30 Apr When NOT to Invest in a Commercial Real Estate Syndication
When NOT to Invest in a Commercial Real Estate Syndication
When you have decided to invest in a commercial real estate syndication, you will likely have put aside the money you want to invest and you’re ready to start pursuing investment opportunities. That’s a good start, but passive investors should know when NOT to invest in real estate syndication deals also.
There may be clues or warning signs or important information about a real estate syndication investment that may cause you to review the real estate project on a deeper level. That’s why we’re going to cover some important items you should look out for when you’re reviewing real estate deals or even a real estate syndicator and the sponsorship team.
In this blog post, we’ll discuss the data underwriters review, the potential warning signs and some basics of real estate syndication, in an effort to help you to understand and decipher what makes up a good deal and the circumstances under which you may want to take a pass and locate another investment offering.
Our team takes a deep dive into all of the analytics of a deal before we present a property syndication to our valued investor partners. So, to give you a better understanding we’ll take a closer look at the real estate syndication process and what to watch out for.
Why Underwriting is Such a Valuable Component
So, we see our underwriters as our gatekeepers. These are the individuals who determine if the deal makes it to the next level of due diligence or not. They understand what our parameters are and what our potential investors are looking for in a real estate syndicate.
It is during this phase that we also look into the geographic locations of the deals and the population growth, the job growth, supply pipelines, and absorption rates of multifamily units in the area and a whole array of metrics that help us make a more informed decision.
It’s important that the team review all of the details of the deal, and we must be confident we can provide a good investment for our passive investors.
The Negative Aspects of a Competitive Real Estate Market
A deal may look great at the start – it might be in a fantastic metro area or have significant population growth with the potential for higher-paying jobs, it might have great schools that are close to the asset and it may have the potential for strong rent growth in the yearly projections. However, with strong metrics comes fierce competition, and oftentimes bidding wars ensue, which can drive the cap rates down to a point where the numbers will not work for our strict parameters.
As you are aware with any investment there are inherent risks – there could be construction and labor cost increases, complications with inflation or a steep rise in interest rates or simply maintenance issues that can pose risks to the project.
The good news is that there are several approaches we use to help us determine if we should take a pass or dive deeper.
How to Recognize When It’s Time to Pass on a Property: The Details
We all have a common purpose when we’re investing – to make sure that the investment meets our goals and timelines as much as possible with as little risk as possible. We generally look for investments that would give a return of 18% IRR (or more) within a five-year time period.
There can be circumstances where operators cash out or refinance within a shorter term, but there can be some significant risks with those types of investments. Of course, with increased risk there can be the potential for higher returns, but that is not our approach to commercial real estate investing. We’re looking for good solid returns, yes, but we want our risk to be mitigated as much as possible.
You may be comfortable with a higher risk profile and you may be willing to take the risk with a project that needs extensive remodeling or is in an area that is on the cusp of gentrifying. Our team likes a steadier approach to our investment strategy when we’re dealing with larger projects such as a multifamily complex.
How Seasoned Commercial Real Estate Investors Look At A Potential Investment Deal
Let’s dig into numbers.
When we acquire an apartment building, we know that certain factors such as real estate taxes, payroll, property insurance premiums, administration costs, and property management fees may increase or decrease so it’s important to understand how cash flow will be impacted once a new sponsor team and the property management team take over the ownership. That’s why it’s critical that the property manager and general partner have extensive experience to adequately project any fluctuations in cost.
We first start with the current income at month one based on the cap rate going in. Then we compare current rents and the unit mixes (one bedroom, two bedrooms, etc) to those assets in the area that are comparable. We will want to be able to see if the area rental rate will cover the renovation costs outlined in the business plan and is consistent with the general partners’ cash flow projections.
We look for comparable units, built around the same year as our potential deal that have already been renovated, and then we use their current rates to calculate our anticipated commercial property lease rates.
Examining the Various Financing Choices
The Advantages of Using Bridge Debt
In some cases, a bridge loan can be the best option. The benefits of a bridge loan can be no prepayment penalty or a minimized prepayment penalty, a short loan duration, non-recourse capital, and a higher leverage opportunity beyond the normal 75% loan-to-value threshold can all be significant advantages of going with a bridge loan depending on the asset and the goal of the business plan.
The Downside of Taking Out a Bridge Loan
The disadvantage of using a bridge debt lender is that they charge a higher fee. Bridge loans have more up-front fees and back-end costs as well as higher interest rates to offset the higher risk. There is also the risk that interest rates will have adjusted upwards when the time comes to refinance out of the short-term bridge loan. So, there are risks with a bridge loan.
