The Worst Case Scenario in a Real Estate Syndication

by The Darwinian Doctor

In this post, I review the worst case scenario in a real estate syndication: losing your entire investment.

This post may contain affiliate links.

Ever since I started Cereus Real Estate, I’ve had dozens of calls with physicians and other high-income professionals.  It’s clearly one of the best perks of starting the company.  I absolutely love the opportunity to speak to other medical professionals about their financial hopes and dreams.  It’s a fun time to commiserate about our shared experience of being in the trenches of modern medicine and start to sketch a blueprint to a brighter future of financial freedom. 

Physicians are generally conservative and risk averse, though.  It’s trained into us during medical school and residency.  First, do no harm, right? 

This comes up a lot when physicians consider investing their money.  Since real estate has inherent risks, I get a lot of good questions about the risks of real estate syndications.  They range from general questions to hyper-specific, depending on the deal. 

For example, I got this great question via email last month:

What keeps you up at night about real estate syndications?  What’s the worst-case scenario?

Cereus Real Estate investor

To answer this, I wanted to go over some of the risks of a real estate syndication, using the current deal available via Cereus Real Estate as an example.  This is the Hampton Meadows + Ridges deal, which is a 360-unit apartment complex in Des Moines, Iowa.  (As of early July 2024, there’s still an opportunity to invest in this deal, but you must be an accredited investor.)

Why is this the first time you’re hearing about this deal?  It’s because we recently converted it from a 506(b) to a 506(c) deal.  That basically means that I can talk about it publicly now, but only accredited investors are able to invest into it.

Learn more about all the deals available through Cereus Real Estate by joining our investor list here!

But first, the benefits!

Before I talk about the worst case scenario, let’s start out on a positive note by discussing the possible benefits of a real estate syndication deal.

In my opinion, the main benefits of real estate syndications are as follows:

  • Strong returns
  • Tax benefits
  • Diversification
  • Passive investment

Strong returns

How strong are the returns?  Well, it obviously depends on the deal, but since becoming immersed in the world of apartment investing over the last few years, I’ve come to understand that there are some standards. 

Your average stock market index fund like VTSAX or VTI is expected to return 8-10% annually.  This is based on historical data.  It’s a good return.  If you invest into an index fund like this annually for 30 years, you’re likely to end up with a nice nest egg in the long term. 

I talk more about the benefit of index funds here: How to Save, Invest, and Become Rich

Since real estate syndications involve more inherent risk than index funds (more on this below), they have to offer a higher return to compensate investors for that risk.  Again, this is deal dependent, but I’d expect most real estate syndications to offer a projected annual return of around 15-20%. 

That’s right, about double the return of an index fund! 

The Hampton Meadows + Ridges deal is projected to attain an annual return of around 20%, which is on the higher end of that spectrum.  This return is one of the reasons why the deal caught my eye as the first deal for Cereus Real Estate investors. It’s going to be attained through a trio of planned improvements such as unit renovations, bulk internet, and renting out vacant garages. 

That means that at end of the 5-year deal lifespan, your investment is projected to roughly double (ie:  put in $50k and get back $100k total at deal exit). 

As I discuss in this blog post, higher returns on your capital simply means a much faster path to exponential growth of your wealth. 

Tax Benefits

In terms of tax benefits, real estate is inherently tax protected via depreciation, which is one of the ways that the government incentivizes investment into real estate.  Even though investment into a syndication is passive, you still receive tax benefits from depreciation.

You can read more about the tax benefits of real estate here: Tax Benefits | Why I’m Investing In Real Estate Over Stocks – Part 2

Diversification

Next, just as index funds offer diversification in terms of the stock market, it’s also great to have diversification in terms of the types of investments in your portfolio.  Real estate syndications are a good way to gain exposure to the real estate market in a passive way. 

Passive investment

Finally, real estate syndications offer the ability to invest in real estate in a passive manner! Especially after my experiment with short term rentals over the past few years, I can confidently say that active real estate investing involves a tremendous amount of time and effort. Even my long term portfolio continues to be essentially a full time job in terms of its management. To get the chance to invest in real estate via syndications, without the hassle of actually running the deal is a tremendous opportunity.

Worst case scenario of a real estate syndication

Now onto the risks, specifically the worst case scenario of a real estate syndication!

In my mind, the worst-case scenario is the risk of losing your investment. 

