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I advise LPs on existing and potential positions and write articles here weekly on what I see in the marketplace that could help you invest better. You can find me on LinkedIn or Twitter.
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Preface
I wanted to thank Devon Kennard and Justin Pugh for inspiring me to write this (and making it free for all), explaining some of the challenges that professional athletes are facing (most notably investing their earnings in an effective matter), and taking the time to review and add to this article. I never thought I’d be co-writing an article with professional athletes, but here we are! Here’s Justin and I below.
An important introduction - please read in full
There are many places to put your money, and real estate is just one of them. This article assumes you want to put your capital into real estate, but it should be clear that asset allocation is a discussion in its own right (but not the purpose of this post).
Beyond deciding how much you’d like to allocate to real estate investments, you should also have a clear strategy on how much you should allocate to (1) a specific deal and (2) a given sponsor (across several deals). Don't over allocate yourself - you will never be able to catch all the risks of an investment, which is why diversification is critical.
If you’re new to investing (and even if you’ve invested before, but don’t know the entire landscape) it is always valuable to have an independent opinion both from the perspective of (1) evaluating an investment and (2) reviewing the legal documents that you’ll be signing (which you should always read and understand yourself as well). An attorney can also help with additional legal and privacy risks when investing in a deal.
I didn't want to title this “top 15 red flags” because “red flags” have a connotation that’s too strong. In other words, and as I write in my three pillars of LP investing articles (Execution, Alignment of Interests, and Property), the tips below are meant to guide an LP investor in realizing that something in a deck is off-market based on that one factor. However, it is important to know that one of these being true in a given deal doesn't necessarily mean that the deal is bad and the investor should pass - it just means you should stop & think.
One of the best examples of not passing on an investment based on above-market terms is a hedge fund called Renaissance Technologies. Investing in their Medallion Fund comes with some of the highest fees in the hedge fund world (see below).
However, Medallion Fund’s returns speak for themselves (really recommend a read for the nerds among us). What we learn from this is that at some point a GP may choose to increase fees (or change other parameters) away from what is considered market based on their track record and performance and supply/demand dynamics.
There is nothing wrong with non-market terms, as long as you (as LP) are (1) aware that the terms are not market and (2) are fine with them in the grand scheme of the investment opportunity.
Having said that, one of the most important aspects of investing carefully is not losing your money. Avoiding principal loss is not talked about enough and I will write on this in detail next week. One of Justin Pugh’s favorite quotes is, “money is like soap, the more you play with it the less you have." As I advise LPs on existing transactions in some form of distress, I have seen the below 15 mistakes pop up over and over again (oftentimes more than one in the same deal).
People tend to overestimate the benefit of marginal wealth and underestimate the pain of losing it.
The goal of this article is to make sure you're alert when you are looking at a transaction that has something about it that is unusual. All investments carry risk and one of the below factors being true in a deal needs to be weighed carefully against what benefits the transaction has over other similar deals. Syndications will vary and I can't stress enough looking at a transaction as an entire package rather than investing or not investing based on the investment memo/deck meeting (or not meeting) a factor contained herein.
Furthermore, there are exceptions to nearly every single point below. However, I believe I (together with Devon and Justin) did an honest job of laying out the top “signals” that should be top of mind for the vast majority of real estate syndications. Let me be extremely clear - just because a deal “passes” the 15 points below does not mean you should invest without doing further due diligence, this is only meant to be a list of the most common issues.
Lastly - there’s no replacement for education, and there are many sponsors who will (unfortunately) take advantage of those who aren’t educated on these topics. I hope that this article helps you in a small but meaningful way. If approached carefully, investing well can transform your life.
If you have anything that you’d add to this list, have questions, or you simply want to say thank you (we’ll take those too!) feel free to comment below.
Top 15 reasons to stop & think (note the new title!):
Any syndicated real estate deal with lower than 65% split to LPs (70-80% is market) in a promote and/or a preferred return lower than 6% (7-8% is market)
Be mindful of (1) how often (i.e. monthly, quarterly, or annually) returns are paid, and (2) when you can expect to get your first distribution.
