11 Underwriting Red Flags an LP should look for
Syndicators marketing a project will generally make projections on how much and how quickly they can increase revenue.Increased revenue is key in forecasting the value of the property in the future.The higher the projection of future revenues, the higher thhe chance those expectations don’t come true.
Conversely, the underestimation of expenses a property will incur will lower returns.Just like with rent revenue, forecasting operating expenses gives the investment group the ability to derive expectes future net operating income from a property.
The best way to mitigate this risk is to include additional reserves in the underwriting.Yes, this will pot a damper on expected returns, but as a limited partner you are presented with a more conservative projection of the returns you\ll recieve if reserves are baked into the projections.
A good investor is one that makes up for where they lack expertise. Be sure that whomever you’re investing your capital with either has the experience of executing on similar projects or at least has someone on their team that has the necessary expertise to see the deal through.
Make sure the general parartner you are investing with is conservative with their cap rate projections. This is even more important in a low interest & cap rate enviornment where any small change in either of those numers will have a large impact on the valuation of a property.
The Internal rate of Return should be around 14% – 22% depending on the hold period and risk profile of the project deal. Equity Multiple: The equity multiple should at least be 1.6x – 3.0x depending on the risk profile of the project deal. DSCR: The Debt service Coverage Ratio should at least be 1.25x
In any apartment syndication, the property, the local market, and the General Partnership team are your three potential risks. In addition, if the GP team does not address the topic of risk when discussing the deal that is a red flag.
If there is no preferred return, that is an indication that the upside in the deal is too small for the General Partners to offer a “pref” and be compensated as well. A preferred return is the best way to align the interests of the Limited Partners and General partners.
If a refinance is needed in order to achieve the necessary return projections for returns, then that is a red flag. Debt markets can be unpredictable so investment performance should not be contingent on new debt during the hold period.
No one has a crystal ball to see into the future. A key component of smart, conservative investing is “stress testing” certain assumptions to see how the property performs in all scenarios.
Sponsors are paid through putting the deal together and management such as the acquisition fee or asset management fee. But beware of other large, hidden fees where the sponsor may be trying to maximize the profit they receive. Such fees could include a loan guarantee fee or travel costs being covered under the asset management fee. Most fee structures should be between 1-3%. Be wary of fees larger than this.