Syndication Secrets (Part 1)
By: J SCOTT
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Okay, I’ll admit that this is a bit of a click-bait title... There really aren't many/any secrets when it comes to syndication. But, as someone who spends a good bit of time talking with investors about passive investments, I find that there is often a good bit of confusion about exactly how syndications work, what to expect from your investment (and when), and why things don't always play out exactly as expected.
It's not that operators are purposefully keeping information from their investors -- it's simply that there are lots of nuances to how large investments operate, and these details often get lost in investor presentations and investment documents while everyone is focused on the bigger picture items, like the deal, the returns and the operating team.
So, I thought I'd spend some time talking about the details that often get glossed over until it pops up after the investment has been made. I expect that there will be a lot to talk about here, so to be safe, I'm going to call this Part 1 of the topic. I suspect I'll have at least a Part 2 in the future, and perhaps even more.
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The Concept of Preferred Return
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One of the biggest areas of confusion I see with passive investors is around this concept known as Preferred Return (commonly referred to as a “Pref”). Most syndications have this concept of a Pref, and it’s basically a promise to the passive investors that they will receive a predefined annual returned on their investment before the operators take any cash flow or profits from the deal.
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A common Pref these days is somewhere in the 6-8% range. So, as an example, on a deal with a 6% Pref, a passive investor who invests $100,000 is promised a $6,000 annual return before any of the cash flow or sale profits would go to the operators.
If in the first year ownership, there is enough cash flow to distribute more than 6% to investors, each investor would get their 6%, and then anything above that would get split between investors and operators based on the promised deal split (for example, 70% to the investors and 30% to the operators).
But, what if there’s not enough to pay investors 6% in a given year?
If there isn’t enough to pay investors their Pref in a given year, one of two things happens: Either the shortfall is carried forward to the next year, or the investor simply loses that upside for that year. While you should always verify with your operator, it’s most common for the shortfall to be carried forward.
So, in our hypothetical situation above, if the investor who invested $100,000 only received $5,000 in Pref in year one, the $1,000 shortfall would be carried forward to year two, where the investor would now be owed $7,000 – and the operators would collect no cash flow or profits until after that $7,000 was paid in year two. If the $7,000 isn't accomplished in year two, the shortfall would be carried forward again. And so forth...
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Worst case, if the Pref isn’t fully paid during the hold period of the investment, the investors will receive all back-owed Pref from the sale before the rest of the profits are distributed.
Pref is Different Than Cash Flow
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A lot of investors believe that the Pref is the minimum distribution they should expect to receive in any given year. But, in reality, it’s not uncommon for a syndication – especially one that is doing a big renovation of the property (called a “value add”) – to not have enough income to pay the full Pref in year one (and sometimes in year two or year three either).
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This is why investors should always ask what the expected Cash Flow will be in years one and two, as this is the projection of how much the investor should actually expect to receive. Remember, if the projected cash flow is less than the Pref, the shortfall from the Pref will likely be carried forward to the following year; but again, it’s not uncommon for the operators to expect to not hit the Pref early on in a big value add project.
Distributions are Not Generally Fixed
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Many investors expect that their monthly/quarterly distributions will be a fixed amount. This is generally not the case.
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While some projects do promise fixed distributions (or attempt to provide them), most syndications are making distributions based on the actual performance of the property. If a property does well one month/quarter, that distribution may be higher; if a property does poorly another month/quarter, that distribution may be lower.
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Remember, based on a whole host of things – timing of tenants moving in/out, evictions, renovations, lease renewals, etc. – all properties will have months of higher income and months of lower income. The trend should always be upwards over the life of the project (assuming the project is going to plan), but there will be variability each month. In fact, we even see months with lower income twice a year when the calendar aligns with three payroll periods in one month instead of just two, and payroll expense are higher those two months!
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So, if you see big distributions for a few months and then suddenly see a smaller one, that doesn’t necessarily mean that the project is struggling or off-track. It could simply be a natural variation in income and expenses for that period.
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Also, keep in mind that operators who pay monthly distributions will be more prone to these variations in distribution amount than operators who pay quarterly – in those cases, we tend to see smoother distribution amounts because those operators can average across several months.
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Which brings me to the next point…
Cash Flow Will Often Ramp Up Over Time
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During the early years of a big value add project, there is often much less cash flow than in later years. This is because in the early years, the operator is doing evictions of bad tenants held over from the previous owner, is doing renovations on units (meaning higher vacancy rates) and is waiting for leases to renew to raise rents.
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So, while a project might project an average 9% cash flow over the life of the project, that doesn’t mean you should expect to get a 9% return in every year. It’s more likely that you’ll get a lower return in the early years (maybe a much lower return), and then a higher return in the later years. With all the years averaging to that 9% return.
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Likewise, you may receive much lower distributions over the first couple quarters of the project as the operator looks to fix the major issues inherited from the previous owner.
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Make sure you ask your operator what the cash flow projection is for each year of the project (as opposed to just the average), so you know what to expect in the early years. And also ask what the expected distributions will look like very early in the project (the first six months) if the cash flow matters to you.
Cash Flow May Not Start Immediately
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Because operators recognize that the first few months/quarters can require a big transition, with lots of evictions, vacancy and renovations, it’s not uncommon for operators to not start distributions until 3 or 6 months after the property is acquired.
While this is often disclosed to investors, it can get lost in the details. So, make sure you ask your operators when you should expect to start receiving distributions.
Why Most Value Adds are Minimum of 3-5 Year Holds
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If you invest in the value add multifamily space, you’ve probably noticed that the typical minimum hold period is projected at between three and five years. This isn’t just coincidence – this is based on how a value add business plan is carried out.
Historically, apartment complexes tend to see the bulk of their tenants turn over every two years, or about 50% per year. In other words, on average, an apartment owner can expect that most units will be vacant at some point during the first two years of ownership (obviously there will be exceptions for tenants that stay for many, many years, but this is the rule of thumb).
For this reason, most value add syndicators will expect that it should take about two years to complete all interior renovations on the property.
Year three is typically a stabilization year, where all the recently renovated units are leased, the operator strives to push rents to their reasonable limit, implement all additional income streams and finalize any management efficiencies.
In order to sell a property for top dollar, most buyers look for at least one year of stable income. After the business plan has been fully executed by year three, the expectation is that year four should see full stabilized income for 12 months, at which point a broker can start shopping the property to potential buyers based on that stabilized income.
Assuming everything went to plan, a sale is common towards the end of year four or in year five.
Sometimes it’s possible to speed up a repositioning if the property turns over more quickly or if not all the units need renovation. And sometimes the stabilization period is a good bit faster. But, in general, this is why it’s common for value add operators to project a sale after a minimum of three to five years.
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Those are just a few of the syndication myths I often hear passive investors misunderstanding. Hopefully that clears a few things up, and stay tuned for Part 2...coming soon!
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