Besides public market REITs with their often volatile ups and downs like any stock, private syndications in the so-called “exempt market” are becoming quite popular. Syndicating a large piece of real estate i.e. pooling of your money with others to buy larger commercial real estate projects is a great idea – if executed well. It is indeed a proven path for wealth creation – if bought at the right price and managed well.
Not all real estate classes are created equal – and not all operators are equal either – and this recent recession and collapse of prominent syndicators such as First Leaside, League, Concrete Equities, Shire, Foundation Capital, Signature Capital or Libertygate, is a case in point.
There are nine typical steps in real estate syndication projects that you must check ! What are they ?
1. Experienced Operator with OPERATING TRACK RECORD.
Operating a business is hard work and takes years of experience .. through the peaks and the valleys of the economic cycles. Many a syndicator has had some success raising funds, sometimes for flow-through tax deals or for other parties as a sales person. They make a commission only. Hey, let’s open up a syndication firm they say: Buy an asset and manage it and take commission and an operating profit. Others see the US as a big opportunity, but have actually never bought and sold in the US for significant profits. Big mistake in many cases as it takes years to understand how to buy, even more years how to buy well and not overpay .. and even more years to manage an asset well .. and then profitable exit, especially in a more normal less heated economy !
Ask: Has the promoter and the operator actually delivered real results on previous products sold ? Many people hop from unsuccessful to unsuccessful deal but present a very polished image & wonderful story. Love the story .. and prove the expertise !
Thus: check the operator’s track record ! Scrutinize the depth of knowledge in the asset space they operate .. and not just before the boom that ended in 2008 .. but through it ! Don’t confuse slick marketing for a great investment ! Talk is cheap .. and sexy marketing with beautiful charts and fancy pictures is only a bit harder bit still very easy !
Delivering hard returns in the harsh cold reality is very hard .. and has been done by surprisingly few ! Very few.
2. Realistic ROIs using realistic assumptions – or paying you from your own money ?
“Double your money” .. by gambling in Las Vegas ! Place your money on “red” on the roulette table, and you too could make a 100% ROI in 2 minutes ! But on average, you’ll lose ! Hence: look at the risk adjusted return: look first at the chance of a return OF your money .. then look at a return ON your money !
A common trick is to use unachievable future values of condos or land prices as a high ROI is easily achievable on a spreadsheet or in an ad. However this is now a lower demand world caused by more cautious and financially less wealthy baby boomers.
Although housing has shown feeble signs of recovery, this economy has been a wake-up call to investors who thought they could ride a never-ending real-estate bubble for condo projects, land sub-divisions or international real estate in allegedly hot markets like Costa Rica, Mexico, Las Vegas or Belize. Then there’s commercial and office real estate, where many institutional investors have taken enormous losses in 2007 to 2010.
Additionally, often the promised returns are paid from your own investment $s ! It is easy to produce a 20% return over 5 years .. by paying you your money back. Thus: look at the underlying vehicle that produces this return and ask: are these future values achievable in the timelines advertised ?
Any promise to deliver any distributions over 6% in the current environment has very high risks. Very. Yes, you can do 10 or 12%+ returns overall, but only after assets have sold some years later. Sustaining an 6%+/year distribution is usually primarily from your own cash, or new investors’ cash. Beware of very high risks of return of your capital ! See also point 7 below re FFO ratios.
3. What is your security ?
Syndications using terms such as “asset backed” or ” up to 18%+ interest on our mortgages” or “secured by a mortgage” need some further investigation. In many cases these mortgages are in 2nd or 3rd position and exceed by far the value of the underlying real estate. In construction or land development projects the investors money is often in 2nd or sometimes in 3rd position behind an expensive first position .. hardly security but a sham ! Don’t call it a mortgage if it is indeed equity or investment dollars.
Thus: security not in 1st position or exceeding going in prices, based on future speculative possible prices is not security .. it is false advertising !
4. Un-inflated Assets sold to investors without a premium.
Often an asset is purchased by the syndicator, and then sold to the “innocent” public for a lift up from a low of 20% to several 100% on some land deals. This used to be OK in a very strong market. Thus: check the true asset value if you intend to invest .. and do not accept their excuses for uplifting the building or land value because there isn’t any ! Then hopefully you can co-invest with one of the many ethical syndicators out there !
