BiggerPockets Money Podcast - 456: The Harsh Reality Real Estate Syndicators (and Investors) Face in 2024

Episode Date: October 6, 2023

Many real estate syndications are facing absolute failure in 2023. But, even if you aren’t investing in any, this could be a learning experience like no other to help you build your wealth in the future. If you’ve never heard of a real estate syndication before, here’s a quick summary: a real estate syndication is where an “operator” raises money from a group of investors to buy a large commercial property, often an apartment complex, self-storage facility, or housing community. Over the past ten years, these investments have boasted massive profits, but everything is about to change. Real estate syndications face obstacles like they never have before. Rising interest rates and vacancies, a backlog of evictions, plummeting prices, and inexperienced operators who have NEVER been in a down market. These failed deals could lead to opportunities for you to invest at a massive margin, but how do you know which deal is worth putting money into? J Scott, world-famous investor, flipper, syndicator, and author, is on the show to explain exactly what to look for in a syndication, whether investing now is the right move to make, and what to know before investing in a syndication. The right syndication can make you hundreds of thousands in a completely hands-off, passive investment. The wrong syndication can tank your entire net worth. How do you know which is which? Tune in!   In This Episode We Cover Syndication investing explained and whether putting money into this “passive” investment is worth it The commercial real estate crash and why property values are plummeting Massive economic headwinds syndicators face in 2023 and why many won’t survive The danger of “floating rates” and why many syndicators could be forced to sell Accredited vs. non-accredited investors and who should consider syndication investing The most critical question you should ask ANY syndicator   And So Much More! Links from the Show BiggerPockets Money Facebook Group BiggerPockets Forums Finance Review Guest Onboarding Join BiggerPockets for FREE Scott's Instagram Mindy on BiggerPockets Grab Scott’s Book, “Set for Life” Listen to All Your Favorite BiggerPockets Podcasts in One Place Apply to Be a Guest on The Money Show Podcast Talent Search! Money Moment Grab the Best-Selling Real Estate Books by J Scott Syndications: Everything You Need to Know BEFORE You Invest The Biggest Crash Imaginable is Coming For Commercial Assets REITs: How to Make Real Estate Money WITHOUT Owning Rentals w/Jussi Askola  Click here to check the full show notes: https://www.biggerpockets.com/blog/money-456   Interested in learning more about today's sponsors or becoming a BiggerPockets partner yourself? Email us: [e-mail]   Learn more about your ad choices. Visit megaphone.fm/adchoices

Okay, my dear listeners, strap in. Welcome to the Bigger Pockets Money podcast where we interview Jay Scott and talk about syndications and what can happen if they go wrong. Hello, hello, hello. My name is Mindy Jensen. And with me, as always, is my sober co-host, Scott Trench. Great to be here with you, Mindy, and with my co-host who has contemplated the meaning of the phrase, you can't drink all day unless you start in the morning. Every time I start in the morning. Yes. Every time I start in the morning, I think of Scott.

That's a lot. It's more than you would think. I think we should say that Jay Scott has a podcast called drunk real estate, not just we're sitting here talking about getting drunk at whatever time you're listening to this show. All right. Scott and I are here to make financial independence less scary, less just for somebody else to introduce you to every money story because we truly believe Financial freedom is attainable for everyone. And even though real estate's indications are a great investment, we also want to show you what happens when they don't always go according to plan. That's right.

Whether you want to retire early and travel the world, go on to make big time investments in assets like real estate, start your own business, or confront the sober realities of the commercial real estate market in today's in today's market conditions. We'll help you reach your financial goals and get money out of the way so you can launch yourself towards those dreams. That was good, Scott. That was really good. Okay, it's time for the segment of our show called The Money Moment, where we share a money hack, tip or trick to help you on your financial journey. Today's Money Moment is, do you want to hang out with friends, but you don't want to spend a bunch of money on dinner out?

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Okay, Scott, before we bring in Jay, let's talk about your syndication investments. Are you investing in syndications right now or thinking about investing in syndications right now? I am in a syndication that I invested in a few years ago. I think that will be impacted by current market conditions. but with professional operation. And I am not currently exploring lots of syndication opportunities. I'm a little bit bearish or fairly bearish on the commercial real estate space through the end of 2024.

