28 Red Flags on a New Apartment Syndication Deal That Should Make You Worry
One of the main advantages of passively investing in apartment syndications rather than being an active apartment syndicator is that you do not need to be a real estate genius.
However, a potential downside is that you are not a real estate genius…
How is this possible? How can this be both beneficial and a drawback at the same time?
Well, it is advantageous because you do not need to invest years into learning the ins and outs of apartments before experiencing the benefits of investing in large multifamily. At the same time, since you do not now the ins and outs of apartments, you must entrust your capital to someone else, an active syndicator, who should know what they are doing.
To reduce the impact of this potential downside, you must know how to screen the team, the market, and the deal.
This third point – the deal – will be the focus of this blog post.
When reviewing a deal, simply locating the projected returns and basing your investment decision on those numbers alone isn’t the smartest of ideas.
Sure, some investors do this. For some, it worked out. But others have been burned.
Once you have qualified the team and have invested in multiple deals, it is less risky to invest solely based on the returns offered. But I still recommend performing at least a high-level analysis of the opportunity.
How do you review an opportunity? Locate the information used, data acquired, and assumptions set when the apartment syndicator underwrote their deal.
To accomplish this, the first thing to do is get your hands on their investment summary (may be called something else, like a market summary, investment package, investment analysis, etc.). You will likely never receive the full underwriting model from the apartment syndicator. Therefore, you will use the investment summary to determine the data, information, and assumptions underlying their underwriting. Anything that cannot be found on the investment summary can be uncovered either during the new offering conference call/webinar or in the private placement memorandum (PPM) before you are required to submit funds.
In this blog post, I want to outline the 28 top red flags to look for when reviewing an investment summary. When these red flags are present, they indicate a “hole” in the apartment syndicator’s underwriting or business plan in general. Regardless of whether these “holes” were created on accident or intentionally, they likely mean that the return projections to passive investors are inaccurate and that you should not invest. For simplicity, each red flag is in one of the following categories:
- Market: the geographic location in which the subject property (i.e., the property to be purchased) is located
- Business plan: the apartment syndicator’s plan-of-action after acquiring the subject property
- Projected returns: how much money the apartment syndicators are expecting to distribute to passive investors
- Debt: money borrowed from a lender to cover most of the project costs
- Purchase and sales assumptions: the “educated guesses” made by the apartment syndicators regarding the acquisition and disposition terms
- Pro forma: break down of the income and expense line items for each year of the projected hold period
- Rental and sales comparable properties: the other properties used to determine rental rates and purchase price (in part)
- Other: miscellaneous red flags that didn’t naturally fit into one of the other categories above
“Market” red flags
1. Stagnant or shrinking population: “people” make up a portion of the supply side of the “supply and demand” equation. The more people moving to a market, the more renters competing for apartment units, and the greater the demand for real estate. If the net migration is negative, meaning more people are leaving than moving in, this is a major red flag.
2. Stagnant or shrinking rental rates: another metric that indicates demand for apartments is the rental rate trend and projections. Ideally, the rents increased more than 2% to 3% annually in the years prior and are projected to increase by more than 2% to 3% annually in the future. Stagnant or, even worse, decreasing median apartment rents is a major red flag.
3. Low Absorption rate: the absorption rate takes the supply and demand of new apartment units into account. For apartments, the adsorption rate is usually a measure of the share of newly completed apartment units that are rented over a three-month period (measured by US Census Bureau each quarter). The higher the absorption rate, the greater the demand for apartments in the market. The absolute absorption rate is important and should ideally be greater than the national average. However, the trend is just as important. A low and/or decreasing adsorption rate may indicate hyper-supply in a market, which in turn reduces the demand for apartments, and is a massive red flag
4. No neighborhood or submarket level data: the investment summary should include a detailed analysis of the market. However, the analysis should be more focused than the metropolitan statistical area (MSA) and city. Depending on how large the market is, they should provide data on not only the MSA/city, but the submarket and maybe even the specific neighborhood. For example, if a deal is in Dallas, TX, demographic, rental, unemployment, adsorption rate, etc, data for all DFW is not as relevant as the same data for the specific neighborhood the subject property is located in. DFW level data is an average of countless submarkets and neighborhoods. Some perform far better and others far worse than the average. The only way to know which category the submarket or neighborhood in which the subject apartment is located is to review submarket and neighborhood-level data. Therefore, if the apartment syndicators only provide data on the overall MSA or city and not the submarket or neighborhood, this is a red flag.
