By Dr. Jim Dahle, WCI Founder
We write about real estate investing, syndications, and private real estate funds around here all the time. However, a lot of our writing is theoretical, since these illiquid investments take years to go full circle. There is no central database of their returns like there is for mutual funds (Morningstar) either. While projected returns on syndications are nearly always higher than the expected returns on stocks, bonds, and even publicly traded REITs, the actual returns people achieve are much more opaque.
I think it is useful to provide an illustration from time to time on how these investments actually perform, so whenever one of my investments goes full circle, I write a post about it.
That is not what today’s post is, however. Our text for today’s post comes from a recent quarterly update I received from one of my equity real estate funds. I committed $100,000 into this fund in 2017, and the capital was called from 2017-2019. Capital started being returned in 2020 and then accelerated through 2021 and 2022. Most of the capital has now been returned although the fund probably won’t wrap up until the end of 2023 or even 2024. We’re not going to spend a lot of time talking about the overall return on this fund, at least until it goes round trip.
We’re just going to focus on one of the 17 properties in this fund.
Syndications Do Go to Zero
This particular property had a complete loss of capital. Here is an excerpt from the quarterly update email from the fund with some more details:
“Dear Investors,
We are pleased to provide you with an update on your investment in the Fund. As of Sept. 30, 2022, the Fund is projected to generate a 57.5% gain on invested equity, reflecting a 14.1% total return over the prior 12 months. Assuming a full liquidation as of Sept. 30, 2022, the Fund generates a 12.9% internal rate of return. As of Sept. 30, 119.8% of invested equity is returned to investors through distributions of operating cash flow and asset sales . . .
Only one office investment remains within the portfolio. Due to significant adverse changes in the capital markets for office assets over the past quarter, the value of the asset has fallen below the outstanding debt amount. A continued hold of the asset is possible but would require a debt restructuring alongside an injection of additional equity. Despite strong recent leasing activity and the lender’s willingness to entertain a discounted payoff, a new equity investment would not produce a satisfactory risk-adjusted return. As such, the net asset value is reduced to zero, reflecting the full loss of the Fund’s initial investment.
Notwithstanding the further write-off of equity, a 12%-13% net IRR and 1.58x-1.60x net multiple is projected. A full and final liquidation of the Fund is expected by the end of 2023 or early 2024; however, the ultimate timing of final asset sales could change based on strategic decisions to optimize value creation by adjusting to property and market conditions.”
Lessons Learned
This is the second property I have invested in that had a complete loss of investor capital. The other one was a syndication I owned directly rather than via a fund. It’s actually not completely done yet (and when it is I’ll write a post about it), but I’m pretty sure it will end up with a near-total loss of capital. That doesn’t mean a return of -100%, but it’s not that far from it. In addition, the single-family home REIT I’ve invested in is on the rocks as previously described in a blog post and on the podcast.
I think there are a few lessons that can and should be learned by syndication investors from situations like this.
#1 Diversification Matters
Imagine I had put all $100,000 into this property. I would be out $100,000. But I used a fund instead, so only around $5,000 of my money went into this property. This diversification limited my loss to $5,000, not $100,000. And in fact, the rest of the portfolio did sufficiently well to make up for that loss, still providing double-digit returns.
More information here:
A Private Real Estate Investment Update: My CityVest DLP Access Fund Goes Round Trip
#2 Past Performance Does Not Predict Future Performance
Just about every operator and fund manager I’ve ever seen has awesome past performances. But you can’t buy that. Two prior funds from this manager provided equity multiples of well more than 2. That isn’t going to happen with this fund, in part due to the performance of this property. Projected returns are just that. Past returns are just that. You can buy neither.
#3 These Are High-Risk Investments
Real estate syndications are high-risk investments. Not only is it possible to get returns upward of 10%, you can get returns in the 20%-30% range or even higher. But you can also lose your entire investment. There’s a reason you have to be an accredited investor to invest in them. Accredited investors should theoretically be sophisticated enough to evaluate an investment on its own merits without the assistance of financial professionals. Perhaps most importantly, they should be able to lose their entire investment without it affecting their financial life in any significant way. The reason is because it really is possible to lose your entire investment. That’s not going to happen with an index fund.