However, my interest would be peaked if a syndicator came to me and said, I'm about to invest a quarter, a third, or half of my net worth personally into a deal. Okay, now I'm interested. But I'm certainly not exploring. opportunities with folks who are, you know, trying a new fund and not are, that's not a major part of their personal positions at this point in time. I think I still have one syndication left. I might have two syndications. I would have to look. One was, uh, on the market. So I'm not sure if I have one or two right now, but I have two syndicators whose documents I would read through.

Everybody else right now is just getting in the no thank you pile. I'm not even going to read pile because I don't love the current state of the real estate, the commercial real estate space, and I don't love the current state of the interest rates for that same space. Tax season is one of the only times all year when most people actually look at their full financial picture, including income, spending, savings, investments, the whole thing. And if you're like most folks, it can be a little eye-opening. That's why I like Monarch. It helps you see exactly where your money is going.

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All right, today's guest needs no introduction, but we're going to do it anyways, with over 17,000, I guess it's 17,995 forum posts, 15 years here on bigger pockets, many more years in investing in real estate, hundreds, thousands of units at this point, hundreds of millions of dollars in real estate transacted, owned, operated, all that kind of stuff. Today, we are having Jay Scott. back on the Bigger Pockets Money podcast. He's the author of not just one, but five Bigger Pockets books with creative titles like The Book on Flipping Houses, the book on Estimating Rehab Costs, the book on Negotiating Real Estate, and more. His newest is Real Estate by the

Numbers, co-authored by Dave Meyer, and he's also the owner of Bar-Down Investments. Do we have all of your titles there, Jay? And welcome to the Bigger's Money Podcast. Thank you so much. I am co-owner of Bar-Down Investments. I'm a partner there with my awesome business partner, Ashley Wilson. And I just want to remind everybody that's listening that when I found bigger pockets, it was the day that I decided I wanted to flip a house and I did a search for how do I flip houses. And that's how I found bigger pockets and became affiliated with bigger pockets.

So for anybody out there who's thinking that I'm just some big wig real estate investor based on that introduction, when I started my journey, I knew a whole lot less than most people when I found bigger pockets. In 15 years, you too can be like Jay Scott. Just post 18,000 times to the forums and write a couple books and you'll be there. Okay, Jay, for those of our listeners who may not be super familiar with you and haven't heard you on this show yet, even though you've been on like a thousand times, can you tell our audience a little bit about yourself?

Yeah. So I am a former engineer and business guy from the tech world 2008. my wife, Carol and I quit our jobs, and we fell into real estate investing because we were looking for something that would allow us to put our life over our work. And this has given us the work-life balance to raise two amazing kids. We live in Sarasota, Florida. And yeah, for the last 15 years, we've been doing what Scott mentioned. We flipped a lot of houses for about a decade. And then for the last five years, I've been focused on multifamily syndication, basically buying, repositioning and selling large multifamily properties as part of bar down investments. Well, that leads very nicely into my next question. Way back on episode 219 of the Bigger Pockets Money podcast, we talked a little bit about syndications. I believe it was a two-hour episode where we, you, Scott and I just kind of sat around and let you talk for two hours, a deep dive about syndications, all the things you need to know. But now the environment has changed.

And today we're going to talk about everything that's going on economically. And what happens when syndications go wrong or sideways or maybe not exactly perfect? To start, let's explain to our audience how syndications function. What does it mean to invest in a syndication? Yeah. So a syndication is based. Basically, think about when a large real estate deal needs to get done. And when we talk large, it could be $2 million, $5 million, $10 million, $500 million. When a large real estate deal needs to get

done, typically the person that's operating the deal, the person that's putting the deal together, they're going to go out to their friends, to family, even to the general public, to raise the capital that's needed to do that deal. So if you're doing a $50 million deal, maybe you're getting a $25 million loan on the deal, but then you still have to come up. with another $25 million. A lot of real estate investors don't have $25 million sitting around. So they'll go out to, again, friends, family, the general public, and they'll raise capital. They'll find people that will put the capital into the deal that will allow that deal to get

done. And for nomenclature, for context as we talk to this discussion, we're going to refer to the people that are operating the deal that are putting the deal together as the operators or the general partners. The people that are investing in the deal, generally they're investing passively. Basically, they're putting their money in. They have no say in the decision making. They're not doing any of the work. They're just putting their money in and earning a passive return. We typically refer to them as the passive investors or the limited partners, the LPs. So how does an LP make money fundamentally? What are the basics of how a return is generated for these limited partners? Yeah. Well, when everything goes right, the LP, the limited partner, the passive investor is going to put their money in at the beginning of the project.