Exploring Profits at the Sale
The next aspect we explore is the anticipated value of the property when we are planning on exiting – after all of the renovations have been completed and the tenants are paying the market rents based on those improvements. Let’s say that we are projecting an increase in NOI of $500,000. This is when we consult with the commercial brokers to find out how much they think the asset will sell for based on the projected purchase price, the renovations, and the anticipated increased market rents. If our projected returns are coming up short say at 12% IRR (or anything less than the 18% IRR that we are seeking), then what would we do?
All Considered, Are the Returns Worth It?
In this example, we would pass on this real estate investment opportunity. There are various opportunities in commercial real estate investments that can be less risky and can offer greater returns than the example above. The profits just aren’t compelling enough for us to want to invest considering the alternatives for commercial real estate investments that are less risky and offer greater returns than this one. The profits just aren’t enticing enough for our investors.
While we currently look for projects that generate at least an 18% IRR, that could change in the future based on market conditions, the state of the economy, expenses, taxes, and various other factors. For the past decade or so, cap rates have steadily declined and Covid increased the decline, so this may not be the same approach we adhere to in the coming years.
Overall, the success of each commercial real estate syndication should be examined by the risk-adjusted return. You should always be comparing returns against the amount of risk your capital is being subjected to based on such factors as the asset class, real estate market, location, and the business plan put forward by the sponsor team. The higher the returns, the more risky the venture may be.
When Preferred Structure Deals Are in Your Favor as a Commercial Real Estate Investor
A preferred return structure or “pref” means that those individual investors in the limited partnership will receive all returns up to a certain percentage based on the “pref”. This is the specified amount of passive income that you as the individual investor can expect to receive. The sponsor team doesn’t get paid until this preferred return is met with this group of investors. As a result, the deal sponsor team is strongly motivated to ensure that the profits exceed the preferred rate of return to the investors so that they can get paid.
There are always certain factors that arise that are outside of our control and our projections, such as inflation, a drastic rise in interest rates, or a natural disaster such as an extreme storm. This is one of the reasons why PCRP Group concentrates on areas of the country where severe weather events are occurring less often or are virtually nonexistent.
That is why there is so much due diligence that has to be conducted upfront before any consideration can be made as to whether we feel comfortable with investing in a commercial real estate syndication for ourselves and our investor partners.
When to Say No to a Commercial Real Estate Investment?
So now you understand more about our process in how we determine whether we should move forward and start researching further or take a pass.
We always assess the extent of renovations the property needs versus the anticipated returns. If an apartment building needs extensive work and there is only going to be say a 14% or 15% IRR, then that will not work for us or our investors, so we move on and look for other opportunities.
Alternatively, if we locate a newer project that needs little to no renovations and has a return of 14% or 15% IRR, then we will pursue digging deeper into the details of the project and start more extensive research.
In short, the preliminary phase of our approach to determine if a project gets a pass or a fail before we take the next steps is fairly straightforward.
While this article discusses the approach to investing in a multifamily real estate syndication, our process is the same for any investment vehicle whether it be for self-storage facilities, mobile home parks, or various other types of commercial real estate opportunities.
By the time a potential commercial real estate syndication opportunity reaches your inbox, the team at PCRP Group has already completed a much more extensive amount of due diligence, sensitivity tests, research, and underwriting models to make sure we are as confident as possible in the deal before we present it to our investor community. If you’d like to learn more about the deals that we may have coming up, we’d be delighted to welcome you as a member of the PCRP Group Investor Club. We would love to know what your investment goals are and how we can assist you in reaching them.
Until next time, Earn Passively and Live Abundantly!
Note: we are not financial advisors and are not offering financial advice of any kind. Please consult with your advisors before making any investment or financial decisions.
Ready to Learn More?
The best way for you to learn more about commercial real estate syndications is to join the PCRP Passive Investor Club.
Through the PCRP Passive Investor Club, you’ll get a priority review of all the deals we offer. We’ll work with you to determine your investing goals and then present you with the best deals to meet those goals. We’ll then guide you every step of the way as you invest in those deals.
So if you’re ready to start investing passively in institutional-grade, commercial real estate in fast-growing, climate-resilient markets in the U.S., join the PCRP Passive Investor Club – IT’S FREE! – and get started on your path to EARN PASSIVELY and LIVE ABUNDANTLY!
If you would like to know more about what we do and how it may be of value to you, please reach out to us anytime. We’re always happy to help!