7 Ways You Can Lose Money Investing in Commercial Real Estate Syndications
Just like there is no guarantee that you will make an X% return when investing in commercial real estate syndications (or anything), there is no guarantee that your full investment will be preserved. While it is unlikely, it is possible that you lose a portion or all of your investment when investing in commercial real estate syndications.
One of the main goals of the Best Ever brand is to provide passive investors with an education on how to preserve and grow their capital. In this blog post, we will go over 7 ways you could potentially lose money, as well as the solutions to make sure you keep your full investment.
1. Bad Operator
One of the three major risk points when investing in syndications is the operator. They are arguably the biggest risk point because they control the two other major risk points (the deal and the market – more on these below). Therefore, the most common way to lose money is to invest with a bad operator.
An operator can be “bad” for many reasons.
- They lack experience: You invest in one of their first deals and they fail to implement the business plan properly.
- They have an inexperienced team: They hire a property management company that doesn’t have a track record managing this type of investment, for example.
- They lack transparency: They don’t provide frequent updates on the investment, including actual financial reports, so you don’t know if or when something has gone wrong for months.
- They aren’t actually an operator: They are a co-GP or owner of a fund but aren’t actually the operator of the investment. This isn’t always bad but would be a problem if the “operator” misrepresented their involvement in the investment.
These are just a few examples. The point is that their lack of expertise could result in the investment failing and you losing a portion or all of your investment.
The solution: Learn how to properly vet the operator and their team (here is a guide for how to do so). Proper vetting can help you quickly uncover an inexperienced operator.
2. Untrustworthy Operator
It is one thing when the operator is bad. An untrustworthy operator is a different story. You could lose a portion or all your money due to fraud. You could invest your capital and the operator disappears. You could invest in a Ponzi scheme. Losing money due to a fraudulent operator is rare, but still possible.
The solution: Review their past performance and track record. Speak with people who have invested with them in the past. Perform a background check using the Better Business Bureau, Google reviews, and the 506 Investor Group.
Also, invest with multiple operators. You could do all the due diligence in the world but still invest with a fraudulent operator. By diversifying your investments, if one operator ends up being a fraud, only a portion of your investments are exposed.
3. Bad Deal
The second major risk point when investing in syndications is the deal. You invest because the projections of a deal meet or exceed your return goals, but the actual returns are significantly less. Or, the business plan fails and you lose a portion of your investment.
This typically happens due to poor underwriting assumptions. For example, the operators assume the market will be the same or better at sale. They base their rent growth assumptions on historical rent growth or “expert” forecasts. They expect to cut operating expenses or increase other income without adequate justifications. They vastly underestimate the capital expenditure costs and/or timeline.
Another possibility is that the deal doesn’t actually align with the business plan. For example, the operator expects to raise rents by $150 per unit on a multifamily deal that is completely renovated and already a market leader in rents.
The solution: For each deal, find (or ask for) a sensitivity analysis. A sensitivity analysis is a “stress test” that increases/decreases certain underwriting assumptions to determine how the overall returns are impacted. Usually, there is a base case, which is what the operators expect to happen, as well as a “downside” and “upside” case, which is what happens if the deal fails to meet or exceeds their expectations.
Also, read through the investment summary to confirm that the business plan actually makes sense for the type of property they are buying.
4. Bad Market
The third major risk point when investing in syndications is the market. You could invest with a “great” operator and in a “great” deal but still lose money if the investment is in a bad market.
The solution: Learn how to properly qualify an investment market (here is a guide for how to do so). You don’t necessarily need to perform market research on your own. The operators should include their market research in their investment summary package. Just confirm that the data points to a strong market.
5. Economic Recession
Each commercial real estate asset class and market is affected differently by economic recessions. For example, during the most recent COVID-induced recession, retail and office space took a massive hit while multifamily and industrial were impacted much less. Rents decreased substantially in large urban markets but rose in the suburbs and secondary markets. Therefore, depending on what you are investing in and when the investment was purchased, you could lose a portion or all your investment during an economic recession.
Another possibility is that you make less money than you would have otherwise. Maybe you were projected to make a 2.0 equity multiple but end up making a 1.5 equity multiple instead.
The solution: Invest with operators who follow the three immutable laws of real estate investing. They buy for cash flow, not appreciation. They secure long-term debt. They have adequate cash reserves.
6. Opportunity Costs
Syndications are fairly illiquid. There might be a process by which you can receive your capital back before the end of the business plan. However, it is typically up to the discretion of the operator. Therefore, there are opportunity costs to having your capital tied up for five or so years. Maybe you are forced to pass on an amazing investment opportunity because you lack the capital.
The distribution frequency can also result in opportunity costs. The more frequent the distributions, the faster you can use your profits to reinvest into more deals. For example, if you invested $250,000 and received a 10% annualized return in monthly distributions, you would have $25,000 in cash to invest into a new deal at the end of year 1. However, if you invested $250,000 into a development deal with no cash flow for years, you could end up missing out on one or more investment opportunities.
The solution: By investing in certain types of funds, you can liquidate your investment much easier. Also, invest in opportunities with ongoing distributions to quickly reinvest your profits into more deals.
7. Lose Your Passive Investor Protection
Passive investors are not involved in the business of commercial real estate (i.e., finding the deal, underwriting, investor relations, asset management, property management, etc.). The law protects limited partners from bearing any financial responsibility against lawsuits. A passive investor cannot be personally sued, which means their personal assets or other investments are not at risk. The operators, however, are personally exposed to that risk.
If you invest in a syndication and have an active role, you can lose that protection. Therefore, in the event of a lawsuit, your personal assets or other investments may be at risk, which can result in financial catastrophe.
The solution: Either remain a passive investor or have an in-house compliance person to protect the company against lawsuits.
How to Lose Money When Investing in Commercial Real Estate Syndications
Losing money when investing in commercial real estate syndications is uncommon but possible.
You could invest with a bad or untrustworthy operator, invest in a bad deal, or invest in a bad market. You could invest with a great operator, in a great deal, and in a great market but lose money because of an economic recession. You could lose money due to opportunity costs from missed investments. You could be exposed to lawsuits if you have an active role in the investment.
Most of the scenarios where you could lose money can be avoided with proper education. For more educational blog posts on how to properly invest in commercial real estate, click here.
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.