TL;DR: Investing in syndicates can be overwhelming with the wide array of options available. To do it well, focus on a few markets and strategies, then follow a clear checklist of GP and deal diligence before putting any money to work. You want to make sure the GP is the right partner for a given market, and you should make sure you understand the specifics of the deal as if you were buying the property yourself. With the proper approach, syndicate investing can offer great returns and diversification. It just requires discipline in your approach to help protect your downside.
I’m a big fan of investment rules. They keep you grounded and focused when you might otherwise lose your cool. I’ve previously laid out my investment rules to live by, along with the more specific real estate investing rules I follow. As I was writing up my thoughts on the world of syndicate investing, I felt it might be helpful to codify the approach I use when evaluating a deal. Generally speaking I use a three step process:
- Market & Strategy: Is this a market and strategy I am targeting?
- General Partner (GP): Is this GP a good partner for this market and strategy?
- Deal: Is this deal a good one given the risk and reward profile?
The goal of the process is to identify a deal in a target market, with a competent GP, that offers an attractive risk reward profile for the given strategy and market. If at any of the stages the answer is no, I walk away.
Once you get your deal flow going, you’ll realize there are a ton of opportunities out there. You don’t need to swing at every pitch, so take your time and wait until the right opportunity comes along. For starters, I’ll track any deal that is remotely interesting in my Syndicate Screen Sheet – this is a simple way to keep track of the various deals that come across my desk. It helps me run some quick back-of-the-napkin math on the deal. It also gives me the benefit of providing a record of all the deals I’ve seen, which is helpful when trying to compare whether a new deal looks attractive based on risk profile, upside potential etc.
Once I’ve identified a deal that I’m interested in from the screen sheet, I’ll take it a step further and do a deep dive using this investment checklist (request access to the checklist from ramen [at] ramenretirement.com). I walk through this checklist on every deal I invest in – this keeps me honest and forces me to answer the tough questions I might otherwise brush aside in my rush to do another deal. Also, it gives me a record I can look back on in the future where I can assess why I made an investment, and whether I was thinking clearly and investing safely. Take a spin through the checklist yourself and feel free to use it if it might help you with your investing.
The Market & Strategy
As mentioned above, once you have inbound deal flow, you’ll quickly find there are way more opportunities than you could ever review, let alone invest in. You need a good filter up front to focus your efforts. Targeting specific markets and strategies is the best way to filter out the noise.
Start with your strategy
I recommend figuring out your investment strategy first, a topic I covered extensively in another post. What type of properties will you invest in? What type of returns are you looking for? How do you expect to generate that return? For example, my main focus for syndicate investment is on residential multifamily properties that offer a mix of yield and appreciation through a value add approach. I’m looking for relatively conservative deals that will be able to weather a downturn well should that hit us in the next couple of years.
Choosing the right markets
With a good handle on what you’re looking for, finding the right markets will be a lot easier. One of the main benefits of syndicate investing is that you can diversify across multiple markets relatively easily, so I typically have a short list of the top five markets I am interested in at any given time. Generally speaking, I look for a mix of yield and appreciation, which has me focused on three broad market personas:
- Sprawling metros
- Small town growth
- Slow & steady markets
The current list of markets I’m interested in includes San Antonio, Madison, Kansas City, Indianapolis, and Cincinnati.
Another thing to keep in mind as you make your list is your portfolio balance. If you’re already heavily invested in a particular market, you might take it off your list for a while until you can place bets elsewhere.
Filter your deal flow
So now that you’ve narrowed your search down to a specific set of strategies and markets, the next thing you do is wait. Wait until a deal that fits your criteria hits your radar. If you’re getting multiple deals a day then you probably haven’t filtered heavily enough. Ideally, you’ll review at least one or two deals a week that hit one of your target strategies and markets. That’s a good cadence to help you get a handle on the range of expected returns, operators, expectations etc. That’s the goal at this stage – get familiar with the range of opportunities out there, so you can start to form a point of view on what the good ones are. You should be noting the ‘projected returns’ (and composition of those returns – yields? appreciation?) offered from the various different strategies and markets you follow. Once you’ve seen at least 10-20 deals, you should have a better sense of what ‘market’ returns look like, and this will help you further filter deals up front if they don’t hit your targeted returns, or return composition.
The General Partner
Once you’ve got good deal flow, and you can assess whether a deal meets your expected returns for a given strategy and market, you need to go a layer deeper by evaluating the GP. The goal in this evaluation is to determine whether this is a good partner for this particular market. I try to answer a few key questions:
- Are they a relative expert?
