#251 Hidden Risks in Real Estate Syndications (and How to Avoid Them)

Hey everyone, Hope you've had another great week. This week I'm going to talk about a topic that I think is so important. It's something that I'm constantly learning about, and that is the hidden risks in real estate syndications and how to avoid them. If you're investing in syndications, if you're investing passively, you want to know about these pitfalls. We're going to talk about them today, so stay tuned. Welcome to the Passive Income MD Podcast where we talk about creating your ideal life through multiple streams of income. If you enjoy hearing about this stuff, make sure to hit subscribe. Now, let's get on with the show. So I know a lot of people in our community are investing passively through things called syndications or funds. And often they're pitched as just hands off, low risk ways to invest in real estate. And I believe it can be like that and they can be amazing tools for building wealth. The truth is they definitely come with risks just like any other investing, some of which are easy to overlook if you're new to investing or even if you've been investing for a while. In this space, I will say that I made all of these mistakes. I've continued to make some mistakes and I feel like it's important for me to share these because my hope is that you can invest with more confidence that you don't make some of the same mistakes I've made and that you can improve and that can hopefully create a lot of success for you investing in this area. But before we do that, I want to just make sure that we're on the same page as to what a syndication actually is. Just to give you definition, it's when a group of investors just get together, they pool their money to purchase a property. Maybe it's an apartment building, maybe it's a hotel, commercial space, industrial warehouse. Whatever it is, this is a deal that you are investing in and it's managed by someone called a general partner or a sponsor or an operator, all basically the same thing. And they are supposed to handle everything from finding the property, creating the business plan, managing it, figuring out how to create income and profit for themselves and their investors. Maybe they do sell it at the end, or they keep it. Whatever it is, it's that pulling of capital to buy this and you're investing someone else's deal. And if you're an investor, obviously there's a lot of appeal to this. You can own a piece of a professionally owned and managed real estate deal without having to be active in it to actively manage it. You can provide passive income, it can help you with diversification, and it can give you access to maybe some assets that normally would be out of reach in terms of a price point for someone like you or me. But just to let you know, even though they're marketed as, like, simple and sometimes low risk, and I have to tell you, there are definitely some hidden risks that could impact your return and could lead to losses if you're not careful. So let's break those down today. And I will say I've learned this one the hard way. The first and probably the most important risk is the sponsor or operator or the general partner. This is the person or the team that that's running the deal. And their performance will make or break your investment. And I'll tell you the truth, not all sponsors are created equal. Even if they all seem to have a great track record, they're not all the same. Some may have benefited from just being in a good market. Some have shown how great they are over the test of time. So it's your job, before you invest in something like this, to figure out how to avoid essentially investing with a poor sponsor. So that's where a lot of the work does come in. Even though this is passive, your work comes up front to figure out who to invest in. You want to thoroughly vet the sponsor. You want to review their track record. You want to really scrutinize it. Have they done well in good times? When things had some challenges, were they able to pull it out? Did they struggle? What did they learn from it? Have they been successful now? Maybe in the beginning they had some challenges, but they've learned now. You want to talk to people who've already invested with them. How did they deal with some of the challenges that came about in the investment? Because inevitably every investment will have their own challenges. It is up to the sponsor operator to figure out how to navigate through that. How do they communicate? Are they transparent? Are they forthcoming? Are they accessible? If you need to talk to somebody there. And I've made this mistake too. I've maybe skirted over or kind of glossed over maybe some of the due diligence that I needed to do because maybe because they're a huge operator and they have billions of dollars of assets, that must mean they're great or they've done really, really well getting huge returns for their investors in the last two, three years. So thinking that that would repeat itself indefinitely no matter what. And again, I have made this mistake too. And so I'm always trying to Figure out how to do better in this area. It's about asking the right questions. It's about getting to that place of confidence. Again, there is no guaranteed success in any investing. But you want to at least feel like you did the full due diligence here and got comfortable and got to a place of confidence. If you're not fully confident, it's better to walk away. There are many sponsors that you can invest in. So take your time here and do this part right. The next is market risk. I think we all know that even the best property, if it's in the wrong market, it can be a losing investment. This can be especially true in markets that are maybe overly dependent on one industry. Think Detroit with the auto industry at times. Or maybe there's an industry that's experiencing rapid but maybe it's unsustainable