If the deliverable says “guaranteed return,” proceed with a lot of caution - nothing is guaranteed in investments and it’s deceiving to use that wording in a deck. A preferred return is not guaranteed!
For example, if an asset is stabilized it makes more sense for you to get paid immediately, whereas on a development deal you’d naturally need to wait until the real estate is built and leased before you can expect to be paid.
Line up your personal goals (e.g. cash flow now, or wait for a larger sum of capital in a few years from now) with what you’re investing in - and make sure you have the same expectations as the GP up front. A typical hold period (the time it’ll take to get your investment back) is 5 years, but there are some that are shorter/longer so you should be aware and comfortable with what you’re signing up for.
More here on both of these and waterfall structures in general)
Any social proof tactics; examples:
___ person invested and made ___% returns
I’ve been on #x podcasts, have #y followers on Twitter/Instagram/TikTok (etc), or am famous (for whatever reason) - all of these are wonderful, but aren’t a true signal of investment acumen so they should not weigh in on your investment decision. Being an investor and marketer (regardless of platform) are two different skillets, and the cross section between the two populations is slim.
I used to be in your career (or am a part of the same ethnic/religious community), and can help you achieve financial freedom
Pressure to invest/make a decision quickly
Family/friend is investing, is the GP, or sent you the deal - nothing wrong with this, but also don’t mean the deal is good
Just because you’ve spent a lot of time with someone, doesn’t mean you should invest with them
Invites to conferences/courses by the GP where the LP has to pay to join
Investment decks that are overly salesy in nature (e.g. focus too much on “providing housing” or “tax benefits” as opposed to the underlying investment, show glamorous lives, or convince to invest by claiming that “investing will allow you to quit your 9-5 job”)
A typical IRR is in the 10-20% range, but never trust IRR (Internal Rate of Return or - roughly speaking - the rate of return on your investment) without due diligence, whether the number is high or low.
One simple assumption (e.g. cap rate compression - see #7) can take an IRR from 5% to 20%+ .. and that changed assumption doesn’t make it a good transaction to invest in!
Generally speaking, the higher the IRR (or returns) the higher the risk. Risk includes the risk of losing ALL of your invested capital - this isn’t fictional and the loss can happen to you as well (I advise on these losses for a living and nobody thinks it would be them, until it is)
Make sure you check (and ask) whether the returns presented are deal level or LP level. The former do NOT typically include fees and the split that would go to the GP, thereby making the LP level returns significantly lower.
No return of capital clause to LP investors, or a return of capital clause that doesn’t return all of LP capital before the GP is tapping into their returns
More here on how return of capital works
Also see never budge on this when investing for why this is so important with an example)
Anything higher than a 3% acquisition fee as a percent of Purchase Price
1-2% is common
For example, if a property is being acquired for $10 million with 70% Loan to Value (equity capital is $3 million and debt capital is $7 million). The acquisition fee would be $10 million * 3% = $300,000… this would be considered to be on the higher range of market
Be mindful that the percentage should get lower as the Purchase Price gets higher (for example, a 3% fee on a $1 million dollar deal would be fine, but the same percentage would be absurd on a $100 million dollar deal)
More on how acquisition fees, in particular, impact your investment
No clear outline of all fees that you’ll be charged, waterfall structure, or Sources and Uses of the transaction (where the money is coming from and where it’s going)
As I discussion in the Execution pillar, trust is paramount and you want to make sure you’re investing with someone who’s being transparent about every dollar. There’s a reason why this pillar is the first of three.
