You may have seen the article that I wrote a while back titled, “The 7 Red Flags for Passive Real Estate Investing.” This article was originally published back in 2019 after my wife and I made several passive real estate investments with other operators.
It started out with only 5 red flags and now I am adding another red flag to make it 8 red flags now.
My wife and I are currently invested in 78 different passive real estate syndications as a limited partner (LP) which comprises over 10,000+ doors located in the Carolinas, Georgia, Tennessee, Texas, Idaho, Colorado, Indiana, Arizona, Maryland, and Florida with 17 different operators.
This list of red flags has been developed for our own personal investments. Feel free to use this list for your own investments. Just remember that these are RED flags and not yellow flags. This means that if the passive real estate investment that my wife and I are reviewing does not fit into these criteria then we choose NOT to invest. That is how a true red flag should be treated.
I am going to do something a little backwards here and discuss the new 8th red flag first and then I will share the other 7 red flags so you can review those as well.
Red Flag #8 – Floating Rate Loans with No Interest Rate Caps
In Q3 of 2022 I received a phone call from one of our long-term, valued passive investors asking me for some advice. He proceeded to tell me how he had decided to diversify his investments with other operators.
He ended up investing with this one group after a friend had referred him over. He reviewed the offering and then decided to place some capital with this group.
He had been invested for about a year in this deal and the operator ended up doing a capital call after the cash flows and operating reserves were depleted. Needless to say, he was not very happy about this but knew this was a potential risk when investing in private real estate syndications.
In further research, he found that the operator had acquired the asset with a floating rate loan, and they decided not to purchase an interest rate cap because it was “too expensive” at the time of the loan closing. When Federal Reserve began their unprecedented interest rate hikes in 2022, the debt service was so high that they could not keep up with it. The debt service ate up their cash flows and was depleting their reserves, so they were being forced to do a capital call to be able to continue to pay the debt service.
The investor was calling me to ask if there was anything he could do, and I had to tell him that unfortunately that is what happens sometimes when you don’t invest with a group that utilizes the benefits of the interest rate caps.
So, if you are reviewing an offering with floating rate debt, you MUST be sure to ask if the loan will have an interest rate cap to mitigate the downside risk.
Now the interest rate cap may still cause the property to have reduced cash flows and potential dipping into reserves, but, if properly capitalized, should reduce the likelihood of a capital call or worse, losing the property to the bank because you can’t afford to pay the higher debt service.
Red Flag #1 – No Successful Background in Business
One of the sponsors of the syndication must have a successful background in business. The key word here is “successful” since I know people who know how to run a business, but they know how to run it into the ground. I think you know what I mean here. I want to invest with an operator that can successfully run a business even when times get tough like we saw in the financial crisis of 2008, the COVID-19 pandemic, and what we are seeing now in the volatile capital market.
The reason why this is important is that when we are buying a large $100mil+ asset, it is more like we are a buying a fully operational business that just so happens to have real estate attached to it. The operator must know how to manage people, put systems, procedures, and processes in place, and also be able to set proper key performance indicators (KPIs) in place to monitor the performance of the asset on a consistent basis.
Red Flag #2 – Part-time Operator
Real estate syndication is a full-time business and must be treated as such. There are many people that are getting into the real estate syndication business, but they want to keep their W2 income. I have worked hard for my money and do not want someone who is not all-in to manage my investment. This type of business cannot be run like a hobby at night and on weekends. I demand full time efforts to watch my investments and you should too.
Red Flag #3 – Only 1 Managing Partner
My preference is to have at least 2 unrelated partners on the project. You should NEVER invest with an operator if unrelated partners on the project. You there is only 1 partner. I know an investor personally that invested $200,000 of his own money, and he also brought in $200,000 of his friend’s money to the deal where the operator went ghost on them after 6 months. They cannot find the operator and they can’t get their money back. The likelihood of a group of 2-3 unrelated managing partners going ghost on you is very low.
