Case Study: A Real Estate Syndication Deal Gone Wrong

Lessons to Take Away from This Debacle

So what have we as a real estate investment club learned from all this?

 

1. Yes, You Can Lose 100% 

The property doesn’t need to lose 100% of its value for you to lose 100% of your investment. 

Remember, the lender gets paid first. If the sponsor borrows 75% of the purchase price, and the property drops 25% in value, you get none of your money back as a limited partner. 

Actually, it’s worse than that. The total property acquisition costs add up to far more than the purchase price. The property might only drop 10% in value, and you can still lose your entire investment capital. 

 

2. You Can Actually Lose More than 100%

When sponsors get in trouble and need money to bail them out, who do they turn to? 

You.

They do a capital call, asking limited partners (LPs) like you and me to cough up more cash. And if we don’t hand it over, the sponsors are left with no good options.

They could try to borrow more money, at usurious rates. Or they raise capital from a private equity firm, which takes higher priority in the capital stack over the original LPs. 

Or they could sell at a loss. In this particular case, the sponsor made it very clear that if they sell the property now, we’re all losing 100% of our money. 

When the LPs refused to give the sponsor the money that they needed to try and stabilize this particular portfolio, they turned to trying to raise money from private equity investors. It remains to be seen whether they’ll get enough money, but even if they do, the best case scenario isn’t rosy. 

In it, the sponsor stabilizes the cash flow as the first priority, so the properties aren’t bleeding money every month. Then they slowly start renovating units again, to gradually drive up rents and the net operating income. Eventually cash flow improves, and hopefully in a few years from now, cap rates drop back down and they sell for a profit. 

Even then, we LPs may not get all or even some of our money back, because we’re so low on the priority list for repayment. 

 

3. Scrutinize the Lead Sponsor

We didn’t invest money through the (shady and incompetent) lead sponsor. We invested through one of the several cosponsors of this deal. When we looked at the track records of the sponsorship team, we looked at two of the cosponsors. 

Again, one of those cosponsors is a massive player in the industry, who’s done dozens upon dozens of deals. It gave us a false sense of security. 

We never got ahold of the lead sponsor’s track record, never even talked to them. And, embarrassingly, none of us verified who the lead sponsor was. 

It’s not a mistake we’ll make again.

Deals often have multiple sponsors, sometimes four or five. Find out who the lead sponsor is, and make sure you’re comfortable with them — not just the one or two cosponsors who you might already know. 

 

4. Breakeven Occupancy Is a Forecast, Not a Fact

The sponsor told us that the breakeven occupancy for these properties was 66%.

“Wow, 66%, that’s super low! There’s no way the occupancy will drop that low, so this deal must be pretty safe.”

Even when the occupancy plummeted at these properties due to bungled management, it never fell below 66%. So how did the properties end up losing money?

Because all the other expenses went up faster than the rents. 

That means the breakeven occupancy turned out not to be 66% at all. In fact, I asked the (now) lead sponsor on the deal what the current breakeven occupancy rate is. His answer: “Somewhere around 100%.” 

Don’t put too much stock in breakeven occupancy rates. They — like every other forward-looking number in the investment deck — are forecasts. They’re based on calculations made by the sponsor. That makes them fallible at best and manipulated at worst.


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