- Have they performed in the past?
- Are their interests aligned with the Limited Partners (LPs)?
- Are they trustworthy?
The whole point of investing in a syndicate is that you get access to the expertise of a local operator who is intimately familiar with the target strategy and market. The two things to look for here include:
- Past experience and activity of the GP leadership – what have the principals of the GP been doing for the last ten years? Ideally they have been doing the exact same thing for the last decade or more – i.e. investing a similar strategy in this market or a very similar one
- Current footprint – what investments does the GP have in the target market today? Ideally they are one of the major players in the market with multiple existing properties under management. If they are one of the ‘big fish’ in the market, then they’ll be seeing the best deals in advance, they’ll have the scale that will help reduce management costs, and they’ll have the insight into market dynamics to ensure they’re getting the best deals on purchase and sale. This isn’t a hard rule, but all things being equal, I’d rather invest alongside someone who owns 10 other properties in the surrounding area, as opposed to someone who is doing their first deal in a given market. I don’t want to pay for their education
The GP should provide information on past performance of deals they’ve completed. This will give you some confidence that they’ve been able to execute against their strategy successfully. Ideally, you’ll be able to see how they performed through an entire market cycle – i.e. if they were investing pre-2007, how did their deals perform through the 2007-2012 downturn? Since?
You want to know that the GP is motivated to make everyone money. This means two things:
The right fee structure – You want to make sure the GP isn’t getting rich on management fees. At most they should be earning enough to cover modest expenses and keep the lights on. The bulk of their compensation should be driven by performance fees. Some general rules for fees are as follows:
- Acquisition / disposition fee: For sourcing, buying and selling the property. Should be 1-2% or less of the property price
- GP management fee: Sometimes they’ll charge a management fee on funds invested (shouldn’t be more than 1%), or a fee on gross revenues (a few percent), or some mix of both
- Property management: Sometimes the GP is also the property manager – this is okay, just make sure they’re giving you a good management rate. Five percent or less is pretty good
- Performance fee: Expect the GP to take 20-30% of profits beyond a preferred return that LP investors receive before the GP earns any performance fees (typically 8-10%)
Healthy co-invest – For added downside protection, the most important thing is a healthy GP co-invest. Sure, the GP will benefit if things go well through performance fees, but I want to make sure they will feel the pain if things go poorly. This is the best way to make sure they are thinking about risk management and downside protection. Personally, I prefer deals that have 10%+ GP co-investment. Anything less than that and I wonder why they aren’t as excited about the deal. If I see a high GP co-invest, I get very interested. Of course, keep in mind the age and expected assets of a given GP operator as well – if they’re younger they might not have as much wealth to invest, which could make a lower GP co-invest more reasonable, as long as you think it makes up a meaningful share of their net worth.
The last thing I think about is how trustworthy they seem to me. This is admittedly a highly subjective exercise, but I try to assess three things:
- Stability and predictability – First, do their past experiences, career moves, accomplishments and credentials suggest a stable, predictable future? Does their story make logical sense? Joining a syndicate means we’ll potentially be partners for the next 7-10 years, so I want to know they’re going to stick around and see things through
- Career capital at risk – Are they deeply invested in their career and relationships? Do they stand to lose a lot should their reputation become damaged? I want to know that they have much more to lose in terms of reputation and future earning potential should they mess things up on a deal. It’s what people do when shit hits the fan that matters, and only people who are committed and ‘all in’ on a particular path will have the staying power to do the right thing
- Authenticity and trustworthiness – this is the most subjective part of my assessment, but I will certainly listen to my feelings about the person. I will listen to my animal instincts. After hearing them speak or connecting with them directly, are there any flags thrown up? Any lingering doubts that you can’t quite articulate? Being able to trust people has always been integral to human survival, so our brains have been wired through eons of evolution to detect minor inconsistencies that might point to deeper issues. I can’t tell you how to do this, but can only say that if you have a bad or negative feeling about someone, listen to that instinct and walk away. There will be other deals.
This last part around trustworthiness is hard to assess through an offering memorandum, so try to connect with the GP at some point during your diligence. I like to prepare a set of questions (some quite detailed) and see how they respond. If they respond in a thorough, professional, thoughtful, and upfront way, then that tells me a lot about how they will probably react throughout the life of the deal. If they are scattered and evasive, that also tells me a lot. I act accordingly.
