I am often asked if I can recommend a book for a Limited Partner to gain a better understanding of syndications, including how to better understand a deal. I am happy report that I finally found a book that I can whole-heartedly endorse as a great introduction to syndications for LPs: The Hands-Off Investor, by Brian Burke [1].
This book provides a complete overview of syndications: starting with an introduction to the terms used in the deals, discussing options for how to find potential sponsors, outlining the questions that you should ask GPs about the deal before you invest, helping you understand the documents you sign, establishing expectations about interacting with the sponsor, and finally explaining what happens when a deal is wrapped up.
The book has a definite slant towards value-add multifamily deals, which is the author’s area of expertise. However, the information is broadly applicable to almost any real estate syndication deal.
While the majority of the book is focused on the due diligence an LP should be doing before signing the paperwork, which makes sense since, as the author states, “it’s actually harder to get out of a deal than to get into one”, it also provides an excellent overview of the entire deal workflow, from initial engagement through the final sale of the property and winding down of the syndication.
There is a lot of valuable information in these chapters – far too much to include everything here. A few insights that stuck with me are:
- Why you should look beyond the individual GP you are working with to the entire team that is being engaged. While the GP may be a single individual or a small group, it is unlikely that they have all of the experience required to successfully perform all aspects of the deal – from the sourcing of the property, to the inspection, to the various legal engagements, to the repairs and management of the property, to handling all of the accounting, bookkeeping, and taxes. As a result, knowing who else makes up the team can provide additional confidence that the deal will succeed. Does the property manager have extensive experience with this type of property? Are the accountants and book keepers familiar with syndications and have experience working together? Is the GP looking just for the lowest cost providers and cutting corners on their partners?
- One of the advantages of being an LP is that you do not need to spend time doing due diligence on the property itself. However, you should make sure that the GP has put in the time to truly investigate the property and uncover any potential issues. They should understand the market and demographics that the property is in. The sponsors should have personally visited the property and done their own in person inspection. They should also have professional inspections done, for example environmental studies, property inspections, pest inspections, and roof inspections. The lender may also require a feasibility study completed by a third party, which can validate the GPs proposed approach and underwriting. As a potential LP, you should be able to access these documents, although it is likely that you will need to sign an NDA since the information they contain is business sensitive.
- The Source and Uses table provides an important overview of all of the money coming in to a deal and how it will be used. The sources of funds include not only the money provided by LPs, but also all debt (loans) and preferred equity that is being used to fund the deal. This gives you insight into how many people need to be paid before you are. The uses of the funds provide the allocation of that money to different source including the purchase of the property, closing fees, legal fees, sponsor fees, due diligence expenses, insurance, taxes, deposits, start up expenses, planned renovations, and reserves.
- The GP and LP should be clear on what communications are expected. In particular, what is the anticipated frequency and what information are you expecting to share. In most cases, you should expect there to be at least quarterly communication from the sponsor, such as a regular newsletter, that provides an update on what is happening at the property as well as a profit and loss statement that gives you an indication as far as whether things are proceeding according to plan or not. If there is a lot going on, or things are not going to plan, then expecting more frequent communications is reasonable.
- When looking at the returns being presented, make sure that you are looking at the net returns (i.e. to the investor returns) and not the gross returns for the project. The gross returns include the fees paid to the sponsor and thus would appear higher than what you would see as an LP. I was surprised to hear that some GPs present gross returns instead of net, but apparently that is a thing.
- Before entering the deal, understand the potential exit strategies that the GP is considering. There is usually a primary plan, for example return all of the investor money through a cash out refinance or sale of the property. But that might not end up being the best option when the time comes – for example, if interest rates have increased dramatically, maybe a refinance won’t work. What are the other strategies that are being considered. Ultimately, there are 5 basic strategies, with variations depending on the specific circumstances: a sale of the property; recapitalize by selling to a new set of investors; a refinance to return the investor capital; continuing to hold for long term cash flow; and converting the syndication to a REIT. The last one is fairly uncommon and the fourth one isn’t really an exit from the deal, so in practice as an LP you get out of a deal by either selling the property or refinancing and getting your money back. In the latter case, you are still technically part of the deal, but you have your money back and can reinvest it elsewhere. This is also known as the “infinite return” strategy since you are getting a return but have no money left in the deal.
- While no-one ever wants a capital call, it is important to understand what will happen to your investment if a call is made. In particular, what happens if you don’t put more money into the deal: Will you lose the money you have put in so far? Will your ownership be diluted? This information is contained in the offering documents, so take the time to understand what happens. In the best case, if a capital call happens and you don’t contribute, your ownership will be diluted based on the new funds coming in. That is reasonable, especially if the new funds allow the syndication to ultimately have a positive exit. If the capital call provisions are putative (e.g. you lose all of your ownership if you don’t contribute) you should seriously evaluate whether or not the deal is worth investing in.
Overall, I highly recommend that LPs read this book and learn what they need to know in order to become informed passive investors. It is always better to learn from others instead of making costly mistakes yourself. Following the lessons included in the book will help you find great deals and avoid potential pitfalls – both important steps in a successful investing journey.
If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.
For additional reading:
This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.