5. Population demographic doesn’t match the property: Generation Z, Millennials, Generation X, and Baby Boomers want different things in rental housing. Therefore, you will want to know who the apartment syndicator’s target demographic will be, what portion of the total population that demographic is, and the trend of that population demographic (is it growing or shrinking?). Then, you want to compare your findings with the type of property the apartment syndicators are purchasing and their renovation plans, if any, to determine if there is a match. The property must match the target demographic. A mismatch, like creating a super high-tech apartment experience with smaller units in a market dominated by baby boomers, is a red flag.
“Business plan” red flags
6. Property doesn’t match business plan: similar to the “population demographic doesn’t match the property” red flag mentioned previously, the property also needs to meet the business plan. Here is a blog post we wrote about the different property classes – A, B, C, and D. If the apartment syndicators claim to be purchasing a Class A property, then it needs to be in excellent condition, fully rented, in a highly desirable market, built (or renovated) within at least the past 5 to 10 years, and have the latest and greatest amenities. If they claim to be buying a Class A property but there is a lot of deferred maintenance, no amenities, outdate interiors, etc., this is a major red flag.
7. Truly a value-add, turnkey, or distressed/opportunistic: the vast majority of apartment syndicators either implement the value-add, turnkey, or distressed/opportunistic business plan. Here is a blog post that covers these three in more detail. For example, if they plan on implementing a value-add strategy, then the apartment should be stabilized and have upside potential. A fully renovated and updated apartment that is fully rented at market rates probably doesn’t have many, if any, value-add opportunities. Therefore, if the apartment syndicators claim they will double your investment in 5 years by adding value to such a property, this is a red flag.
“Projected returns” red flags
8. Guarantee a return: if the word “guarantee” appears anywhere in the investment summary, RUN. This is not only an SEC violation but is also a lie. There is no such thing as a guaranteed return in real estate investing.
9. No sensitivity analysis: a sensitivity analysis is when the apartment syndicators adjust certain metrics to reflect a “best case scenario” and “worst case scenario” and recalculate the returns based on these adjusted figures. For example, worst case scenario interest rate on the loan, vacant, rent premiums after upgrading units, exit cap rates, other income, etc. Oftentimes, the summary of the sensitivity analysis is included in the investment summary package. From the sensitivity analysis, you can get an idea of how much money you will make if the deal exceeds expectations or performs below expectations, which will allow you to make a more educated investment decision. If not included in the investment summary, you can request one from the apartment syndicator. If they will not provide you with at least the results of their sensitivity analysis, this is a red flag.
10. No distribution split details: in addition to any preferred return offered, the GP may also offer you a split of the total profits. While the preferred return is important, since that is the cash you receive each month/quarter during the business plan, you make the largest return based on the profit split (assuming you participate in the upside). Therefore, you will want to know how much of the total profit you receive and how much the GP receives. The most common profit split is between 50/50 and 70/30 (to LP and GP). However, oftentimes, the profit split will change once a certain return hurdle is achieve. For example, the GP may offer a 70/30 profit split up to a certain internal rate of return, at which point the profit split changes to 50/50. You want to make sure that the passive investors are receiving most of the profits, since you are the ones bringing the vast majority of the capital. If the splits are more favorable to the GP or information on the splits are missing, this is a red flag.
“Debt” red flags
11. Total loan term is less than 2x stabilization timeline: a rule-of-thumb for all real estate is to secure debt with a term that is at least two times the projected stabilization timeline. That is, two times the time it takes to complete any renovation projects and stabilize the deal. Once a loan term ends, the borrower must either sell or refinance. By securing debt with a term that is two times the stabilization timeline, the borrower has a cushion if renovations take longer than expected and so that they are not forced to sell or refinance. If the debt secured is less than two times the projected stabilization timeline (for example, a two-year bridge loan is secured and the plan is to renovate 100% of the units in 24 months), this is a major red flag.
