5 reasons to invest in real estate syndications

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5 reasons to invest in real estate syndications

Welcome back, and Happy Thanksgiving.

I wasn’t sure whether I should release this today, but then I thought … what could be better than talking about syndications over family dinner! In all seriousness, enjoy your weekend and I hope you’ll find time to read this before falling asleep on the couch after the turkey. 😊

In last week’s post, we spoke about protecting an investor’s downside in investing. I also noted that missing the 10 BEST trading days in the stock market (out of a 8,033 day period!) barely doubles your money over a ~22 year period - that is a long time. This illustrates the importance of not staying on the sidelines and investing your capital.

After posting this article, I got the question below. Please continue to send me questions you’re wondering about - it means a lot and I keep track of them to ensure I address them in a later post.

“If it takes so long to get your capital back after losing principal, why should I invest as an LP altogether?”

I think this topic isn’t discussed enough - people who SHOULD be invested as an LP aren’t, while many who SHOULD’T be investing as an LP are invested.. and, at times, overinvested.

Today, we’ll discuss why LP investing should be part of most - but not all - investing strategies.

First, a few notes:

• The first thing that anyone should think about is their family goals, risk tolerance, age, etc. This will be the topic of another post.

• Even if all of those check out, in my opinion, it still doesn’t make sense to invest as an LP until certain wealth criteria are met, or perhaps you’re just very knowledgeable about the real estate space.

• I will write about this in detail soon as well, but for now suffice it to say that LP investments take effort to vet and the more capital you’re able to place (generally speaking) the better deal flow you’ll have access to.

Once 1 & 2 are met (important to note that #2 requires that you either know how to vet transactions or are getting good advice), you’re ready to be a real estate LP investor.

But the question for today is why?! Perhaps it’s just better to put your money in an index fund and forget about it?

I’d like to propose 5 separate answers:

• Diversification

• **Access to smaller deals within a specific asset class and a local market **

• Easier to analyze/learn relative to other alternative investments

• Lower volatility

• Tax benefits

For each one of these, we’ll touch on the benefit, it’s risks, and mention any mitigant(s) that are relevant to balance out the discussion.

1 - Diversification

• Benefit: Diversification against other positions in your portfolio (stocks, bonds, cash, etc). Note that the index fund should be in your portfolio, so it’s not a contradiction to have both!

• **Risk: **Investment in a syndication is concentrated in a single asset (typically, unless it’s a in a fund). This can be riskier than, say, taking a position in a public Real Estate Investment Trust (“REIT”) that has more diversification across different properties and better liquidity (can sell at any point).

• **Mitigant: **With proper vetting, a concentrated bet (as long as it’s not a big portion of your overall net worth - more on that soon) can be beneficial to you from a returns perspective.

2 - Access to smaller deals within a specific asset class and a local market

• Benefit: All three of those are fairly unique to the syndication space:

• Smaller deals, generally speaking, get overlooked by larger institutions and that market tends to have more inefficient transactions (i.e. where the price you paid is cheap relative to the return you might be able to attain by operating the property).

• These are typically referred to as sub-institutional deals for this specific reason.

• Note that “small” typically refers to $1-10MM investment amounts. In other words, the syndication allows you (LP) to get access to a deal that you wouldn’t otherwise be able to buy on your own, but the deal itself is also relatively small in the marketplace of all real estate deals.

• Specific asset classes can be found in public markets (e.g. apartment REITs, Single Tenant Net Lease REITs), but as a retail investor you’ll never be able to meet the people who are investing your money. That’s not to say you shouldn’t allocate to a REIT - you should - but rather that there’s something special about placing capital into a specific deal with someone you got to know.

• **Local markets **are hard to come by outside of the syndicated universe. If you live in a small town, you can certainly find GPs around you who’ll buy something a few streets away from your house and turn it into something special. Institutional capital tends to focus on a much broader themes as opposed to investing in a small geographical area. I’m a proponent of investing in markets you’ve been in - there’s something special about investing in a neighborhood or GP that you believe in, and have it work out.

• **Risk: **You might love the smaller deal, in a specific asset class and in a perfect market, but you - as LP - have little to no rights if things go wrong. This lack of control goes both ways - you don’t need to do anything to make a return on your money (which is great and a reason to invest), but you also can’t do anything in challenging times to change the trajectory of the outcome.

