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Why Multifamily Syndications Right Now are Susceptible to Risk?

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When you first roll into a casino, you don’t usually put all your chips down on your first hand or the first roll. It was a long drive or flight to the casino and you don’t want to go home after just one sitting.  You’re cautious at first but as you win more and more money, you set aside what you brought to the table and play with just your winnings. Now you’re playing with house money – money you won from the house. Now you start getting bolder – making bigger and bigger bets. You figure the worst that could happen is you go home with the money you came with if you end up losing all the house money.

Since the Great Recession, the U.S. has become increasingly a renter’s nationEscalating rents, rising home prices, and student loan debt are putting homeownership more and more out of reach.

As a result, in many parts of the country, demand for multifamily housing has outpaced supply and investors have jumped on the bandwagon – with many organizing syndications to finance their acquisitions. Cheap money due to low-interest rates is fueling surging interest in multifamily investments and with promises by the Fed to keep interest rates low for at least the next two years, we can expect this trend to continue.

Multifamily demand along with cheap money is fueling a surge in multifamily syndications. But buyer beware! House money is why multifamily syndications right now are susceptible to risk.

Because of low-interest rates, more and more promoters are leveraging their multifamily acquisitions with bank financing – typically only needing to come up with 20% down and typically without recourse.

By using capital raised from private placements to satisfy the entire down payment, promoters of multifamily syndications can often finance their entire projects with investor capital without any of their skin in the game.  

The allure of playing with house money in multifamily syndications is attracting inexperienced promoters as well as encouraging lax and often reckless behavior – jeopardizing the economic viability of a project and, in turn, investor capital.

Here is a summary of why multifamily syndications right now are susceptible to risk.

Overly optimistic promoter assumptions. The financial projections in the pro forma financial statements are just that – projections. These projections are based on assumptions – aka “what if” scenarios – that impact these projections.

For example, a promoter projects X percent IRR over the next five years. The IRR projection is based on the assumptions that rental rates can be increased by Y percent annually and that the average annual occupancy rate can be maintained at Z percent. To show high rates of returns to potential investors, inexperienced or careless promoters will be overly optimistic about these assumptions. For example, an assumption of 100% occupancy and collection would be overly optimistic.

Dependence on low debt rates promotes fiscal irresponsibility. Low debt servicing encourages lax management. Some promoters figure that with low-interest expenses, they can afford to relax in other areas of expenses. They overpay instead of minimizing costs on marketing, utilities, payroll, etc. This jeopardizes a multifamily project’s profitability and the potential returns to investors, especially long-term.

Promoters with no skin in the game have nothing to lose. Promoters who don’t invest their capital or personally guarantee the bank loan to fund a deal have nothing to lose. You’ve heard of the saying “there is nothing more dangerous than a man with nothing to lose?”

There is nothing riskier than a promoter who has nothing to lose. Just like how they play fast and loose with their financial projections, promoters with no skin in the game will also play fast and loose in every phase of the project – often deviating from their timelines from missing their projections, deadlines, and milestones.

Bandwagon promoters lack the experience, knowledge, infrastructure, and personnel to ensure a project’s success. Promoters whose only investment experience is with flipping homes and who want to be a part of the multifamily gold rush often lack the experience and knowledge to not only acquire and operate a multifamily property but also to manage a syndication.

Has the promoter ever invested in a multifamily project for their account without investor capital? Have they managed syndications in any other sector? Answers to these questions are critical to determining the viability of a project.

A confluence of factors including cheap money and surging multifamily demand is attracting inexperienced and careless promoters who are making multifamily syndications right now susceptible to oversized risks. With no skin in the game, these promoters are overstating their financial projections and underperforming their duties to their investors. Be careful with the promoter with nothing to lose. 

ferd-niemann

Ferd Niemann IV

Ferd Niemann is a mobile home park owner, operator, and lawyer, as well as a real estate investor, financial analyst, entrepreneur, and attorney whose career has focused on a myriad of areas of real estate. His experience includes mobile home park investments and turnarounds, retail development and redevelopment, residential investments, and real estate law.

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