For decades, private multifamily real estate syndicators have operated under securities law that banned general solicitation of their investments.
That ban on advertisement made it difficult to raise capital. As a result, new syndicators often started small by pooling their capital with that from family and friends. If they succeeded, repeat investment and word of mouth fueled incremental growth.
However, one misstep could spell disaster for their company leaving them unable to raise capital.
That ban on solicitation may have been difficult for syndicators, but it afforded potential investors significant protection. It created a situation similar to natural selection in that only the strong survived.
Fast-forward to 2012 and the Jumpstart Our Business Startups (JOBS) Act. With the goal of reducing barriers to capital, Congress lifted the prohibition on general solicitation and allowed for broad advertisement of investment offerings. In essence, it deregulated our industry and opened the floodgates to new capital.
Strong syndicators continue to thrive, but now weaker ones have a seat at the table too. They no longer have to live and die by their performance. Instead, they can hire professional marketers (crowdfunders) to raise money for them and shield them from scrutiny.
Given this riskier landscape, it’s never been more important to have a deep understanding of the syndicator you’ll be investing with.
Below are four little known questions that can help you better evaluate a multifamily real estate syndicator.
How do you raise capital for your projects?
Multimillion-dollar apartment buildings require millions of dollars down to finance. And experienced syndicators with track records of success have no difficulty raising that capital.
Investors swarm to their projects because of their proven track record of success. A simple email or webinar presentation is all it takes for them to raise the requisite capital.
Other syndicators aren’t so fortunate.
They have to utilize crowdfunders. For a fee, these marketing middlemen will raise that needed capital. There are a variety of reasons why a syndicator might utilize a crowdfunder, but lack of experience and a marginal track record are two possibilities.
Unfortunately, that could mean more risk for you, the investor.
Utilizing a crowdfunder for raising capital isn’t necessarily disqualifying, but it is a red flag deserving of further scrutiny. Especially when you understand that top quality syndicators don’t require the services of crowdfunders and their extra layer of fees.
What type of debt do you utilize for your projects?
As important as individual investment capital is to the commercial multifamily real estate space, the majority of the capital comes from bank financing. In fact, the Mortgage Bankers Association reported that more than $600 billion in new multifamily originations occurred in 2019.
As the biggest investor in these properties, institutional financiers have a keen interest in these properties being successful. However, not all debt is created equally. Government-sponsored enterprises (GSE) like commercial Freddie Mac and Fannie Mae have some of the strictest, most conservative underwriting standards as evidenced by their miniscule delinquency rates.
Commercial multifamily real estate also happens to be a favored investment for life insurance companies. And since they have guaranteed death benefits to pay out, they can’t afford to lose money. Their conservative underwriting standards similarly produce a negligible delinquency rate.
Local banks and thrifts as well as commercial mortgage backed securities (CMBS) typically have looser underwriting standards. They finance riskier projects for more fees and higher interest rates. As such, their delinquency rates are higher.
Knowing what type of debt a syndicator utilizes gives you a window into their risk tolerance and can help you determine if that’s congruent with your own comfort level for risk.
What is the break-even occupancy and debt service coverage ratio for every property in your portfolio?
Many investors focus on return metrics when they evaluate a syndicator. Those numbers are important. However, it’s also critical to understand the risks that the syndicator takes to achieve those returns.
Two important safety metrics are breakeven occupancy (BEO) and debt service coverage ratio (DSCR). BEO is the minimum occupancy level one needs to maintain to cover all expenses. Any occupancy level above this number represents profit.
It’s important to view BEO in conjunction with current and historic market occupancy. The more market occupancy exceeds BEO, the safer the investment. A property with a BEO of 88% in a market with historic occupancies of 90% is a lot riskier than a property with a BEO of 78%.
Debt service coverage ratio is defined as annual net operating income divided by annual debt service. It’s a measure of how much your annual income exceeds your annual debt.
It’s critical that the DSCR exceeds 1.00 because anything less than that is losing money. The more that DSCR exceeds 1.00, the more profit that property is making and the safer the investment. A DSCR of 1.75 is much safer than one that is 1.15.
Remember that DSCR changes over time. So you want to understand what the DSCR was at first acquisition and how it has evolved. Every year, as they pay down the debt and increase the revenue, DSCR should increase. If it isn’t, that should give you pause.
Certainly, good syndicators can have a bad year in which there isn’t much movement in DSCR. But, if it’s a consistent problem over multiple years or multiple properties, that can be telling as to the quality of the syndicator’s management.
How many of your properties are performing at pro-forma projections and how many are above and below?
Top syndicators evaluate hundreds of properties a year. And part of the process of evaluating those properties is called underwriting. The underwriting process involves taking the current financial numbers and projecting what the growth will be over the next several years.
They need to combine their experience, capabilities, and historic data to project things like future occupancy, rent growth, expense growth, and investor returns. These assumptions are necessary to make competitive offers on properties.
Their estimates are the foundation of their projected returns. Those numbers get shared with potential investors to help them understand what they might make if they invest in the property. And while projected returns can be useful, actual returns are really what matters.
That’s why it’s important to compare a syndicator’s past projected returns at the beginning of a project to what they actually achieved. This will help you understand if their underwriting is conservative, realistic, or aggressive.
Hypothetically speaking, let’s look at three different syndicators. All have been in business for ten years and all have had twenty past projects. The first syndicator has had 18 projects perform consistent with their initial projected returns. One was above projections and one was below.
The second syndicator had 12 properties that performed consistent with initial projections while six performed above expectations and two performed below. The third syndicator had five properties perform as expected with three that performed above expectations and the other 12 performed below projections.
This information is useful. It tells you that the first syndicator uses realistic underwriting assumptions in their projections.
The second syndicator does so as well, but might even be a bit conservative in their projections. Unfortunately, the third syndicator uses aggressive numbers in the underwriting process and tends to be one of those types that overpromise and under deliver.
Private multifamily real estate is a partnership between investor and syndicator
Passive investing in multifamily real estate allows one to derive the benefits of investing in apartments without having to become a landlord. Instead, investors can ride shotgun alongside a syndicator who manages these investments for them.
That syndicator’s experience and expertise can make those investors more money than they could ever make by themselves.
However, not all syndicators are equal. Some are more expert than others and it’s imperative that you have the tools to separate the contenders from the pretenders. These four questions can help you gain deeper insight on your path to finding the syndicator that is right for you.
