For real estate syndication investors, there are many opportunities to choose from and there is a lot of capital competing for various real estate investments. Before racing to place your hard-earned capital, take extra time to conduct due diligence, and be aware of the following seven challenges of today’s environment that can hamper returns — or worse yet, sour a deal completely.
1. Under-capitalized construction costs: Trade wars, a lack of skilled labor, a lack of available labor, period: These are all headlines, but they are also directly impacting the bottom line of your investment, particularly if the sponsor isn’t experienced in what costs really are in the second half of 2019. Different geographies can also produce different cost profiles, just as a different general contractor can. Be aware of the deal sponsor’s relevant construction experience in a certain product type in a certain location.
2. Too much leverage: Debt financing is cheap and readily available today. In fact, currently the United States 10-year Treasury yield — a figure that is closely tied to bank and agency financing rates — is close to its lowest rate in history. With all the debt financing being offered to sponsors, it’s easy to take cheap debt as a replacement for more expensive equity. Time has proven that it can be a fatal financing decision — when the market turns and the required payments to keep current with the debt can’t be met, the deal goes back to the bank. Sponsors should be stress testing their assumptions with loan-to-value (LTV) and different rates to avoid this downside scenario.
3. Exit sale assumptions: Some of today’s exit metrics might be ephemeral unicorns due to the amount of capital available, and in the race to place the capital, valuations are driven up and records are being set on exit cap rates, price per square foot and price per door. This won’t last forever. Just as fast as we saw rates drop this year, they could go up next year. A change from a 5% cap rate to a 6% cap rate is 17% of the value of the asset — an amount that is typically equivalent to the profit on a deal. Ensure the sponsor is underwriting exit metrics that aren’t for today, but rather tomorrow or many years in the future when the sale would occur.
4. Timelines: Real estate projects almost never go according to the original plan on paper, especially in terms of timeline. Timeline delays come in a variety of forms: start time, availability of labor, inspections, utilities, approvals, politics, lender funding, the list goes on. There is a buffet of variables that can impact timelines, and when many delays happen together, it can substantially impact a deal. Be comfortable having your capital in the deal longer than you think it might be, as there is a good chance it will be.
5. Lender restrictions: Remember, the lender is the other partner in the deal. At the very least, understand the nature of the lender and where the risks might be. Is the lender funding bridge debt on a short timeline with no extension options? Is that same lender securitizing their loan on the deal, creating a high level of inflexibility in the business plan? Does the lender use a servicer and, if so, who is the servicer and how long does it take the lender and servicer to make decisions? Is the loan full recourse, and how would that impact the sponsor’s balance sheet?
6. Newly built oversupply: While some markets have not seen a full recovery in terms of newly built supply, others are experiencing tremendous supply growth. Back to the availability of capital — a lot of capital is being put to work in the form of new development. As a result, that supply may impact your investment if it’s directly competitive, or it may weigh down the entire pricing of the asset class. For example, if there is too much Class A supply, the pricing of Class A product can drop into Class B territory.
7. Operating growth assumptions: Many multifamily markets have been growing at 5% or more per year for the last few years, so many sponsors underwrite a similar level of top-line growth in perpetuity. The issue is the growth will plateau and come back down to reality, unless you can uniquely identify why tenants will be able to pay that much more money. Perhaps there is a new industry or a major corporate relocation that will drive rents for the long term, but at some point, rent increases have to be manageable to the tenant and in line with wage growth.
This list above is by no means complete or exhaustive. Every real estate deal is unique, and there are many variables and risks to consider. The above might serve as a due diligence starting place for your next real estate syndication investment.