Top Risks of Investing in Multifamily Real Estate Syndications and How to Mitigate Them

So, you’re considering investing in multifamily syndications. That means you’re likely doing your due diligence, weighing the risks and benefits, and deciding if this fits your investment goals and philosophy.  That’s great! You’re in the right place. 

We recently covered The Top 5 Benefits of Investing in Multifamily Real Estate Syndications.  While there are certainly a lot of benefits of investing in this type of real estate asset, there is no doubt that there are also risks. This article will cover the top risks associated with multifamily real estate syndications. 

There are no two ways about it - all investments carry some risk. Risk is simply the likelihood of something “negative” happening. It is commonly thought that a higher risk always results in a higher reward. However, that is a subjective thought process, as what is perceived as high-risk to one person may not be the same for someone else. 

As with any investment, risk can not be entirely avoided. You’re making an educated and informed decision to put your money into a project that you hope will return a high reward, though the unexpected is sometimes unavoidable. Markets, plans, and situations inevitably change. However, there are strategic ways to mitigate the risks associated with multifamily syndications to lessen your chance of exposure to the unknown. The good news is that these are actually within your control!

Check out a few common risks regarding multifamily apartment syndications, including what to look for and how you can reduce the chance that they will impact you when you decide to invest.

Risk 1: The asset is not liquid 

With a longer-term investment such as multifamily real estate, your money is tied up in the deal for an extended period of time. This can be anywhere from 2 to7 years. During this timeframe, you will not have the opportunity to pull your principal money out of the deal. While you may receive payouts throughout the life cycle of the project, depending on how it’s structured, it will only be a percentage of your principal investment. 

Unlike stocks or other short-term investments, you must be committed to the long-term lifecycle and understand that such investments may take longer than originally projected by the syndication team. The trade-off for this is that you will be rewarded with a higher return than your average index fund, making it worth the wait. 

How to mitigate the risk: 

You have to adopt a long-term mindset when going into a multifamily apartment syndication. Make sure you aren’t using your last dollar or tapping into your emergency funds to get into the deal. Understand that the money you invest in multifamily real estate will not be liquid for some time, so you must be able to maintain your lifestyle without those dollars until the project goes full cycle. That may mean that you have to wait to save up a bit more cash before you make your first investment, and that’s ok. Good syndicators often have multiple deals a year, so don’t feel you’re “missing out.”

Risk 2: Lower than projected returns

The general partner on a multifamily syndication project pours a great deal of time and effort into creating a business plan intended to result in a high return. Using their knowledge and expertise, they work diligently to create a plan (and backup plan) where everybody has the potential to earn a profit even if some things change along the way, such as organic market rent growth or economic changes.

With all the planning in the world, sometimes the unexpected still happens. Whether the economy changes and construction supplies become more expensive, rent growth slows down, or vacancy rates are higher than expected, there is always a level of subjectivity to any large-scale project. These unexpected factors may result in lower returns or even periods of paused payouts during the life of the project than what was originally projected and sold by the sponsorship team. 

How to mitigate the risk: 

Thoroughly vet your syndicator, ensuring that they consider all risk factors when underwriting the deal and include an appropriate buffer into the business plan. For example, if a market is currently growing 10% year-over-year in rent growth, the business plan should not depend on that to remain true through the deal's life cycle. To mitigate the risk of this rate change, a syndicator may factor in a 0% increase in organic rent growth. Additionally, they may only consider rent growth that is within their control when calculating the projected returns on investment. Controlled rent growth factors include adding value to the property through unit renovations and premium additions. If the market changes over the next several years, there is still an opportunity for the deal to remain profitable. 

Risk 3: Losing principal

In the rare instance that the syndication team has to decide to sell the asset for the same price, or less than it was purchased for, there would not be a profit made for anyone in the deal, including both the general partners and the limited partners. This could happen if the syndication team did not ensure they had enough capital reserves (cash in the “bank”) to weather any increases in interest rates. A change in interest rates would increase the monthly mortgage cost if the deal is using a variable interest rate loan. In that case, it is possible that the asset would not generate a profit, and therefore, investors would receive their principal investment (or less) at the end of the project. 

