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Syndication Diligence: Evaluating a Project

If you intend to invest your self-directed IRA or Solo 401(k) in multifamily real estate syndications, understanding how to evaluate projects is crucial.  In our first article of this series, we discussed performing diligence on a project sponsor.  In this article, we want to cover some of the basics involved in evaluating whether a project itself is a good opportunity.

Determining whether to have your IRA become a limited partner in an apartment project is similar to but not really the same as deciding whether to purchase a property.  When you invest into a syndication with your IRA, you are not so much purchasing the property, as buying into the sponsors ability to turn a profit from the property.

It is the role of the syndication lead to identify a suitable property and execute the project.  As an investor, it is your job to determine if they know what they are doing and are therefore to be trusted with your investment.  Being able to review the project prospectus and see if it makes sense is a key skill necessary to make this decision.

Location and Market

Much of what drives success in apartment investing is based on market demographics and economics.  Cities, and neighborhoods within those cities, draw tenants when there is the right mix of jobs, transit, schools, and amenities like shopping, entertainment, or parks.

The “why” for most apartment projects hinges on these types of market factors.  The story of how a property fits into a neighborhood that is newly emerging on the edge of a growing metro area, or how the extension of a transit line is revitalizing an older suburb is often front and center in the marketing of a project.

While these stories may sound good, it is important to make sure the project sponsor is reading the market correctly.  You will want to do your own research to verify the assumptions being made.

This can be as easy as doing an internet search of real estate news and transactions in the area.  If a new employer is coming to town it will usually be well publicized.  Likewise, major infrastructure projects such as transit improvements are easily identified.

Information on several key metrics like population growth, average income, income growth, and trends in rents and home prices can be found in several public databases like www.census.gov and www.rentdata.org.

Comparable Properties

Comparing apartment properties can be a difficult task.  There are so many variables in terms of age, condition, size, and how long they have been under current ownership, and this makes it hard to draw comparisons within most markets.

With that in mind, it is often better to see where a particular property falls within the scope of its location.  Is it one of many similar properties, or is it unique?  Are there a lot of apartments in an area?

The syndication sponsor will usually provide their evaluation of the market and how this property fits.  It is good to perform your own analysis to confirm what they are saying.

Sometimes this can be as simple as pretending to be a tenant looking for a place to rent and browsing the listing sites on the internet.  You’ll get at good idea of what is available in a location and whether the proposed project will be within range in terms of amenities and rents.

If there have been sales transactions for other apartment properties in the area, that can in some cases provide meaningful data to help corroborate the numbers proposed for the deal you are considering.

Project Risk/Reward Classification

Each investor has their own threshold for evaluating risk and reward, and how aggressive or conservative they want to be with an investment.  In addition to performing a risk assessment of a particular project, you need to look at how that risk is balanced with other investments in your overall portfolio.

Real estate syndications are often grouped into categories as follows:

Core: Lower risk projects with minimal leverage in high quality class A properties in established and diversified markets.  The returns may be lower, but income can be more stable and reliable.

Core Plus: Properties with core classification employing a greater degree of leverage.  The greater debt burden increases risk but can also produce higher returns if the project is executed successfully.

Value-Add: This class of project represents a medium to higher risk opportunity.  An example would be the acquisition of an older or under-performing property, with the intention to upgrade units and management operations to increase lease rates and income. Leverage is usually involved at a moderate level.

Opportunistic: These are more tactical, niche investments that often come with a higher level of risk and commensurate returns.  New developments in underdeveloped markets, niche properties, or change in use from commercial to residential or the reverse are examples of this class of investment.  Other cases may involve restructuring of financing on an overleveraged property.  You should only consider such opportunities when the project sponsor has significant experience in the project type and local market.

Key Return Metrics

Judging an investment prospectus is an art form.  Probably the best approach is to take a big picture view and compare some of the key numbers with other projects.  It is especially useful to be able to look at completed projects or syndications that are many years down their path in similar markets, or by the same sponsor.  For someone to say the projected net return will be 100% over 7 years is one thing.  If that number looks a lot like similar projects that has more meaning.

