The opportunity for 20%+ returns is attractive. Make sure you understand how these deals work.
New investors often get excited about investing in commercial real estate deals (better known as syndication deals) such as multi-family, offices, self-storage, retail and others. The opportunity to get annualized returns upwards of 20%+ seem so attractive that an investor puts aside critical questions on if commercial real estate investing is right for their investment goals.
Here are some of the top misconceptions that investors have about how commercial real estate deals work.
Passive Income is Guaranteed
A key misunderstanding that many investors have with syndication deals is that they will always receive passive income. Sponsors make projections on how much cash income that a project will provide to investors each year but that is just an estimate assuming that their execution plan on the project goes as planned.
Lets take an example. The sponsor in a multi-family deal is projecting a cash on cash return of 7%. This projection is based on them reaching a certain occupancy level, rental revenue and a certain level of expenses that results in a target net operating income. The unexpected happens and their is market downturn and renters fall behind on payments. Other renters leave and the units cannot be filled. The sponsor still needs to pay loan payments, employee salaries and other expenses. With the occupancy lower (resulting in lower revenue), the sponsor decides its best not to provide investors with distributions until they can recover the revenue. The result is that the 7% expected income to the investors goes away.
These type of scenarios can happen. Investors should remember that the targeted cash income is just that, a target.
Target Returns are Annual
Another misconception many investors have is that the 20%+ annual return or an internal rate of return (IRR) on a deal is the return they will see each year.
Target returns are based on a projection of the cash flows associated across the full time horizon of the deal. This includes an assumption of what the property will sell for at exit and the appreciation that investors will see in the property.
When seeing a target, its important for investors to remember that it is not annual return. It is an annualized target return based on all cash flows including the appreciation at exit.
Deals Exit on time
Time horizon on a deal is the most common misconception that investors have when investing in syndication deals. A project may have a target time horizon of 3 years. Investors assume that the deal will exit in 3 years since that was the target. The time horizon is only an estimate any in many cases, real estate projects will go longer.
Investors must remember that a sponsor does not have a crystal ball. At the targeted timeline to sell a property, the market conditions may not be right. Its possible that it took longer than expect to complete a rehab on the property. The occupancy may be lower than targeted impacting revenue so the sponsor needs to hold on a little longer. Finally, it may take longer to find a buyer willing to pay the target selling price for the property.
When investing in a deal, its important for investors to remember that the target time horizon is only an estimate for the deal and not a guarantee.
Fancy Presentations = Great Deals
Some sponsors are great marketers. They build fancy presentations with lots of statistics, market data and financial projections. They send out emails on how great the deals are to investors and they will sell out in hours. They create enormous pressure on investors that if they don't $50,000 or $100,000 in the deal, they will be left behind. Its a common tactic used by real estate sponsors.
But just because a sponsor is great at marketing and convincing investors to buy into his deal does not mean that the investors will get the returns they were hoping for. Its critical that investors research the sponsor and the syndication deal. Many investors forgot to ask even the most basic question to a sponsor before investing - "How many deals have you exited and what were their returns?"
A fancy presentation and high pressure sales tactics does not mean its a great deal. It only means that that the sponsor is a great marketer.
Syndication Deals are Low Risk
When reviewing a real estate deal presentation, an investor could easily take away that a syndication deal is low risk. Its important for investors to remember that high returns come with higher risk. A commercial real estate project is just like any other multi-million dollar business. Things can go wrong and an investor can lose their original capital. In almost all deals, the bank/lender has the first lien on the property, not the investor. If the sponsor lacks sufficient experience, the deal returns will be impacted. In a worse case scenario, the lender may take over the property resulting in a complete loss of investor capital.
While not common, syndication deals can fail. Investors should be prepared to take a loss on a deal. That is the risk you take for the opportunity to get a high return.