How to mitigate the risk: 

As previously mentioned, it is essential to have a complete understanding of the team you are choosing to invest with. There is nothing more critical than making sure they have situations like this written into their business plan as you evaluate a potential deal. You want to know their plan for situations like these, including ensuring that the team has a cash reserve (or rainy day fund) in the event of changing market conditions. Additionally, be sure that the property you are choosing to invest in is generating a cash flow prior to deciding to partake in the syndication. These are all questions you can and should ask the syndication team before you decide to invest in any deal they present.

Risk 4: Lack of direct control 

As a limited partner in any syndication, including apartments, you will not be in direct control of the day-to-day operations, the money, or the way the business plan is executed. Some may consider this a risk factor when considering potential investment opportunities, while others consider it a benefit because they themselves lack the expertise. You are relying on a team of professionals to manage your investment properly and trusting that they have the expertise to do it right. 

How to mitigate the risk: 

Take your time to vet the syndication team you are considering working with thoroughly. There is no rush to decide who you will invest with. In fact, good syndicators should be trying to build a long-term relationship with you versus just a transactional one. It’s vital that the syndication team shares common goals and can offer a track record of success that makes you feel confident and secure in your investment. Seek to understand your potential sponsor’s experience along with their goals, plans, and expectations for the project. 

An important question to find out is how much skin the sponsor has in the game when it comes to financial responsibility. Are they the guarantors on any loan associated with the project? Do they have their own money invested in the deal? What do they have to lose if things don’t go as planned? If their own returns are at stake as well, it is in their best interest to make sure they execute the business plan and generate a profit.

Risk 5: Capital calls 

A capital call happens when the syndication team calls on the limited partners for additional funds to support the project. You may also hear this called a  “cash call.”

This can happen if something unexpected occurs, like an increase in construction costs necessary for the value add pieces of the project. This could include renovating units or building new amenities. The syndication team should have enough reserves budgeted; however, if they were not conservative enough in their underwriting, then they may need additional funds to complete the renovations. 

While investors are not required to put in additional funds, you risk diluting your ownership percentage in the project if others do put in additional funds and you do not. If no other funds are available to add to the pot, then the syndication team may have to make the call to sell the property at that time, and the entire project is at risk of not making a profit, depending on what the sales price is.

How to mitigate the risk: 

Seek to gain a clear understanding of the syndicator’s business plan ahead of time, including how and when the funds will be spent as well as the cost of the projects. Ensure the operators have a plan for if projects go over budget and how they will handle these situations. Review the PPM and other legal documents provided to you for documentation of how a capital call would be handled and your rights as a limited partner. 

Risk 6: Management unable to perform

At the end of the day, no matter how large a project or specific a business plan may be, humans still run syndications. As humans, we all know that the unexpected happens from time to time. Partnerships dissolve, life emergencies occur, and people get sick. So, what do you do if something happens to a member of the management team during a multifamily syndication project? This is something to factor into your decision-making when considering which syndication team to partner with. 

How to mitigate the risk:

When reviewing a business plan and interviewing syndicators, ask about the succession plan in place for the unlikely event that something like this occurs. Who will take over if someone gets sick or can not continue to work for an unforeseen reason? Whose hands do the project fall into if the person leading the operations can no longer perform necessary asset management duties? Additionally, ask about the team’s success and longevity together. Have they worked together before? If so, for how long? This will give you an idea of how well they overcome obstacles together and if they can stay the course in the face of adversity. 

Remember that all investments have their fair share of associated risks. Multifamily real estate syndications are no different. Understanding the risks before investing your money into a deal is of the utmost importance. Nobody wants to be caught off guard by situations like these. The more you know, the better you can mitigate and plan for contingencies. Only you get to decide which risks you’re willing to accept and which ones you’re not. There is an investment path for everyone! 

If you want to learn more about how these types of investments can fit into your current investing strategy, schedule a call with an EZ FI U team member today.

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