• **Mitigant: **

• There’s no way to mitigate lack of control other than knowing that challenge may appear throughout the lifecycle of a project and doing proper due diligence up front as a result.

• Allocating a wise percentage of your net worth here is particularly important - nothing more painful than seeing someone make mistakes with a significant chunk of your net worth AND not being able to do anything about it as an LP.

• It should be noted that sometimes having no control is actually good, since people tend to make kneejerk reactions to news. This is why picking a GP who knows how to invest & operate in good and bad times is helpful - you’ll sleep well at night knowing they’re a great steward of your capital.

3 - Easier to analyze/learn relative to other alternative investments

• Benefit: With practice, real estate investments are easier to understand (in my opinion) than many other investments. For instance, I would much rather pick apart a real estate transaction than look at a public company’s filings to determine whether it makes sense buying a stock. This preference changes based on experience, but I do believe that it’s fundamentally true because there are “less variables” to analyze in a typical real estate deal and you can vet the surface of a transaction fairly easily.

• **Risk: **Because real estate is an asset people assume an array of nonsense (perhaps because they connect to recent market trends or their residential property), such as the points below:

• “Real estate prices / rents always go up”

• “I can’t lose my money since the GP can always sell the asset”

• “Everyone needs a place to live, so this is a safe investment”

• Mitigant:

• It’s important to understand the potential downside on an investment as I wrote about here - losing 50% of your investment can take 9 years to recover! If you think about the downside enough, you’ll make investments tactfully.

• Real estate investments that aren’t speculative in nature (examples of speculation would be assuming something will happen to interest rates, buying with high Loan to Value or floating debt, etc.) tend to be resilient from a cash flow perspective even though difficult macroeconomic environments.

• The mentality should be “it’s ok if I don’t make the projected 2x and just earn a 1.5x on my money over a 5 year period, as long as I minimize the chances of losing money.” Of course there are circumstances where you can (and should) bet on higher risk deals, but make sure you’re doing this while realizing that the chances of losing money is also greater.

The mentality should be “it’s ok if I don’t make the projected 2x and just earn a 1.5x on my money over a 5 year period, as long as I minimize the chances of losing money”

4 - Lower volatility

• Benefit:

• Remember that the purpose of your real estate investment is to attempt to outperform other investments (such as an index fund). While that’s true, it’s also true that almost no real estate investment will likely yield 5x or a 10x return on equity .. real estate is simply not the place to search for those types of returns.

• Investments like venture capital (many other examples) have much higher possible returns, but investors need to go into those investments understanding that there’s a high probability of losing all of your money… but if you win, you win big!

• **Risk: **Similar to #3’s risk above, I consistently see investors assume that real estate investments can’t lose money. These comments (which are sometimes made directly or indirectly by GPs themselves) are dangerous in my opinion, because people assume that “the worst thing that can happen” is the LP gets their money back. This isn’t true.

• **Mitigant: **Real estate is not the place for “YOLO - You Only Live Once” bets. Since the upside on the investment is fairly capped (I would say you should never expect more than 2x within a 5 year period), you should feel confident at the outset that the chances of investment losses are low. This probability is never zero - all investments carry risk - but with an investment that can only earn you 2x in 5 years, the downside better be manageable and have strong mitigants. The reality of a somewhat capped upside also leads to investing in more sturdy cash flows - ones that can’t be “wiped out” by increases in debt costs due to floating rate debt, for example. More on this here.

Real estate is not the place for “You Only Live Once” bets.

5 - Tax benefits

• Benefit: Investing in syndications can come with immense tax savings due to the depreciation.

• **Risk: **Two big ones stand out here:

• The tax benefits may not apply to you AND the actions that lead to those tax benefits (e.g. running cost segregation on time) are in the hands of the GP.

• Don’t let tax savings make your investment decisions for you - it’s undoubtably part of the overall decision, but shouldn’t blind you. Sometimes it’s better to pay the taxes!

• **Mitigant: **If tax savings are a material part of your investment decision, be sure to consult with a CPA and ensure that the GP has the exact same plan as you need in order to benefit from those tax savings.

Thank you for reading! I genuinely hope you found this helpful - the best way to say thank you is to spread the word.

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