the 95% range so there is potential to refinance out in 90 days. It's just a little nerve wrecking because I lived through 2008 and I'm somewhat shocked that neither syndication didn't buy extended rate caps. Glad they did buy the shorrt term rate caps. Each deal is expected to be held for 5 years.
The last syndication I am in is a homerun. It's a land development deal in Mustang Ridge near Austin. It is doing well, the city is giving us great work when it comes to utilities. The interest rate on the debt is mostly fixed it seems. The great thing is the exit is in three years.
Thanks for sharing Rob. What were the original debt terms on the deals that are struggling?