That’s right – in a real estate syndication, it’s possible to invest capital into a deal and then at the end of the deal, come away with nothing.  Zilch, nada, zippo. 

That is the worst-case scenario that keeps me up at night. 

As a passive investor (i.e.: limited partner) in a real estate syndication, you’re very protected against other risks like legal liability and responsibilities related to the mortgage debt.  Those risks are taken on by the general partners.  That’s one of the reasons why a portion of the equity in a real estate syndication is reserved for the GPs – they take on the lion’s share of the personal liability. 

But there’s still risk associated with your hard-earned dollars that you’re investing into the deal. 

How might this happen?

It shouldn’t come as a surprise that there’s a risk of losing money in an investment.  Virtually all investments have a risk of losing money, be it a purchase of Tesla stock or investing in a friend’s restaurant venture. 

When it comes to a real estate syndication, there are a myriad of ways in which investor capital can be lost. 

Here’s a short list (not meant to be comprehensive):

  • National Market forces:  Downturn in the national real estate market, recession, bank implosion
  • Local market forces:  city legislation related to property taxes, permitting, zoning.  Unforeseen shifts in crime rates or demographic trends.  Unexpected new construction increasing competition.
  • Building related:  higher than anticipated repairs, vacancy, turnover or administrative costs.
  • Financial malfeasance:  fraud, embezzlement by the management team

Any of these factors can cause the final returns to miss the projected numbers. 

How bad can it get?

Missing projected numbers isn’t great, but it’s not the worst case scenario of a syndication.

If there are minor factors that affect deal returns, like struggles with vacancy rates or increased levels of repairs, final returns might miss the projections by a few percent.  In this case, I would expect that many general partner groups would consider sacrificing their own equity or returns to ensure that investors come out well compensated. 

However, there are some catastrophic events from which a deal can’t recover.  For example, there are many real estate deals that started in the last few years with variable interest rate debt. This debt is from bridge loans that were used to finance construction costs.  Variable rate debt was super-cheap a few years ago, but the financing costs on these loans have literally quadrupled since the federal reserve started raising rates to combat inflation

That just wasn’t a scenario that many real estate investors even considered as a possibility after more than a decade of interest rates at historic lows. With debt service so high for these types of loans, there have been a number of high profile deals falling apart that have been covered in the national media.

Furthermore, interest rates have an interesting relationship to the valuation of apartment buildings (and real estate in general).  Since so much real estate is purchased with debt (mortgages), the actual value of real estate can go down if interest rates stay elevated for too long. 

For real estate deals that are suffering from the double-whammy of both factors, so much value has been eroded from the deals that many of them have fallen apart.  That is, the buildings have been repossessed by the lenders and all investor capital has been wiped out

In some cases, the lenders are even coming after the general partners in an attempt to recoup remaining debt.

This is the worst case scenario of a real estate syndication; that investors can walk away with none of their initial investment remaining.

How to mitigate risk

Any real estate syndication deal offered through Cereus Real Estate is one that I’ve researched, inspected, and picked apart as much as humanly possible, but this doesn’t eliminate all the downside risk.

But there are ways to mitigate risk. 

For example, the Hampton-Meadows deal has these risk mitigation factors which reassured me about its investment potential:

  • No variable rate debt
  • Stable, tertiary market
  • Professional property management
  • Low purchase price from a distressed seller
  • Multiple lines of value add:  renovation, bulk internet, garage leasing
  • Excellent fixed rate, agency debt (7-year term, 5.45% interest rate, 5-year interest only)

That doesn’t mean there’s no risk, but I hope that there is less risk. 

Conclusion

I hope you understand the worst-case scenario in a real estate syndication.  In short, it’s the possibility that all your initial investment is lost. 

In my opinion, the prospect of a complete loss is unlikely in any current deal that avoids variable rate debt, absent some other catastrophic market force like Covid, war, or natural disaster.

As I discussed above, for well selected deals with enough risk mitigators, real estate syndications can offer a substantial opportunity to accelerate your wealth building. 

Daniel Shin, MD

The Darwinian Doctor


Comments? Make sure to leave them below! Interested in learning more about real estate syndications?  Make sure to sign up to the investor list over at Cereus Real Estate.

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Since everyone is different, it may not be appropriate to generalize my doctorly advice to your own situation. Please run all medical, life, and financial advice by your own physician or financial professionals before applying it to your own life! Consider all information for your entertainment only!

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