The concept of investing in a syndication seems like a grand slam. A passive investment where I as the limited partner get access to private commercial deals, bonus depreciation of a multimillion dollar asset, frequent distributions, upside of the deal at sale, and no liability with kick ass returns that are not correlated with the stock market. Entering the space for the first time, I quickly asked myself how can it be this good? How can there be that many great deals out there to invest in in the private market when it seems like every deal in single family, I evaluate, makes no sense. The truth is…. There isn’t. In 2021, QC Capital underwrote over 100+ deals to identify and acquire 1 deal that met our investment standards.
A successful syndication is a combination of a great deal, quantified by numbers, and a great team, quantified by experience and proof of success. If you are like me though, it took time to understand what those metrics were, meant, and applied and how to ask them in a way that allowed me to form an opinion. My goal is to share with you those learnings because once you hold these, there are only two mistakes one can make:
- Fail to take action
- Invest before taking the time to educate yourself
How to measure returns:
What is the difference between IRR and Equity Multiple?
These are the two flashiest terms that will be advertised on every deal past or present to show potential or earned returns. Before digging any deeper, let me just put out there, no one number makes or break a deal, it’s a combination of many numbers and your personal risk profile that determines what is “good”. Below I will show why its important to not just rely on one or the other.
Equity Ratio: A simple ratio that shows the total gain or loss on your investment. It takes into consideration if your initial investment was returned, the cash flows you received, and any upside you may have shared at the sale.
For example, if you invested 100k into a syndication and received 20k in cash flow, your 100k initial investment back, and 30k from the gain on sale, you would have made a 50k gain. This would be a 1.5 equity multiple (150k / 100k). To summarize, an equity multiple above 1 demonstrates a gain, 1 would demonstrate a break even return, and anything less than 1 (.01 and .99) symbolizes a loss.
You might be saying to yourself, I would take a 1.5x Equity Multiple every day, but what you aren’t taking into consideration is how long does it take from start to finish to receive that return. Is a 50% overall return as enticing of an investment that requires an 8 year hold as 2-year hold? No.
IRR: Is a financial ratio, displayed as a percentage, that not only takes into consideration the return but the time it takes to get it. By taking time into consideration, two IRR’s can allow an investor to make an apples to apples comparison which investment has the potential to make the highest return if they were both held for the same period of time.
How to evaluate risk:
(Risk) DSCR – A calculation commonly used by lenders but also investors to analyze a properties ability to cover its debt payments. DSCR is calculated by dividing your NOI by your debt payment and ideally ranges from 1.2 and up. No investment comes without unforeseen costs (CAPEX or vacancy) and if your DSCR is close to 1, you may want to question how will an operator keep your capital safe if the property doesn’t run perfectly from the get go.
Breakeven occupancy – this gives an investor an idea how much vacancy an investment can withstand and still stay afloat (operational and debt). In any new offering, current occupation levels and the breakeven occupancy should be provided. Keep in mind, levels that are too high (>65%) and too low (<35%) leaves room for question. If the breakeven levels are extremely high, is it because the rents are substantially under rented or is it because there is little cash flow and they are speculating it will rise in appreciation. If the levels are that low, why would the seller give the syndicator the property at such a low valuation. Is their major capex that needs immediate attention or is there line items that are not being considered but should be in the calculation that are being left out?
How to evaluate an operator –
No matter how strong of a deal, the operator is the key difference maker that determines its success. Therefore, here are some of my favorite questions that can give you a better idea if this individual is good partner:
- How many deals have you exited? What were the outcomes good and bad?
- What was your background before becoming a syndicator (what is their edge)?
- How do you align your interests to your limited partners? Do you invest alongside them in your deals?
- What is the assumption that makes this a good deal? What happens if you can’t execute on the assumption?
- Who was the previous owner? Why did they decide to sell?