Once you’ve found a deal that meets your high level criteria, and you feel good about the GP, you can settle down to do your final analysis. As mentioned, the high level metrics for the deal have already passed your test – the expected cash on cash returns and annualized rate of return look attractive given the investment strategy and market. For example, you might say that an 8-10% cash on cash yield, with a 20% annualized return is a good deal for a multifamily value-add strategy in the Dallas market. The goal then is to pressure test the assumptions that arrive at that numbers so you can get comfortable with the deal.
Understand their assumptions
First simply seek to understand the assumptions that are driving deal economics:
- What are the drivers of operating profit?
- Rental rates?
- Operating expenses?
- What capital expenditures are expected?
- What are the target financing activities and rates?
- What sort of cap rates are expected on sale?
Model out which of these items contribute most to value creation in the deal. Is it all about driving up rental rates? Reducing expenses? Or is there an assumption baked in around exiting the deal with a favorable cap rate?
Pressure test their assumptions
Once you understand all the assumptions the GP is making in their deal projection, pressure test each of them. With the drivers of operating profit, look for proof that the building can improve performance in the future. Also seek to understand why it is not performing today. Is the building just outdated and in need of a facelift? Is there an unattractive tenant profile today? Could the property value be enhanced with some select amenities? Is the current owner inefficient in operating things?
If they’re projecting rental rate increases, what makes you believe those will materialize? What are comparable properties renting for in the area (check out Zillow, Rent Jungle, and Rentometer)? Have any properties been recently upgraded to achieve higher rents? How will the target property compare to those other assets? Are the proposed rental rate increases realistic? Don’t give much credit to ‘inflation’ in rental rates – just look at the potential movement from current rates given other market comps, then discount that potential to give yourself a cushion.
How does this property compare to others in the area? What is the general vacancy rate for that zipcode? What reason is there to believe the operator can increase occupancy?
Competition & replacement cost
Markets are dynamic. Always changing. What competition is on the horizon for the target property? What is the forecast for building and permits (see my market report for this)? Is there likely to be an influx of supply during the investment hold?
What is the replacement cost of the target building? Buying at a discount to replacement cost is a great way of protecting the downside – aim for at least 20% or more below replacement cost to be safe. That way, it’s unlikely new supply will come on the market that is able to compete with your property.
For any material expense reductions, what makes you believe that is possible? Property management is one big area where efficiencies can be gained. Is there a reason to believe your GP can operate more efficiently? Any comparable examples of operating expense reduction from similar properties?
Are the planned expenses realistic? Are they spending on the right things that will help drive the largest rent increases?
How much leverage are they using? What is the expected coverage ratio over the life of the deal? What sort of rent or vacancy rates would trigger a default?
What rates are they assuming? Is that debt assumable in the future? Are they predicating certain returns on the ability to refinance the property at some point? What sort of interest rates are they assuming for that future financing? Are all of those rates reasonable given the interest rate trends and macro economic environment? In early 2018 I am expecting interest rates to continue their rise, meaning any deals predicated on cheap debt in the future need to be questioned more seriously.
Lastly, what sort of sale price are they predicting? Is that an expansion or compression of cap rates? If the cap rate is compressed, what makes them believe someone will pay more for the same amount of earnings in the future? How will interest rates affect cap rates going forward? Generally speaking I like to see cap rates on sale that are higher than the current market. I don’t like assuming that there will be someone willing to pay more in the future.
Model out a worst case scenario
In addition to pressure testing each set of assumptions, I also like to model out a few worst case scenarios. What if we have 2007-2012 repeat all over again? What would happen to operating profit and deal economics in a situation like that? What would have to happen for the property to become cash flow negative or trigger a default with the lender? What if rents fall? What if vacancy spikes? What happens to returns at different exit price assumptions?
Bringing it all together
So to wrap things up, a great syndicate investment requires the right mix of market, strategy, GP, and Deal characteristics. Just because a deal is presented to you in a shiny powerpoint presentation, doesn’t mean it’s a great deal. Anyone can pay someone on Fiverr to make slides that look pretty. Don’t take that information at face value. You need to do your own diligence on every aspect of the deal, as if you were running things yourself. Hopefully, if they’re a good GP, they’ve done a lot of the legwork, meaning you just have to pressure test their assumptions and include a sufficient margin of error.
Once you’ve done your diligence you can decide whether the deal still makes sense. Are the numbers realistic? Is there potential upside that could make it a home run? Is there good downside protection if the market takes a turn? Do you know what assumptions need to be true for everything to work out well? With that information in hand, you can make an informed decision and sleep well at night.
Syndicate investments can be a great vehicle for investment and wealth creation, but they still require work up front. Put in the effort and it will be worth your while.