Two Big Mistakes made by Passive Investors in Multifamily Syndications

Multifamily syndications can be great for those looking to invest in real estate in passive manner.

However, in an eagerness to jump in and realize the benefits, there are two major mistakes that investors can sometimes make in multifamily syndications.

1. Not Properly Vetting the Sponsor

As investors, we invest in people first and the deal second…period. There are no exceptions to this statement. There’s no, “yeah, but this is such a great opportunity”. And this is especially true when investing passively in real estate.

The reality is that in any business it takes people to execute the plan. Regardless of how hot the market, how strategic the plan, how great the opportunity looks, or even how solid the numbers and returns appear to be. In business, it takes people to execute a plan and strategy with success.

In multifamily syndications, the Sponsor, or Operator, can make or break the deal. A great Sponsor can actually take a mediocre deal and turn it into a great investment with their strategy and execution, plus their attention to relationship and communication with investors.

However, the reverse is also true, in that a poor Sponsor can take what should be a great deal and run it into the ground such that ultimately no one wins.

Therefore, properly evaluating the Sponsor should be a passive investor’s first step when considering a multifamily syndication deal.

While not exhaustive, here is a list of items to review when vetting a Sponsor:

• How do they treat you as an investor? Are they professional and consistent in what they say and how they communicate?
• What is their experience and track record executing the strategy?
• What is their experience in the particular market?
• Are they conservative in their underwriting and analysis?
• Do they invest their own money into their deals?
• Can you find references for them from other investors?

When investing with someone in a real estate deal, evenly passively, you should understand that you’re entering into a partnership for potentially 3-5 years or more. So when evaluating a Sponsor, ask yourself the question, “do I want to partner with this person?”

2. Not Really Understanding the Return Structure and Numbers

Multifamily syndications come with all types of return on investment structures and numbers presented, and these will be different depending on the asset class and strategy, such as Class A, Class B, Class C, Turnkey, or Value-Add.

The structure and most of the associated numbers ultimately represent the various types of returns investors are projected to receive, sometimes also called the “waterfall”. Others indicate the fees received by the Sponsor.

In multifamily syndications, it’s not enough to simply look at the Preferred Returns from distributions or the annual Cash on Cash Return of the deal.

There are three major areas that passive investors should understand when reviewing a deal’s structure and numbers:

1. Cash Flow from Operations (Distributions during the Holding Period)

2. Cash from Disposition of the Property (Sale and/or Refinance)

3. Sponsor/Operator Fees

The following are terms related to deal structure, returns, and fees, that investors should know and understand when reviewing a multifamily syndication:

• Preferred Return
• Capitalization (Cap) Rate
• Cash Flow
• Cash on Cash Return (including Profit and excluding Profit)
• Internal Rate of Return (IRR)
• IRR Threshold
• Equity Multiple
• Acquisition Fee
• Asset Management Fee
• Guaranty Fee
• Disposition Fee

Investor should always do enough homework and due diligence on a deal to ensure that they understand the structure and returns of the investment. For example, while most investors easily understand an 8% Preferred Return paid out quarterly, many do not really understand how the IRR projection may factor into their returns upon sale of the asset.

And as mentioned above, a great Sponsor will provide as much explaining as needed to make sure their investors understand the deal structure and projected returns. So, if there’s something you do not understand, then ask.

Conclusion:

The benefits of being a passive investor or Limited Partner in a multifamily syndication are numerous. However, investors should do their homework and due diligence in order to avoid two major mistakes, which include not vetting the Sponsor and not really understanding the deal’s return structure and numbers.