growth. And how do you avoid that? You want to research the market fundamentals. So you want to look for areas with strong job growth. Right? A diversified economy, that popular population is increasing. You're basically trying to figure out and know that the wins are at your back. And you definitely don't want to get this information just from the sponsor. You want to do your own market research. Now with the Internet we have access to more tools than ever to understand the market, especially in our community. There are other people who are part of the community, might know exactly what's happening locally there that you're not getting from the sponsor or maybe just from a simple Google search. So you got to understand the market. Hey everyone, I have a quick question for you. Are you looking for a secure and reliable long term investment strategy? Meet Eckerd Enterprises. It's a family owned and operated firm with over 35 years of experience specializing in US energy and alternative investments. Here at Passive Income MD you often hear me talk about the need to diversify. One of the safest investment strategies available today are mineral rights. And with Eckerd Enterprises you can diversify your portfolio. Their team is committed to helping private investors like you and me identify and develop successful diversified portfolios with an average return on investment of over 24% across their portfolios. 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To learn more about the Momentum MD Mastermind and to pre apply for a call with us, please visit momentummd.com let's see how we can help elevate your life to the next level. There are limited spots, so don't wait. Take the first step towards your transformation today. You won't regret it. Next is deal structure and terms Risk. Another hidden risk lies in the structure of the deals. You should know what the fees are or what the terms are that maybe it heavily favors a sponsor. Maybe you're not quite aligned with them. Maybe they're getting paid at the expense of the investors and they're not maybe incentivized to do the right thing or if things are challenged, maybe they don't have enough skin in the game. You want to review this thing called the PM or the private placement Memorandum. You want to understand this thing called the waterfall. You want to understand the fees, the structure, how they get paid, how the profits are split and where the leverage is. You want to make sure again that they only get paid or do really well. When you do well as an investor, you want to be wary of some of those deals that seem to have these excessive fees or unclear terms outside of the norm. And how do you find what the norm is? Now, it's a range and it can vary, but the more deals you see, the more people you talk to, you'll start to understand what that range is. If you're part of our community. And course, obviously we talked all about that. But again, this just takes time to understand what those ranges are. Next, financial projections, risk. Now, every deal that you do will have some sort of financial projections. They'll give you a return, and it's based on what they think will happen to the property or the deal. This can be misleading. If they're overly optimistic, I will say you're never going to get a deal presented where it looks bad for yourself or for the operator. It's always going to create a situation where it looks good on paper. So you want to be able to understand the numbers. You want to understand what's unrealistic. Is that rent growth unrealistic or unsustainable? Are they underestimating expenses just so it looks better on paper? So you got to learn how to scrutinize the numbers. You got to understand what's on the conservative side of maybe something like rent increases or vacancy rates or operating costs, what's more aggressive on that side. You want to compare your projections. So what's actually happening in the current market? Does that make sense? See if that holds up. Now we have a few more risks to go over. This next one's called liquidity risk. Now, one of the risks that many new investors overlook is this thing called liquidity risk. Just so you know, syndications, and most of these investments, they're considered illiquid, meaning that you can't just cash out. You can't just get your money out how you want. It can be tied up for the duration of the deal, which could be five to seven to 10 years. Now, you usually get a return based on that, meaning that usually returns are considered or they should be higher because you don't have that option to just get your money out when you want. So you have to understand, whenever you go into any of these investments, understand that your investment might be tied up for quite a while, that you, if you do need access to that money, especially in the near term, that may not be the right money for the investment. Understand the expected whole period, understand the distributions that are coming, and that'll help you manage this risk. Now, there's also something called vintage risk. Now, how many people there drink wine or wine aficionados, for me personally I can't tell the difference between a good or bad wine. I just like drinking with my steak. But when it comes to wine, I understand there are things called vintages, meaning that certain vintages do better. Now, you've probably heard of it. A certain year in a certain wine, those might be extremely valuable. Why, while the very next year might be quite cheap. And that's because of the vintage is what happened in the weather during that time in the soil to create a certain type of grape that creates a better wine in some way that's just dependent on the year. That's almost pure luck. It's from year to year. Now, that happens in real estate syndications as well. And that might be one of the most overlooked things, this whole concept of vintage risk. It refers to the timing of when