Between the investment deck and legal documents, you should have a clear picture of all the fees that you’ll be charged; if something isn’t clear, ask
This touches on a broader subject of trust. If anything - and I mean anything - is done during the sales process that makes you question the integrity of the other side, be mindful. A few examples that come to mind:
Terms changing (unexpectedly) from the investment deck to the legal documents that you are supposed to sign as an LP … of course this could be a mistake, but be mindful and don’t automatically give people the benefit of the doubt with your hard-earned money
You are investing in a property, but it’s unclear what the relationship is between your counterparty and ultimate owner (i.e. you are investing with someone who’s pooling the funds to invest with the actual GP); while we’re on this topic, it’s important to note that these situations typically lead to diluted returns for you as an LP, since the intermediatory needs to be compensated .. make sure that the intermediary’s value add is worth their compensation
You have been presented an opportunity to invest in a standalone property, only to realize that the sponsor is actually acquiring a portfolio of properties (only one of which is yours). The loan is collateralized by all the properties, so the performance of one (or several) property/ies that you’re NOT invested in can impact your investment returns on the property that you did invest in.
Exit cap rate lower than entry cap rate (typically referred to as cap rate compression) or lack of a sensitivity analysis in cases when the GP has conviction behind such an assumption
Note that even if Net Operating Income has increased throughout the investment cycle of an asset, the cap rate is also dependent on market forces (ie very little can be done by the GP to change it).
As a result if you bought something at 6%, did nothing to it, and expect it to sell at 5.5% (or lower) you are simply making a macroeconomic bet - which is inherently risky.
This touches on a larger point around macroeconomics. You should familiarize yourself with what’s going on in the world, but also realize that macro trends are (generally speaking) nearly impossible to predict well. As such, I’d warn against any investment theses that depend highly on factors outside of the GP’s control.
More on why cap rates can be tricky
GPs business plan (what they plan to do with the property) is vague, or not supported by enough details and data
Never trust vague investment thesis without sufficient support - always think “what could go right and wrong with this thesis” to test its validity
You should ask for the model, and understand/test its assumptions
More on business plan in the Property pillar
Several GPs involved in the same deal (that don’t work for the same firm) and/or it is not clear who is the one making decisions
More in the Execution pillar
Management team has little experience investing in AND operating real estate
Take special note of bios that are vague, overly boastful, or hard to verify
That “AND” above is critical because investment and operational expertise are different and both of them matter
Here’s a summary:
Brokerage experience isn't the same thing as investing experience
Investing experience isn't the same thing as operating experience
Operating experience isn't the same thing as construction experience
It's true that all experience helps, but you should always understand how much!
A lot more on this here
Track record lacks significant experience; slide is vague, missing, or hard to follow
Notice that all experience isn’t created equal - a few examples:
buying properties while being at a firm isn’t the same thing as being a solo GP on a deal
buying properties isn’t the same as lending to them
a track record in multifamily for an industrial investment is less relevant
More on this here
Co-invest from GP is less than 5% of equity in the transaction
Market is 5-10%
Take special note of this number (as a dollar amount) relative to the acquisition fee (which is a fee that the LP pays to the GP)
Note that the coinvest % can go down as the deal (or fund) gets much larger ($100MM+)
More on this
Debt assumptions
Floating (vs fixed - which is less risky) interest rate on the debt taken out to purchase the property
Unclear refinance assumptions or assuming lower interest rates in the future; lack of a sensitivity analysis in cases when the GP has conviction behind such an assumption
Rent and Price Assumptions
Annual rent growth above 2% every year without justification
Material (10%+) changes in existing rents on a property to bring the rents up to market (in cases where the GP thinks that the rents are far below market).
This happens, but needs support and proof… make sure the support is convincing and maybe even call a complex nearby to test one of the assumptions.
The same holds true when the GP plans to renovate apartments and bring the rents up - I’ve seen many cases of GP assumptions not being reached post renovation (many times as a result of not doing enough research up front)
You should try to familiarize yourself with the political landscape in the city/state/country that you’re investing in. What government mandates (e.g. rent control) or other catalysts could occur to create outsized negative implications to the valuation or business plan of the investment?
Sales and/or rent comparables include minimal information or suggest that the property being purchased is the best price in history
More on this in the Property Pillar
Assumptions in year 1 that have simultaneous material increases in revenue AND material decreases in expenses relative to existing operator financials
Or a cash flow model that’s totally missing from the deck entirely
Take special note of property taxes and insurance changes from existing to forecasted numbers
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