12. No cap on adjustable interest rate loan: when a borrower secures a loan with a non-fixed, adjustable interest rate (which is usually adjusted each month), they have an option to purchase an interest rate cap. When an interest rate cap is purchased, no matter how high interest rates rise, the borrower knows that it cannot exceed the cap they purchased. No one knows for certain whether interest rates will remain at the same rate, decrease, or increase in the next five to ten years. Therefore, buying a cap is always a smart move to mitigate that unknown risk. If they did not purchase an interest rate cap, this is a red flag.
13. Refinance or supplemental loan proceeds included in return projections: Many times, especially for value-add and distressed/opportunistic strategies, the apartment syndicators expect to refinance into a new loan or secure a supplemental loan at some point during the hold period. When a refinance or a supplemental loan occurs, assuming you participate in the upside, there is a possibility that you receive a lumpsum profit. However, since refinance and supplemental loans are not guaranteed because no one can predict where the market will be in a year to from know (think people investing in late 2019, early 2020 pre-COVID), these proceeds should not be included in the return projections. If they are, the returns are extremely aggressive and this is a major red flag.
“Purchase and sales assumptions” red flags
14. Exit cap rate is equal to or less than in-place cap rate: one of the most important assumptions apartment syndicators make when calculating projected returns to passive investors is the exit cap rate. This is their prediction on what the market cap rate will be at sale at the end of the hold period. Since no one can predict whether the real estate market will be better or worse in the coming years, the conservative assumption is to always assume the latter – that the market will be worse at sale than at purchase. A “worse” market has a higher cap rate. Therefore, the exit cap rate assumption should be greater than the in-place cap rate (i.e., cap rate at acquisition). A common rule-of-thumb is an increase of at least 0.1% every year. If the exit cap rate is equal to or less than the in-place cap rate, this is a major red flag.
15. Aggressive revenue growth: revenue growth occurs either naturally (via inflation or increase in demand in the market) or forcibly (via adding value), or both. Usually, apartment syndicators assume natural revenue growth of 2% to 3% each year. However, in markets where rents are projected to grow by more than 3%, apartment syndicators may be tempted to set that figure as their revenue growth assumption. 2% to 3% is the more conservative approach, whereas anything higher than that, even when rents are projected to grow at a greater rate, is a red flag. The “forced” revenue increase depends on the business plan. We will revisit this in the section below on rental comparable properties.
16. Same vacancy rate during and after renovations: when an apartment is acquired, depending on the level of upgrades to be performed, a number of the existing residents may decide to leave at the prospect of future rent increases. Additionally, apartment syndicators will usually upgrade units as they turn over (become vacant). They may even “force” vacancies in order to quicken the pace of renovations. Therefore, the vacancy rate usually spikes immediately upon acquisition and doesn’t stabilize until the demographic is turned over, renovations are completed, etc. As a result, apartment syndicators should assume a higher vacancy rate during year 1, and maybe even year 2, before achieving the stabilized rate. If the vacancy rate is the same every year, meaning they didn’t account for the dip in occupancy in the beginning stages of the business plan, this is a red flag.
17. Contingency capital expenditures budget: almost every single apartment syndication deal will have some sort of capital expenditures This budget includes capital to cover the costs of unit interior upgrades, amenities upgrades, adding new amenities, and deferred maintenance. These cost assumptions are based on a variety of inspections performed prior to closing. However, the apartment syndicator will not be able to receive hard quotes until after closing. On heavier value-add and distress/opportunistic deals, additional deferred maintenance may be uncovered once repairs begin. Therefore, apartment syndicators will create a contingency budget to cover any unexpected cost increases. If you review their capex budget and do not see capital allocated to a contingency budget, this is a red flag.
“Pro forma” red flags
18. No explanation for large variances between pro forma and T-12/T-3: the pro forma section of the investment summary should include the most up-to-date income and expense figures over the previous 12 months of operations (sometimes, a T-3, or three months of income and expenses annualized, is included) and a yearly breakdown of the apartment syndicators income and expense projections. Then, they should include notes on what their income and expense assumptions are based on. Some of their assumptions are based on the previous 12 months or 3 months of operations. There should be an explanation for large variance between any income or expense assumption (besides the gross potential rent, which I will address in the next section on rental comparable properties) and T-12 or T-3. If the explanation is unclear or absent, this is a red flag.