#4 Leverage Risk Is Real
The value of this office building did not go to zero. It is still worth something. This particular fund uses up to 70% leverage. So, it only takes a drop in value of 30%+ to wipe out your entire investment. Everybody loves to talk about “leverage” and “other people’s money” and “borrowing at 4% to invest at 10%.” But leverage works both ways, and sometimes it takes a wipeout to remember that.
More information here:
How Our Portfolio Performed in 2023 (Including Real Estate!)
#5 Operator Matters More Than the Investment, but the Investment Still Matters
You have often heard me say that the operator (manager, syndicator, general partner, etc.) matters a lot more than the investment, because a bad operator can screw up a good investment and a good operator can make lemonade out of lemons. I still think that’s true. I think this particular fund manager probably made the right decision not to throw good money after bad (I made a similar decision when given the opportunity to pour more capital into the syndication I had that went bad). However, even a good operator can’t rescue every deal. I went back and read what this operator thought about office building investments back in 2016. Here’s what they said:
“The emergence of Gen Y has created a younger workforce that continues to redefine the nature of demand for office assets. Our analysis has identified two trends in office space that will continue as Gen Y replaces Generation X as the majority of the U.S. workforce.
- Reduction in office square footage per employee. Tenants, particularly larger public firms, are downsizing their offices as they increasingly adopt policies for sharing non-dedicated offices and implement technology to support their employees’ ability to work remotely.
- Changing preferences for workspace setup and features. Companies are increasingly seeking more collaborative work spaces for functional project teams, and there is growing demand for more on-site amenities at office locations.
We believe that the Company should also continue to benefit from the positive supply and demand dynamics of the office market due to increasing costs to build and a decrease in supply of office properties as current assets are being converted to other uses. We conduct specific submarket analyses in all of our Target Markets to understand the full picture of these supply and demand drivers. In Chicago, 4,122,124 square feet of office space have been taken off the market through conversions to hotel and multi-family properties since 2007.”
The operator clearly does not have a functional crystal ball. They did not know that in 2020 there would be a global pandemic that would dramatically accelerate the work-from-home trend and that office buildings would become worth dramatically less. Diversification protects you from what you do not know and what you cannot know. I still like this fund manager. I have invested in another of their funds, and I will probably invest with them again. But they’re human, just like the rest of us.
Real estate syndications can and do go bad, even in relatively good markets. When the market turns against them, even more of them go bad. Invest carefully and go into these illiquid investments with your eyes wide open. If you’re interested in learning more about private real estate investments, consider signing up for our free real estate newsletter and check out our partners in the chart below.
Featured Real Estate Partners
DLP Capital
Type of Offering:
Fund
Primary Focus:
Multi-Family
Minimum Investment:
$100,000
Year Founded:
2008
Origin Investments
Type of Offering:
Fund
Primary Focus:
Multi-Family
Minimum Investment:
$50,000
Year Founded:
2007
37th Parallel
Type of Offering:
Fund / Syndication
Primary Focus:
Multi-Family
Minimum Investment:
$100,000
Year Founded:
2008
Southern Impression Homes
Type of Offering:
Turnkey
Primary Focus:
Single Family
Minimum Investment:
$60,000
Year Founded:
2017
Wellings Capital
Type of Offering:
Fund
Primary Focus:
Self-Storage / Mobile Homes
Minimum Investment:
$50,000
Year Founded:
2014
MLG Capital
Type of Offering:
Fund
Primary Focus:
Multi-Family
Minimum Investment:
$50,000
Year Founded:
1987
Mortar Group
Type of Offering:
Syndication
Primary Focus:
Multi-Family
Minimum Investment:
$50,000
Year Founded:
2001
AcreTrader
Type of Offering:
Platform
Primary Focus:
Farmland
Minimum Investment:
$15,000
Year Founded:
2017
* Please consider this an introduction to these companies and not a recommendation. You should do your own due diligence on any investment before investing. Most of these opportunities require accredited investor status.
What do you think? Have you had any syndications go bad? What happened and why? Comment below!