Red Flag #4 – No Preferred Return or Preferred Return with Catch-up
Every deal must have preferred returns for the limited partners (passive investors.) The preferred returns align the interests with the investors so that the investors get the preferred distributions of cash flows. The preferred return allows the investor to receive 100% of the cash flows and sale proceeds first up to a certain return amount, typically 7-10% depending on the deal. The deal could not be done without the investors. The operator should be willing to provide the preferred returns to maintain a successful relationship.
Also, be sure that the operator offers a true preferred return. This means that 100% of the initial cash flows go to the passive investors and there is no GP (general partner) catch-up provision. The catch-up provisions in this state of the market are too rich for a deal and only benefit the operator and not you as a passive investor. I prefer to incentivize the operator to outperform and allow them the opportunity to have higher equity splits on the backend so I can protect my investment.
Red Flag #5 – Modeling a Refinance in Return Projections
I always prefer to review the underwriting of a deal prior to making a final decision to invest. One of the main items that I look for is whether the operator is including a refinance in the projections.
I have invested in a deal with a refinance, and it has not gone as planned with the returns being impacted greatly. I will not invest in a deal that is projecting a refinance because if the deal only makes sense with a refinance included, then it is too tight for my liking. In my book, modeling a refinance is an extremely aggressive move and sets you up for failure from the very beginning.
Most groups that I have seen that include a refinance in their projections are those that are very fee heavy on the front end or they are trying to include a GP catch-up provision to allow them to pull off excess cash from the deal prior to returning capital to investors. Always review the waterfall in the PPM to check for these types of sneaky add-ons.
Bottom-line on this one…if you see a refinance included in the LP return projections of a deal that you are reviewing…just stop reviewing and run the other direction. There are plenty of other deals out there that are much more conservative.
NOTE: Don’t get me wrong here, I certainly want to have a refinance in the business plan of a deal. However, I don’t want it to be modeled into the projections. It should be the icing on the cake and the success of the deal should not be dependent upon the refinance.
Red Flag #6 – Distributions as Return of Capital
When distributions are being made, they should be classified as return ON capital and not return OF capital. This is a very important distinction, and you should read your PPMs carefully to fully understand how they classify distributions.
They are many implications at play here when classifying the distributions as return of capital including tax consequences and the reduction of the preferred return since the preferred return calculation is based off the unreturned capital contributions. The preferred return % does not change but the amount of the preferred return you receive will go down each time a distribution is made which allows the operator to pull off cash flows faster since the preferred return amount is going down.
This is another tactic that is typically done with an operator that is not full-time in the business and needs the cash flows to live off of or to eventually be able to quit his full-time job. In other words, this is usually only done with an under-capitalized group, and you should run the other way…fast!
Red Flag #7 – No Skin in the Game from Operator
Last but certainly not least, the operator must have skin in the game. I really like to see 10% of the equity required invested in the deal alongside the limited partners. However, some operators cannot invest that much so at a minimum I want to see $100,000 invested from the operator. I want to make sure that the operator is making the best decisions and they have money to lose so I can ensure they make the best decisions for all of us in the deal.
How does PassiveInvesting.com stack up to these red flags?
1—Our managing partners have an extensive background of successfully managing multiple 7- and 8-figure businesses.
2—We are all full time in this business and currently have over 50 full time team members working directly with PassiveInvesting.com protecting your investment.
3—We have 2 unrelated, managing partners.
4—We have always offered a preferred return and don’t include a GP catch-up.
5—We have never underwritten any of our projects with the projections dependent upon a refinance. This has always been the icing on the cake to juice the returns.
6—We always distribute cash flows as return on capital and NEVER as return of capital.
7—Every project we target to invest 10% of our own cash between the 2 managing partners in the various deals that we offer to our investors.
8—Interest rate caps are a MUST in every floating rate loan. Only exception here is when there is a fund with multiple assets, a certain portion of the loans could be without an interest rate cap since there are other assets to help bolster in case of a rising interest rate environment.