19. Real estate tax assumptions same as T-12 taxes: one expense assumption that should almost always differ from the T-12 is the real estate tax line item. Usually, after a sale, the new annual real estate tax is based on the sales price, which is almost always higher than the current tax assessed value. As a result, real estate taxes go up. If the apartment syndicator’s real estate tax assumption is the same, or less than, the T-12 taxes and there isn’t an explanation given as to why, this is a red flag.
20. No upfront or reserves budget: most lenders require a borrower to place a certain number of months’ worth of principal and interest into a reserves account at purchase. Additionally, they require a portion of annual income to be placed into the reserves account. If the apartment syndicator is securing debt, they should already be doing this. But it doesn’t hurt to double check. If they haven’t accounted for this on their pro forma, this is a massive red flag.
“Rental and sales comparable properties” red flags
21. Not a “comparable property”: comparable properties are used to set offer prices (in part) and stabilized rental amounts. Apartment syndicators should include a section in the investment summary about the sales and rental comparable properties used. You should confirm that these are actually comparable properties. Regarding sales comparable properties: the comparable properties should be similar to the subject property in its current condition, not in its stabilized upgraded condition. They should offer similar (doesn’t need to be the exact same) types of amenities. They should have been sold within the past year or two. Regarding rental comparable properties: the comparable properties should offer similar (doesn’t need to be the exact same) type and quality of amenities the subject property will offer once stabilized and upgraded. The unit interiors should be similar in type and quality as the stabilized and upgraded units at the subject property. The units should have been renovated and rented within the past few years. The same fees should be included or excluded from rent (i.e., same parties are responsible for paying utilities). When the comparable properties aren’t actually comparable, this is a major red flag.
22. Market leader in rents or sales price per unit: assuming the apartment syndicator is actually using comparable properties, they will determine an average rent per square foot and sales price per unit for the market. Then, based on that average, they will determine their rental rate assumption and a fair market offer price. The apartment syndicators should not assume that they will achieve rental rates at or above the market leader. Nor should they have the deal under contract at a price that is greater than all other recent sales. Instead, the rental rate assumption and price per unit should be closer to the average – ideally below the average. If they expect to be the market leader or are over paying, this is a major red flag.
23. Comparable properties not nearby the subject property: another important criterion for rent and sales comparable properties are their distance from the subject property. The bigger the market, the closer the property needs to be. In rural markets, a property that is many miles from the subject property is okay. But in a big market the comparable properties should be in the same submarket, neighborhood, or even on the street. Comparable properties many miles away from a subject property in a major metro is a red flag.
Other Read Flags
24. Short investment summary: investment summaries should be long because they are supposed to proactively answer any potential questions an interested investor may have. A short investment summary (less than 10 to 20 pages) indicates an inexperienced apartment syndicator and is a red flag.
25. No risks or disclosures section: since an apartment syndicator is raising money to buy apartments, they work closely with a securities attorney to make sure they are “going by the book”. As a result, apartment syndicators are required to include a “risks” section in their PPM. They aren’t, however, required to include anything about risks in their investment summary. But, when they do, it indicates a higher level of transparency and a trustworthy, professional syndication team. The absence of risk and disclosures isn’t necessarily a major red flag, but by suggest a lack of transparency, trust, and professionalism
26. No GP fee disclosure: in addition to receiving a portion of the total profits, the GPs charge a variety of other fees for managing the asset. These can include upfront fees like acquisition fees upfront, ongoing fees like an asset management fee, and fees at sale like disposition fees. If the GPs are hiding how much or how they are paid, that is a red flag.
27. Typos: another thing that indicates inexperience and a lack of professionalism are multiple typos in an investment summary.
28. No case studies: unless this is the apartment syndicators first deal, they should include a section of “case studies”, highlighting the current deals in their portfolio and past deals already sold. You can review the case studies to determine how the projected returns offered on past deals compared to the actual returns received. This will indicate how aggressive or conservative the return projections are for the current deal. The absence of case studies suggests an inexperienced apartment syndicator or that their previous deals did not meet or exceed their return projections, both of which are red flags.
These are the 28 major red flags to look out for when analyzing an apartment syndication deal.
An important thing to note before concluding the blog post is that all of these red flags are not necessarily a deal breaker. They are a deal breaker when the apartment syndicator cannot offer a satisfactory explanation for why the red flag is present or, even worse, denies that it is a problem.
Learning how to quickly identify these red flags will save you time and save you money when passively investing in apartment syndications.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.