Does This Syndication Deal “Work”? The RIGHT Return for Every Deal

[This blog is primarily for real estate syndicators but can be helpful for investors and others interested in syndication. For more information on what a real estate syndicator does, check out my prior blog post.]

So, you found a deal but you aren’t sure if it is worthy of bringing to your investors. You ask yourself - does this deal “work”? There are a number of parties that will have a say in whether the deal “works”. There is typically a lender, the syndicator and investors and you must know what return will satisfy each party or the deal will never get off the groundl.

LENDER

The lender is the easiest test. So, how does a lender determine if a deal “works”? They underwrite the deal as follows. First they want to look at the syndicator's proforma and evaluate if it is reasonable. The proforma should have a sources and uses statement and a cash flow statement. They will question all the proforma assumptions such as: are these rents supported by comps?; is the expense ratio high enough?; is the income growth rate conservative?; is the interest rate accurate?; etc. Once a lender buys into the proforma they will look at some key metrics. Typically the two primary metrics are loan-to-value (LTV) and debt coverage ratio (DCR). Each lender has different underwriting criteria for LTV and DCR for each property type based on their appetite for loans. You should be talking to your primary lender (or several lenders) so you know the specific metrics that you will need to meet. Any lender underwriting or commitment will be subject to an appraisal. As such, the syndicator must be prepared to scale back the amount of loan due to a lower value or net operating income (NOI) from an overly-conservative appraiser (a common problem). If your deal meets your lender's underwriting criteria then it "works" for them.

SYNDICATOR

Typically, an experienced syndicator will have a fee / return structure that will fairly compensate him/her for their time and risk. This can vary greatly among syndicators based on how they value their time or perceive the risks of the deal.

What metrics does a syndicator wants to hit for their own profit / income? The syndicator will get an acquisition fee, some management fee(s) (property, asset, etc) that is relatively small and some larger percentage of the back end once a hurdle rate (usually an IRR of 10-20% depending on deal - see below) is met. Since the syndicator is confident in the deal (why else would he bring it to investors) he is confident that there will be a sufficient profit upon disposition of the asset. This also aligns the syndicator's interests with the interests of the investors.

The syndicator is doing this as a full time job and thus, a return on investment/IRR calculation is not an appropriate measure to determine if the syndicator's compensation is appropriate. An IRR shows an investor what his MONEY will earn with no active participation, whereas a syndicator is putting in his valuable TIME and EXPERTISE and FINANCIAL RISK (often personal guarantees backed by personal assets) to generate the return and must be fairly compensated for these contributions.

If the deal is sufficiently profitable for the investors then the deal can be structured to “work” for the syndicator. But what level of profitability is needed for investors?

INVESTORS

So what does it mean that the deal "works" for investors? First the investor must be confident in the syndicator, the deal structure (including investment docs and alignment of interests with the syndicator) and that the deal works for the lender.

Many investors will look carefully at the assumptions and cash flows just like the lender. They will ask the syndicator questions about the assumptions. They will want to know what the effect will be on the return from a change in one variable (say, asset appreciation rate or rent growth rate). They may drive by the property to evaluate the condition and neighborhood or ask a local representative (if investing at a distance) to do this for them.

Once the investor is comfortable that they understand the deal and the proforma, the primary way that they determine if the deal “works” is by using the internal rate of return (IRR). The minimum IRR requirement depends on the selected property type and the syndicator’s particular strategy for profiting from the property. This could be a stabilized asset, in a Class A location, in like-new condition with a high-credit tenant on a long-term lease and earning a 2% cash yield annually (this would be a low-risk, wealth retention strategy). On the other end of the spectrum is a gut rehab / new construction in a speculative location (this is high-risk, opportunistic strategy). There are too many factors for me to address in this blog post (cash flow vs appreciation components of return, investment duration and liquidity, interest rates, etc) but there are books written on how to assess real estate investment risks and how to price risk via investor returns.

THE RIGHT RETURN

The right return is the return that a rational, sophisticated investor will accept for the particular risk and duration of an investment. This is subject to change based on market conditions.

For real estate syndications, a rule of thumb for investment returns is:

Low Risk = Low Return (IRR of 5-10%)

High Risk = High Return (IRR of 11-30%) [Note: I have done a deal with a 30% IRR hurdle rate and it paid a higher than 30% return to investors]

Meeting the investors' risk/return expectations are a key job of the syndicator. These expectations change with the market and with investors' perception of risk/return from other investment alternatives (stocks, bonds, REITs, gold, etc). A syndicator only has access to a limited pool of investors and they may have higher or lower return expectations than the larger universe of rational investors. Thus, the RIGHT return is the one that meets the investors’ expectations. A good way to determine this is to discuss the deal with several investors to get their impression. There is always some measure of "selling" the deal (and the return) to investors but it must be grounded in a clear-eyed analysis of the risks.

Being able to create an accurate financial model / proforma is probably a syndicator's most important skill. Using too aggressive assumptions (high rents & rent growth, low rehab costs & expenses, etc) will demonstrate a great return on paper but will inevitably disappoint investors when the deal fails to meet expectations. On the other hand, being too conservative on assumptions will result in no deals meeting your return threshold.

In summary, to determine if a deal “works” the syndicator needs to prepare an accurate proforma that shows the returns to investors. I recommend using strictly an IRR-based return metric (others may use an ROI or equity multiple, but these don't take the investment duration into consideration so they are inferior means for evaluating an investment). Once it is determined that the deal “works” for the lender and syndicator, the IRR must compensate investors fairly for their risks.