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Aleksey Chernobelskiy

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January 18, 2024

Losing it all in foreclosure

Learning from someone else's failed LP investment

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Losing it all to foreclosure

Welcome back!

I started this publication to share LP lessons in an anonymous way to benefit the reader. Once in awhile, such lessons are made public by the LP themselves and I would like to dive in to such an example here. The goal is to help you avoid situations like this:

Today we will discuss how an LP invested in a syndication, funded a capital call when things went south, and then lost it all in the end. To make matters worse, there was a tax surprise in the end as well. **If you’ve been through (or currently going through) a similar situation, reach out by replying to this email. **Also remember that at least some lessons from the loss are on you (as LP) to learn. In other words, you can blame the GP / market conditions (and you would be right), but there’s also at least a small component of due diligence that you might have missed. Learning these lessons now will serve you well into the future.

I hope this will help remind people that, although real estate can provide incredible returns, it’s far from risk free on an asset by asset level. You really need to understand what you’re investing in, and if you don’t (or don’t have time to ask the right questions) … don’t invest.

Here’s the chain of events leading up the email the LP investor got recently (and shared publicly):

  • LP makes an investment into a syndication

  • The investment faces challenges, so the GP issues a capital call for more cash

  • LP invests in the capital call

  • Eventually, the GP realizes the equity investment is not salvageable and gives the keys to the bank (i.e. foreclosure). As a result, the entirety of the investment is lost by the LP.

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There there are a three things we’ll cover on this:

  • The impact of losing capital

  • The capital call decision

  • Tax implications of foreclosures

1) The impact of losing capital

First, you should be extremely careful about losing money (or the chances of it) in a real estate deal. They’re just not meant to be the riskiest of investments, but can be if you don’t do proper due diligence in the beginning.

To illustrate this point further:

  • Let’s suppose you invested $500k in a syndication (or any investment)

  • You lose 50% of your investment (find 50% below on the x axis)

  • You reinvest the remaining $250k at 8% interest (find 8% on the y axis)

  • It then takes 9.01 years (see the highlighted cell) to get back to your original $500k!!

> What you’ll clearly notice above (see blue highlighted area) is that almost any principal loss in excess of 30% takes many years to recoup. This is why losses matter.

For more on this specific topic, I highly recommend reading Don’t lose money, seriously.

Second, real estate has risk as any investment, but because the upside is fairly capped in probability (~2x over 5 years is considered great) it's illogical to invest in something that has a decently high probability of losing you money.

Said another way - real estate is NOT the place for You Only Live Once ("YOLO") investments. High upside investments like VC and Crypto (many others) can earn you 10-100x on your investment, which is why (all else equal) investors are fine with taking on the risk of losing it all. In real estate, this shouldn't be the case!!

For more on this specific topic, please see Is real estate better than treasuries.

2) The capital call decision

Let’s turn back to the email. Below is a small excerpt from the email above and there’s a lesson in there.

As I pointed out above, the investment was struggling and the GP decided to do a capital call for more cash in March of 2023. Some people contributed, and although it appears that not all of that cash was used, it’s not clear how much of it is still remaining.

The lesson here is that not all capital calls should be funded. Just because you have money at stake, doesn’t mean you should put in more. The marginal cash should be treated as an investment decision.. and you should probably be more confident in your capital call decision than you original decision to invest in the project, since now you have the additional information that’s hard to ignore - your investment, led by the GP, isn’t doing well!

For more on capital calls, please see Do sunk costs matter in capital calls.

3) Tax implications of foreclosures

Unfortunately we’re not done.

Not only did the LP lose the initial $100k investment, and the follow on capital call investment (or at least most of it, if the GP manages to sends some back per the email) they now have a tax bill coming due as a result of the accelerated depreciation benefits the LP took in prior years.

So, put in other way, not only did the LP just get negative news about his $100,000 being gone, but now he’ll also need to come up with additional cash to address “repaying” the IRS for the tax benefit he previously took.

I write a lot more on the hidden risks of tax benefits in syndications here.

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To close, I wanted to thank Noah for educating people and sharing this publicly. I think many people share their winnings, but it’s rare to find someone sharing the losses as well.

If you or anyone you know have gone through something similar (I'd be happy to make both you and the GP anonymous) please reach out. I'm hoping to make this year full of incredible content where we dive into real stories of both successful and failed investments. The goal is for you to learn from both of these, without putting any of your own principal at risk (until of course you feel ready to do so).

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

I have dozens of topics on my list for 2024 and I’m very excited. If you have a topic you’d like me to cover or have any questions on this article, please leave a comment.

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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