Whether you are a first-time investor or a veteran limited partner, it is always wise to evaluate key aspects of syndication deals so that committing a huge chunk of your money becomes not a leap of faith, but rather a vote of confidence to the syndication deal and its operator. Bad deals and bad advice abound, intended to deceive easy prey out of their hard-earned money. So, knowing what to watch out for before trusting an investment opportunity will help you avoid costly mistakes.
Dan Handford, managing partner with PassiveInvesting.com, syndicator, and passive investor in multiple deals stresses the importance of being aware of common red flags in a multifamily deal and educating yourself before taking the leap. In our recent conversation, he detailed some of these critical things that an investor should look into, especially considering how volatile and ever-changing the market conditions can be. I’d like to share them with you to help you get through those initial fears and uncertainties while keeping an eye out for warning signs in passive investing. Click here to listen to the full interview.
Here’s Dan’s list of red flags that passive investors should focus attention on before deciding to invest.
#1: Underwriting that does not change even with significant changes in market conditions.
Underwriting must adapt to the conditions prevailing in the current market. So, when a significant event has occurred that has definitely impacted the market, as an investor you should expect your sponsor to make changes in the numbers projected in the original underwriting of the deal. As an example, Dan cites the effect that the Covid-19 pandemic had on the underwriting that was done prior to the health crisis. “A big red flag for me would be if an operator underwrote a deal before all these happened and they didn’t change their underwriting since they’ve been into the deal.”
So, in an economic slowdown that can be brought about by any number of factors such as rising inflation and unemployment rates, stock market crash, etc., expect operators to make changes in the underwriting of the deal and the execution of the business plan to mitigate risks and protect your investment.
#2: The operator doesn’t communicate regularly
“An operator must be communicative to investors, overly communicative if you will,” says Dan. “When Covid hit, instead of monthly, we started weekly communications with our investors because we want them to understand what’s happening with the asset that they’ve invested in.”
Sending out a weekly update report in uncertain times will help investors become aware of the effects of a critical situation on their investment. Keeping investors in the dark about how the asset is performing in those conditions is not how good sponsors should operate. So, it’s definitely a red flag when an operator drops this responsibility. How can an operator expect to deserve your trust and confidence if he or she is not preemptively keeping you abreast of important information relevant to your investment?
#3: The operator does not provide preferred returns
A preferred return is a predetermined percentage that must be paid to the investors before the sponsor collects any of the distribution money. After the investors receive the preferred returns, the remaining money is split between the investors and sponsors at a predetermined ratio.
“If the deal is so tight that you can’t provide preferred returns or that the operator needs the equity splits earlier and that’s why they’re not giving the preferred returns, then that operator is not well-capitalized enough. That’s a red flag for me,” explains Dan.
As an investor, you will want the operator to be able to give you preferred returns. It’s an indicator that the operator is well-capitalized both personally and in the business itself and will not prioritize equity splits over preferred returns. The reason why some operators do not provide preferred returns is that they need the money to live off of. They need that 70/30 equity split up-front and skip preferred returns, so that every dollar that comes in off the cash flow is a profit split 70/30.
“Those preferred returns are very crucial because I feel it’s the best way to align interest with the investors,” he adds.
#4: The operator has a small operating reserve budget
“It is a smart thing to make sure you have ample amount in operating reserves and there is never a situation where I would say it is too much,” says Dan. “Red-flag operators who do not have enough in operating reserves. Why? If, for some reason, you’ll need money, you have a pocket to dip into. You don’t have to do a capital call with your investors because that looks a whole lot worse,” he adds. So, make sure that either the operator or someone else in the syndication team, like the lone guarantor, is well-capitalized as a backup.
What’s the right number to keep in operating reserves? Dan suggests that to calculate the amount to be set aside for operating reserve, assume the property goes to zero percent occupancy. With this scenario, you shouldstill be able to meet the expenses and the debt service for about three to six months. Hence, your operating reserve budget must be equal to three to six months of operating expenses plus debt payments while you’re collecting nothing from rents.
“Very rare that it’s going to go down that low but let’s say it drops down to 50%. So, now you have six to 12 months’ worth of operating reserves in place versus just three to six months and so I think it is a smart way,” explains Dan.
#5: The operator or the operations team has little or no background in business
Vet your deal operator or syndication team. It’s a very crucial piece that they have a background in business, because investing in syndication is essentially buying into a business that just so happens to have an asset associated with it.
So, you want to make sure that the team has extensive experience in underwriting deals and a track record with large acquisitions. You also have to ensure that they have successful experience in managing properties and renovations. Again, you will also want the team to have a history of clear and consistent communication with clients.
“I want to have somebody on that operations team that knows how to put in systems and procedures and processes in place, that knows how to manage people, knows how to make smart decisions, especially in times of crisis. You can’t sit back and just wait, you have to be decisive, and having somebody who has a successful background in business is crucial,” says Dan.
#6 The operator is not full-time in the business.
As a passive investor, you want your real estate syndicators to be operating the business as their full-time job. While there are real estate investment strategies that can be done part-time – such as buying single-family homes, running short-term rentals, and fix-and-flipping – managing other people’s money and a multimillion-dollar commercial real estate portfolio requires an operator’s full attention, time, and energy.
“I want somebody who is full-time invested in all aspects of syndication because I’ve worked very hard to earn the money that I’ve got. I know our investors have as well and so all our managing partners are full-time in the business and I only want to invest in other operators that are also full-time in the business,” says Dan.
#7. There’s only one operator and no structure in the operations team.
“I won’t invest in syndication if it only has one person as the operator. I’ve heard stories before where somebody has invested with an operator that only had one person as the main operator and then all of a sudden, that person went ghost on them and they can’t find them,” warns Dan.
Make sure that you’re investing with a company that has multiple people running the business. Ideally, there should be two to three in charge of managing the operations so that you won’t be left hanging if one of them is unreachable. They should also typically be available to step in should one of the operators be absent or decide to leave. Lastly, having multiple partners in the business is important because, as Dan says, when you have two or more minds thinking about improving the business and strategizing for growth, it’s easier to achieve those goals than with a single operator who has no one to bounce ideas off of.
“We have three managing partners and so every single day, we’re on phone calls and we’re masterminding, we’re strategizing and we’re making sure that we’re getting things done properly for our investors. So, for me, I want to make sure that I have multiple operators,” emphasizes Dan.
Final Thoughts
No one wants to be made a victim of a bad investment. Although decisions are made in a world of uncertainty, making investment mistakes should not be your norm. Make decisions based on thorough research, sound judgment, and wise counsel, and always be alert to red flags on each and every investment opportunity.
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Interested in passive investing? Seek guidance from someone who has been there before. I have spent years learning everything about real estate investing so you don’t have to go through all that trouble. Get started by emailing us at [email protected] or call to see if Life Bridge Capital’s investments are a fit for you.