5. Modest Fees
Some syndicators charge in excess of 10% sales commission which seems to be the norm but is still very high. Some operators charge an acquisition fee, like a realtor, of up to 3 or 4%. While this sounds low, on a 25/75 mortgaged asset a 3% acquisition fee is actually 12% on the invested cash. Combining this fee plus sales commission plus the usually marketing, admin., travel, legal and bookkeeping expenses and a startup might be 25% to 30% in the hole after building is acquired. To get from 70% actual cash invested to 100% is a 40% gain on the actual cash deployed that the asset must produce just to break-even ! Any fund has this kind of J-curve. Thus, aim for a flat J bottom, i.e. as much of your invested cash gets deployed into the underlying asset, and not only into fees for the sales person, operator or slick marketing !
Also an annual asset management should probably not exceed 0.5% of the asset value or 1.5% of the cash invested … otherwise it is too rigged towards the syndicator and not the investor. Some firms advertise “You get 80 or 10% hurdle rate per year” but fail to mention that there will likely will be no profit or profit in that magnitude due to their enormous initial and ongoing fees.
It has to be win/win ! Lower is better !
6. Receiving an offering memorandum or other important documents
An offering memorandum (OM) is the base for raising money in Canada, unless you market only to high networth individuals where less disclosure is required. Don’t accept excuses such as: as they are “too complicated” or “you don’t need to read that” or “we will send it later”. This OM discloses all the fees, profit split, purchase price or syndicator’s background. It must have a current audited, opening financial statement. Look for the fees .. and add them all up .. if they are too high you may wish to invest elsewhere.
Also ask for current appraisals (and not from 2008 before the crash) or actual sales prices of assets you will co-own. Ask to see the title to the project and the actual purchase contract. Do not believe only the fancy marketing brochures. Some syndicators use an OM as an exit strategy for the previous owner connected to the issuer – with enormous profits. Many great deals exist today .. ensure you are part of one !
Ask for current financials, including quarterly updates of very large REITs that consistently buy, re-finance and sell assets. Investing based on financials over 8-12 months old is not too sound in these over very large funds. Ask for current financials.
7. Ask: are these returns actually doable ? The advertised monthly return initially are usually paid for with your own money. Big ads are an expense to the business. These marketing fees often approach 12% to sometimes 30% of the funds raised .. plus sales commissions .. a very high hurdle as it has to be made up through asset performance which takes a few years. A 30% initial cost hurdle (incl. sales commission) assumes a return of well over 40% on the remaining 70% productive cash just to break even !
Thus: look for soft costs or marketing costs besides (huge) commissions too .. 3 % – 5 % of money raised is reasonable .. more is not !
In private REITs look for the distribution to FFO ratio. This is often undisclosed and tough to find – but is usually in the financials. FFO is funds from operation i.e. cash-flow from operating the assets after all expenses such as mortgage payments, operating expenses and management fees for the operator. In a stable REIT that ratio should be well below 100%. In a growth oriented REIT that ratio is often far above 150 to even 200% and as such, your distribution comes not from cash-flow of the assets, but from from cash: your own cash and that of new investors. Ask yourself, or the REIT, if this is sustainable.
8. Who is the actual owner of the asset?
Ensure that the investors actually own the asset ! Frequently the asset is not held by the investment group but by a privately held company and the money is lent to them. It is now almost impossible to trace the money trail .. especially if this company also co-owns many other assets with many mortgages. Thus, one collapsed and unrelated project can derail your project too !
9. Pricing NAV Justified ?
Ensure that there is some evidence that the pricing of the units is sound. All too often the pricing of the units is based on an NAV (net asset value) that is neither verified nor shows any correlation to the IFRS audited balance sheet (i.e. the difference between appraised asset values plus receivables minus liabilities) nor is there any calculations or explanations for the NAV. “Trust me” is not good enough to invest in many private REITs. Ask for detailed NAV calculations before you invest.
In summary: it has to be win/win Are the operator’s profits aligned with yours, the investors i.e. usually at the end on exit? Or are they just growing assets under management, like mutual funds, to gather asset management fees regardless of asset performance ? Is the NAV realistic ? Are distributions sustainable ?
There are quite a few scams out there .. and many were in the news lately .. but some just exploit the legal loopholes .. but there are many honest folks too.
Use these nine guidelines to distinguish between the honest and the dishonest operators .. and you too can successfully and profitably co-own a larger piece of real estate or a pool of hard assets with others !