Spoiler alert: all investments come with risks. Real estate investments are no different.
So what are the risks of real estate syndications (passive group real estate investments)?
Keep the following in mind as you consider your next passive investment in real estate.
Which Is Riskier: Active or Passive Real Estate Investments?
I would argue that real estate syndications come with lower risks than buying rental properties directly. Here’s my logic.
To begin with, active real estate investors need to develop all the skills required for real estate investing themselves. They need to learn how to find good deals on properties, such as driving for dollars or learning how to buy foreclosure homes. They need to learn how to negotiate with contractors, how to oversee their work and keep them on-schedule and in-budget. Which says nothing of pulling permits and hassling with inspectors.
Then they need to learn how to secure investment property loans and financing. And learn how to become a landlord, assess market rents, market vacant units, screen tenants, sign lease agreements, and legally store security deposits. They need to collect rents and enforce their lease contracts and go through the eviction process. The list goes on.
Passive investors don’t need to hassle with any of that. They outsource all those skills to a full-time professional real estate investor.
That doesn’t mean they absolve themselves of all responsibility, of course. They still need to review the deal and the sponsor’s track record to mitigate the risks outlined below.
But as a passive investor, you don’t need to become an expert yourself. You just need to hire the right expert.
Risks of Real Estate Syndications
Passive real estate investments still carry plenty of risk. At the “risk” of scaring you off of them completely, keep the following in mind as you vet syndication deals.
1. Rising Interest Rates
We’ve certainly seen plenty of this going around over the last few years. And it’s knocked out plenty of real estate syndications along the way.
Higher interest rates add real estate risk in several ways. First, many syndicators (AKA sponsors, operators, or general partners) borrow a floating rate loan when they buy the property. When interest rates rise, so too do their monthly payments. Sponsors can (and should!) buy interest rate caps to put a ceiling on their monthly payments, but not every sponsor had the foresight to do so before rates started rising.
Second, many commercial real estate loans come with short terms, often three to five years. If interest rates happen to be high when the loan expires, that leaves sponsors in a pickle: refinance at a high interest rate or sell in an unfavorable market.
Why an unfavorable market? Because higher interest rates typically cause higher cap rates.
2. Rising Cap Rates
Capitalization rates, or cap rates in real estate, represent how much a buyer is willing to pay for a certain amount of net income. You can think of it as the income yield that buyers will accept.
The cap rate formula looks like this:
The higher the cap rate, the less the buyer is willing to pay for the same income. Lower cap rates mean the buyer is willing to accept a lower yield, and pays more for the same property.
Thus, higher cap rates are great for buyers but bad for sellers.
If cap rates rise, property owners can choose between selling now for a lower profit (or a loss), or waiting for better market conditions to sell. But if interest rates remain high, and their loan term is expiring, owners may feel forced to sell in a bad market — potentially for a loss.
3. Stagnating Rents
Cap rates aren’t the only part of the equation that determine a property’s value. Rents also matter, as buyers value commercial properties based on their net operating income.
But what happens if rental rates fail to rise? Or worse, fall?
Stagnating rents don’t just mean steady-but-unimproving cash flow. They mean shrinking or even negative cash flow, because expenses don’t dip. Costs like landlord insurance, property taxes, and labor all keep rising.
That not only makes the property unappealing to hold long-term, but also harder to sell. Lower net rental income reduces the value of the property, potentially leaving the property unprofitable to either keep or sell.