If you follow the real estate news you probably have run across horror stories about people losing all their money after investing in a real estate syndication. The syndicator (General Partner, or GP) has taken investment money from the investor (Limited Partner, or LP). The GP showed the LP the possibility of making huge profits and showed how great they did in the past and the slick sale made it easy to put in the money. Things went well for about 5 years. Then the gut punch.
Five years ago was ancient history now, but it was a time when interest rates were low and bank money was flowing. It was easy to get a loan set up and become a syndicator. Cash was almost limitless and investors were looking for places to put their money. They found syndications, many of whom were just starting out. They underwrote their deals based on the interest rates they were offered at the time: 3.5% or near. Ridiculously low compared to the 8% we see now.
That worked for the purchase, but most commercial loans have a 5 year term, also known as a balloon. The entire loan amount becomes due after 5 years and the owner is expected to refinance. This is a way to protect the bank as interest rates were bound to go up sometime – they weren’t getting any lower with the FED funds rate near 0%!
Many of these GPs didn’t even consider that rates would go up, so high or so fast. They were caught with their pants down when trying to refinance. High rates meant higher monthly mortgage payments, but their rents hadn’t kept up. They were left with a choice: Sell right now, Do a capital call, or Fold up shop and go into foreclosure. Unfortunately, some have taken the third option.
Let me be clear – none of those three options are great. Selling right now means a fire sale, and at the high interest rates we have, they will possibly be under water. A capital call means calling the current investors and asking for more money to invest. This dilutes everyone else’s investment and throws good money after bad. The third option, and the most despicable, is to run away from the problem.
GPs have a tremendous amount of trust placed in them. Sure, the LPs need to be sophisticated and they need to be comfortable with losing all their investment, and sure, black swan events can happen, but this isn’t one of them. This was foreseeable, if not predictable. The underwriting should have considered increased rates and had exit plans factored in.
Here’s hoping the GP in the post above is never able to take investment money again. Acting in that way gives the rest of us a bad name and makes it more difficult to put together good investments. Syndications carry high risk but offer the possibility of high reward. That’s no excuse for the way some of these deals are failing right now.
High interest rate times might be better times to invest. Rates can still go up, but high rates means paying less for a properly underwritten property. That lessens some risk. Most importantly for LPs is that you have to do your background research on anyone you plan to invest with. A slick sales pitch and website is not enough.