Internal Rate of Return

Internal rate of return is one of the favorite metrics for syndication investors and represents the annualized rate of earnings over the life of a deal.

Common ranges for IRR by opportunity class are as follows:

Core: 8-12%

Value Add: 12-18%

Opportunistic: 18+%

Cash-on-Cash Return

Cash-on-Cash Return is another important consideration.  This value represents the annualized return relative to the capital placed into the deal.  If you invest $100,000 and a project returns $10,000 in net cash distributions after expenses, that represents a 10% cash on cash return.  In core projects, this might be a more stable value across the life of a project.  In a value add play, the return may be lower in initial years and increase over time as the performance of the property is enhanced.  Cash-on-cash return will vary based on the project and can range from 5-7% on more conservative deals to 14-18% on more aggressive ones.

Capitalization Rate

Capitalization Rate is a common tool for valuing a property.  The number is the multiplier applied to net operating income at which the property might sell.  Typically, commercial properties are valued this way, with a cap rate range that is common relative to the market and property type.  Higher end properties will usually have a higher price, resulting in a lower cap rate in the 5-8% range.  Riskier projects or less desirable locales may produce good cash flow but have lower value, resulting in a higher cap rate in the 10-15% range.

The best use of cap rate is as a tool to compare a property to similar properties in the same market.  If you find through your research that a class B property in a redeveloping neighborhood should fall in the 10-12% range and the project lead is estimating a cap rate of 8%, you will want to dig deeper.

Equity Multiple

Equity Multiple is probably the best indicator of overall performance, but also the most variable and hard to rely on, since the future sale of the property is factored in and appreciation is never guaranteed.

Equity multiple calculations express how much overall income is made on a deal over its lifetime, including annual income, equity build through retirement of debt, and gain on sale.  If you invest $100,000 and receive a return of principal plus another $100,000 of rental income and profits from sale, the equity multiple is 2.  If the same $100,000 investment were to return principal plus $150,00, the equity multiple would be 2.5.

None of these numbers is particularly meaningful on their own.  You need to take into consideration the balance of all metrics as well as the time value of money.  When is income distributed so that it can be reinvested?  Doubling your money with an equity multiple of 2 is fine on a 5-year deal, but on a 10-year opportunity, maybe not.  If a project has a particularly strong likelihood of appreciation, a lower annualized return from rents may be acceptable.

Investment Hold Time and Exit Strategy

Real estate syndication partnership interests are by nature illiquid.  Before committing to an investment, you should be sure the timeline of the project aligns with your goals.  As a limited partner, you have little control over the execution of the project, so you want to pay close attention to the sponsors plan as well as potential backup strategies.

In a stabilized core project, the hold time will generally be longer.  Depending on the market, the key income dynamic may be rental income, with the potential of higher returns in later years as debt is retired and cash flow increases.  Gain on sale may not be a significant factor unless debt pay-down over time is being used to increase equity share.

With value add and opportunistic deals, the hold times will usually be shorter.  Most of the value is created in earlier years with the development, improvement, or repositioning of the property.  Once a property is stabilized and performing, the sponsor will typically want to cash in and move on to the next opportunity.

Take the time to learn what a sponsor may do if a project does not play out as intended.   Will they look to sell, refinance, turn a value-add play into a long-term hold, etc.?

It is also wise to learn if there are means to liquidate your investment early should the need arise.

In Summary

Every project has a story, as told by the fit of the property in the market and the numbers on the prospectus drafted by the project sponsor.  As an investor, your job is not to play auditor and re-engineer the prospectus that was likely put together by an outside accounting firm.  You will drive yourself crazy and never make a single investment going that route of analysis paralysis.  Rather, your goal is to determine if the story being told rings true.  Take your time, look at multiple deals, do your own research to corroborate key assumptions, and network with other investors to see if the deals they are doing align with the projections.

Download our Free Multifamily Syndication Guide

If you want to learn more about Multifamily Real Estate Syndications and how they can be a great way to invest with your self-directed IRA or Solo 401(k), please download our free guide.

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