Have you ever gone to the grocery store without a list and browsed the entire store, finding things you’ve just “got to have,” and then when you check out, you realize that not only did you buy what you didn’t need, but you didn’t get anything you actually needed?
Your cart filled up with stuff, you spent more than you meant to, and you don’t even know how it happened. Meanwhile, you lost precious time and didn’t really get what you needed accomplished. This is the same aimless frustration you might experience when you first start looking into real estate syndication deals.
It’s possible you’ll begin to receive a seemingly endless string of opportunity emails, each with a summary that could be 50 pages long. Although this may be exciting at first, without knowing specific tactics, your goals, and a strategy for sifting through these, that aimlessness might leave you feeling overwhelmed.
Right here, right now, you’re going to learn how to get focused and decide within
10 minutes if a deal might be right for you.
The First Glance
New deal alert emails are like a surprise gift. You had no idea it was coming, but you can’t wait to rip it open and see what’s inside.
The emails you receive about new deals are full of valuable information, but a few highlights you’ll want to pick out at first glance are the type of asset, market, hold time, minimum investment, and funding deadline. (And of course, the most important factor – are the sponsors people you know and trust?)
If you open the email aiming to focus on only these pieces of information, you can avoid unnecessary information overload. All you’re trying to do at this point is to find out if these data points match your investing goals. If not, there’s no reason to waste any further time or energy. As an example:
You receive a deal alert from sponsors you trust to invest with, and pull these details:
- Asset Type: B-class multifamily
- Market: Abilene, TX
- Hold time: 5 years
- Minimum investment: $50,000
- Fund Deadline: 3 weeks from today
With this simple information, you’re able to immediately see that although this is the perfect asset class, you’re looking for a longer hold time or a deal in a market with higher in-migration. Or perhaps you already know you need more than 3 weeks to access your capital, so…PASS!
You’ll receive another deal shortly and have many opportunities to practice this exercise. At some point, the details will all be exactly what you’ve been waiting for and you’ll dig deeper.
The Numbers
Once you’ve decided a deal’s initial look aligns with your goals, you can dig further into the investment summary.
As an example, you might learn that this particular deal is offering:
- 7% preferred return with a 70/30 split
- 9% average cash return
- 17% internal rate of return (IRR)
- 20% average annual return including sale
- 2.0x equity multiple (i.e., 100% total return)
But what does all that mean for you and your $50,000?
In time, you’ll get lightning-quick at this and know right away what all of that means, but right now, let’s pretend this is your first go.
Preferred Return vs. Straight Split and Annual Return
A preferred return, a common structure for deals, means that the first percentage (in this case, 7%) of returns go 100% to the limited partners (passive investors). Sponsors don’t receive any returns until the property earns more than that. After that 7% is met, the amount of returns exceding that are split, with 70% going to the passive investors and 30% going to the sponsors.
This means that if you invested $50k and everything went according to plan, you should see at least 7% of $50,000 this year ($3,500), which breaks down to $875 a quarter or $292 per month.
Then you’ll receive your share of the extra returns above 7% — sort of like a bonus. Depending on the deal, the excess above the preferred return may be calculated and paid out every quarter, or only once or twice during the year (you’ll get the same amount over the year, regardless).
Since cash returns are projected at 9%, that tells you this deal is projected to pay out above the 7% preferred return at some point. If 9% can be paid out during the year, and the excess above the preferred return is calculated and paid quarterly, it means you should be paid $4,500 for the year ($1,125 per quarter, or $375 per month). By contrast, if the excess above the preferred return is only calculated and paid out once a year, it means you’d get the $875 a quarter preferred return for
3 quarters (or $292 a month for 11 months, if distributions are paid monthly),
then an annual bonus payment of $1,875 in the last quarter (or $1,288 for the
last month).
Now keep in mind, cash returns tend to be lower in the earlier years of the holding period and higher in the later ones. So for example, let’s say the deal can only pay out 6% during the first year, which is 1% short of the designated preferred return. That 1% gets added to your balance due. So in year 2, the deal will have to pay out 8% to the passive investors before the sponsors can begin getting paid.
As an alternative, a deal might be structured without a preferred return (likely with a larger share going to the passive investors), such as an 80/20 straight split. In this case, each time a distribution is made, 80% of it goes to the passive investors and 20% to the sponsors, whether that represents a 5% annual return or a 12%
annual return.
Related article: Syndication Structures — What They Mean for You as a
Passive Investor
Equity Multiple
The next number on the list is the equity multiple. This number quickly tells you how much your investment is expected to grow during the project, using the sponsors’ assumptions.
Continuing on the example above, your $50,000 investment with a 2.0x equity multiple should work out to $100,000 once the asset is sold. This accounts for the cash flow distributions plus the profits from the sale.
We typically aim for a 1.75x – 2.0x equity multiple on deals (i.e., 75% – 100% total return), so you can use that as your benchmark.
Average Annual Return & IRR
My last two concerns when initially examining a new deal alert are the average annual return and the IRR.
The average annual return tells you what the average pro forma earnings should be, averaged over the planned hold time.
In the example above, we discovered that your $50,000 is expected to double to $100,000 over the next 5 years. That total return is 100% of your original investment, and when divided over the 5-year hold period, we see that your average annual return is 20%.
The IRR is the average annual return (in this example 20%) adjusted for the time delay of when the returns are received. Since the majority of your earnings are expected later, at the sale, and time has cost associated with it, the IRR takes that into account. An IRR of 14% or more is a great target.
The Decision
After this brief analysis of these data points, you should be able to tell is this deal is a potential yes or no for you. This isn’t a final decision, but it does mean you can decide whether to spend more time reading into the investment summary or not, and you can make that decision with confidence.
If these numbers align with your investing goals, you can go ahead and let the sponsor know you’re interested by requesting the full investment summary or submitting a soft reserve.
Refining the Decision
At this point, the deal appears to meet your basic criteria, as long as the sponsors’ assumptions about the property and their business plan are correct. So at this point, to further validate the deal, you can look through the investment summary, watch the deal webinar, or ask the sponsors directly about their assumptions. Here are a few things you might be looking for:
- What are they doing to achieve the pro forma rents, and how do they know their expectations are achievable?
- What are their assumptions for expenses, and how do they know they’re reasonable?
- What are their assumptions for economic vacancy (i.e., vacancy, concessions bad debt, etc.) and the resulting economic occupancy?
- What are their assumptions for annual income and expense growth, and what are they based on?
- What eventual sales cap rate is being planned for, and how does it relate to the current purchase cap rate and the market’s current average?
If the assumptions on income, expenses, and sales (reversion) cap rate appear aggressive (e.g., rapid rental growth that isn’t in line with proven market performance, extra-ambitious growth of Other Income categories, etc.), it means there may be a greater chance of the property under-performing compared to the pro forma. If the assumptions are conservative, however, there may be a greater chance of it over-performing and surpassing the pro forma.
Conclusion
New investment deal opportunities can be exciting, but if you get lost in the weeds too quickly, they can also be overwhelming.
Whether you’ve had funds ready for weeks or are working on getting them rolled over into a self-directed IRA, it’s imperative to know exactly what you’re looking for so you can jump on the perfect deal and minimize wasted time.
With the data points discussed in this post, you’ll be able to identify whether a deal is even worth your time and energy right off the bat.
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