Due to the amount of money required to finance commercial real estate deals, many investors rely on a syndication model to raise funds. With this approach, you don’t need to contribute all of a deal’s cash requirements yourself. Instead, you raise money by pooling funds with multiple investors, a process known as syndication. But, as economic warning indicators flash red, many investors have asked us how a recession will affect syndications. As such, we’ll use this article to discuss real estate syndication during a recession.
Specifically, we’ll cover the following topics:
- Real Estate Syndication Overview
- Advantages to Real Estate Syndications During Recessions
- Concerns with Real Estate Syndications During Recessions
- Final Thoughts
Real Estate Syndication Overview
In commercial real estate, investors often find great deals but lack the capital to make them happen. Conversely, many passive investors want a return on their investment but lack the time or expertise to find and execute a real estate deal.
Real estate syndication solves both problems. In this system, a deal syndicator (also known as a sponsor), finds, underwrites, and vets a commercial real estate deal. As part of that underwriting process, the syndicator identifies the cash gap, that is, the difference between the cash required and the cash he plans on personally contributing.
With this cash gap and the deal’s projected returns identified, the sponsor pitches the deal to potential investors. In a commonly-used syndication model, the investors receive a minimum required return – paid out prior to the syndicator receiving a return on his equity investment. If the deal’s performance exceeds this minimum return, the syndicator receives a disproportionate amount of that upside through his catch-up return and promoted interest distributions. This set-up A) protects the investors, and B) incentivizes the syndicator.
Advantages to Real Estate Syndications During Recessions
Advantage #1: Offer Predictable Returns During Stock Market Volatility
During recessions, many stock investors panic when they start seeing huge market swings. While investors with a disciplined, long-term philosophy can ignore this volatility, many cannot. Instead, many people prefer more predictable investment options during the uncertainty of a recession.
Fortunately, well-structured commercial real estate deals offer more predictable returns than the stock market. Yes, you trade liquidity for stability when you move from stocks to real estate. But, many investors prefer to move their money into real estate to avoid massive stock market volatility. For real estate syndicators, this reality can lead to outstanding fundraising opportunities during recessions.
Advantage #2: Many Investors Convert to Cash to “Time the Market”
Related to the above, many stock market investors attempt to “time the market,” that is, sell at a peak and not buy again until the market hits bottom. Despite the difficulty (if not impossibility) of this timing, many investors still choose to sell their stocks at the faintest hit of a recession, choosing to convert higher-risk equities into cash or cash equivalents.
For real estate syndicators, this flight to cash provides a great opportunity. In boom times, many stock market investors have no motivation to cash out and buy into a syndication. However, once converted to cash due to recession concerns, these investors now have the cash on hand to invest in a well-structured real estate syndication.
Advantage #3: Multifamily Assets Often Perform Countercyclically
Syndications typically focus on a specific class of real estate. Ones that invest in multifamily properties tend to perform well during recessions, a result of the countercyclical nature of these properties.
When the economy contracts, people have less financial ability to upsize – either from apartments to starter homes or starter homes to larger properties. Instead, more people take the opposite approach, either downsizing to cut costs or continuing to rent apartments. As a result of this phenomenon, multifamily properties tend to have high demand and, by extension, solid performance during recessions. This countercyclical performance drives multifamily syndication returns higher when the economy struggles.
Advantage #4: Potential for Lower Interest Rates
Of note, we’re currently in an economic “perfect storm” of sorts, one that combines a slowing economy with rampant inflation. To combat the latter, the Federal Reserve (the Fed) has been aggressively increasing interest rates, leading to larger real estate borrowing costs.
However, in most recessions, the Fed takes the opposite approach, lowering interest rates to incentivize investment. These lowered interest rates typically result in lower 10-year Treasury rates, the key driver to mortgage rates. Accordingly, many recessions lead to lower borrowing costs for real estate syndications, and these lower rates translate to higher returns for investors.
Concerns with Real Estate Syndications During Recessions
Concern #1: Investors with High Recession-related Aversion to Risk
Investing involves as much psychology as it does financial analysis. That is, you cannot ignore the effect emotions have on someone’s approach to investing. Even when presented with an incredible opportunity, some investors will never overcome recession-related risk aversion. That is, when the economy turns south, these investors want nothing more than to tie their cash up in the safest assets possible – typically Treasurys.
For real estate syndicators, even the most successfully underwritten commercial real estate deal will not convince these sorts of investors to join a deal.
Concern #2: Investors Not Wanting to Sell Stocks and Realize Paper Losses
Most syndication investors don’t just have millions of dollars in cash. Instead, most people invest in stocks, bonds, and other forms of real estate. A frequently-used saying exists among financial planners: “your losses aren’t real until you realize them.” In other words, until you sell an investment that’s decreased in value, you haven’t actually lost money, which is why stock downturns are called “paper losses.” They don’t exist in reality until you sell those stocks at a loss.
When the stock market collapses during a recession, disciplined investors will not sell their holdings at a loss. Instead, they recognize that, over time, the market will continue to grow (albeit in fits and starts). As a result, recessions create an environment where many investors (the ones who didn’t convert to cash) refuse to sell their stocks at a loss, reducing available cash for investing in a syndication.
Concern #3: Potential for Stricter Commercial Real Estate Lending Standards
In some recessions, lenders may tighten their lending standards in the face of economic risk. While the Fed may seek to boost cash via its monetary policies, individual lenders may take a more cautious approach, worried about property performance and a borrower’s ability to service debt during recessions.
In particular, for syndications that invest in cyclical real estate types (e.g. many industrial, office, and hospitality properties), fears of poor property performance may lead to tightened lending standards. For instance, in an expanding economy, lenders may require 75% loan-to-value (LTV) and 1.25 debt coverage ratio (DCR) performance. But, during a recession, these same lenders could protect themselves by requiring 65% or 70% LTVs and 1.30 DCRs. The result? During recessions real estate syndications need to raise more funds for otherwise identical deals, which ultimately reduces the overall returns.
Some potential obstacles exist for real estate syndications during recessions. For the most part, though, syndications remain an outstanding strategy – both for investors and sponsors – during economic downturns.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.