a deal is executed, when you buy, and market conditions at that time, and what market conditions happen to be at the time where you want to sell this property. Now, some deals we know in the last three, four years, they were executed during a market peak when prices were high, interest rates were low, but then they rose, completely changing the economics and dynamics of the deal. Those kind of deals are more likely to face challenges than deals where it was bought when things were at the bottom, when the market had crashed. Now, how do you know and avoid vintage risk? Of course, you want to analyze the current situation. What are the numbers? What does the, you know, what's the typical cycle? What are the key indicators to say you're in a market peak or downturn? Now, I will say good operators find opportunities at both times, but I will say you're probably most at risk when the market is at its peak. Now, I've made a mist investing in these things personally, but the way I've learned to get past this is that I continue to invest through all periods. You probably heard this thing called dollar cost averaging, where you invest in a certain stock, whatever it is, consistently over time. Because I think we all know it's impossible to time the market. It's very easy after the fact to say, that was the peak, that was the bottom. We should have done this. But none of us absolutely know that. We've all been in a situation where we're like, that is the peak. We haven't invested and it only went up more, and we regret doing it that way. Now we also have gone the other way where we invested, and we're like, oh, I shouldn't have, I should have waited. I made that mistake. You want to find opportunities that maybe will do well in any sort of market. Maybe the more conservative underwriting is there and available. That's what you want to look for. You want to have contingency plans. You want to make sure your sponsors contingency plans when the economy shifts. And the way to honestly get through this is just like with diversification. If you can invest consistently sustainable amounts of. It doesn't matter what the timing is, you'll do well when it times well. You may not do as well when time isn't on your side, but all of that over time will create good returns for you that is diversified and keep you moving in the right direction. And the last one is exit strategy risk. Let's talk about this. A syndication or a company or a business that you invest in that doesn't have a clear or realistic exit plan can really delay your returns or result in lower profits. And one way to, I mean, the way to avoid this is simply just ask the sponsor, what is your exit strategy? If this doesn't work, do you have any other options for your exits? Is the property being held for cash flow? You want to know this? Is it being held for appreciation, meaning that it'll increase in value? Maybe it's held for both. So you want to understand the timeline and the market conditions that are needed for a successful sale. And so you want to talk about the exit, because that is when for a lot of these indications, that's when the greatest returns are created. So I've given you a bunch of questions to ask. It'll also be in the show notes if you want to check it out. The other things you really want to watch for, there are some red flags. Definitely you want to look for overly optimistic assumptions, unrealistic returns. Again, I've made that mistake before and I'm still learning not to be too optimistic, even though that's my personality in certain situations to look actually for the downside. Another red flag you want to look for is if the sponsor seems to lack transparency. You can't get a straight answer out of them. You can't reach out to them, you can't connect with them. That is a big red flag for me. And I know that if it's communication is a problem up front, then communication during a deal, especially if it doesn't go well, will be a problem. So I avoid that at all costs. One of the other red flags is there's significant amount of high leverage mean that the debt is unsustainable. It puts you at a lot of risk, doesn't mean you can't do well. Usually high risk High debt can lead to high results, but it can lead to high losses as well too. So you want to understand that as well. The other red flag is if the sponsor doesn't have a clear contingency plan, if things don't go well, they haven't thought about it, it's only optimistic, then I really try to avoid that as well because you never know what the market conditions will be if any of these come up. It's better to pass on a deal, find another sponsor, find another deal. They will come, I promise you. So yes, real estate syndications, I mentioned it. It can be a powerful way to build wealth. It comes with risks though, just like anything else. The sponsor, the market, timing, how the deal is structured, this whole concept of vintage risk. But with the right due diligence, you can minimize those risks and that's what we're trying to do. And it can hopefully give you the upside potential while you minimize some of those risks. And you can invest with confidence if you understand all of these things. So you want to take your time, evaluate these deals carefully, ask the right questions, and never feel pressured to rush into an investment. We have a great community that helps each other to get through some of these due diligence questions. We also have something called Passive Real Estate Academy where you can learn how to do the proper due diligence. Get coached on building your own portfolio on how to do all this, but either way, get plugged in. Find people who can help and support you during this and we'll do our part as well through these podcasts and anything we can do. Thank you for tuning in. We appreciate you have an amazing week and let's talk again soon. Enjoy the show. 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