and then they're going to get paid, and they're going to get paid in several ways. First, they may receive some amount of cash flow during the project, and that means they're going to get distributions of cash. Could be on a monthly basis, could be on a quarterly basis, could be on an annual basis. In some cases, if a project's not generating much income, they might not get any, but essentially it's a profit share. As the project is generating capital, generating income, the operators, the people running the deal are going to share that with the investors. So cash flow is the first way that investors get

paid in syndications. The second way is that investors are probably going to get some big pot of profits at the end of the project. So hopefully you buy a deal for a low amount, you sell it for a high amount, and some of that difference is the profit. And so the operators are going to share much of that profit with the investors. So the investors are going to get their money back at the end of the deal, plus they're going to get some big, hopefully big pot of profits as well. And third, the investors may get some form of tax benefits throughout the project. And so this typically comes in the form of what we refer to as paper losses, where the project is getting some tax benefits from the government and passing those tax benefits to the investors. So they're going to get to offset some or all of their other income using these tax benefits.

And so what are some ways you can lose money? if a syndication is underperforming. How does that work? Yeah. And so there's a really important point. I know a lot of people think that syndications and investing in these types of deals is equivalent to making a loan. You put the money in, your money is secure, you get paid every month, a fixed amount. But it's very much not that way. The way syndications work is that you are making what's called an equity investment. You're basically a partner in the deal. Even though you're not doing any of the work, even though you have no say over the decisions that are being made, you are a partner, which means if the project makes money, you're going to make money.

If the project loses money, then you're going to lose money. And so this is the thing that a lot of people don't realize. These deals have risk. And for the last 10 years or so, because the economy's been so good, because real estate's been so hot, most people that have invested in syndications have made money. They've made the amount of money, or in a lot of cases, they made a whole lot more money than what the operators projected they were going to make. And so a lot of people who invest in syndications or who have been for the last

decade probably feel like this is an easy way to make money. There's no risk. I'm going to get my monthly distributions. I'm going to get my big pot of profits. I'm going to get my tax benefits. But the reality is if a deal goes south, if a deal doesn't make a lot of money or if a deal loses money as a partner in the deal, the investor is going to lose money as well and potentially lose all of their investment.

Can a LPE lose money, but the operators still make money in a syndication deal? Yeah, it's a good question. And unfortunately, the answer is yes to some degree. So again, I mentioned the LPs make money, cash flow, profits, and tax benefits. Well, the operators also make money cash flow profits and tax benefits, but the operators also make money in a fourth way, and that's fees. So for most syndication, the operators are going to charge some set of fees for operating the deal. The most common fees are number one, what's called an acquisition fee. So a lot of times the operator is going to get between 1 and 3% of the purchase price of the

property back the day of close. So to put that into perspective, if I'm operating a syndication, that's a $20 million deal. I'm buying a property for $20 million. When day one, the day we close that purchase, I may be getting anywhere from $200,000 to $600,000 in fees. And this is the way that most syndicators run their business, keep the lights on, keep their employees paid, because for the most part as operators, we're giving up most of that cash flow. And so the bulk of our profits are going to come at the end of the deal, not throughout

the deal. And so a lot of syndicators look at those fees, that acquisition fee as a way to keep the lights on throughout the project. That said, and this is a really good question. We talked about this in the last episode that we did on syndication. A good question to ask the syndicators is, how much money are you putting into the deal personally? Because a lot of operators will take that acquisition fee, in this example, $200 to $600,000, and they will invest that money back in the deal alongside their passive investors.

So a lot of times while we're taking a fee, we're investing that fee back into the deal. And then there are other fees that we might take. There's a common fee called an asset management fee. So a lot of us have the CEO type person who runs the deal. day in and day out. Their job is to carry out the business plan for making sure the deal makes money. And so we'll take one or two percent per year of the income we bring in. And oftentimes that what's called an asset management fee is used to pay that person who's running the project. There might be a construction management fee where we take a fee based on construction or

renovation work that we do. There might be a fee at the sale of the property or the refinance of the property as well. So there are definitely ways that the operator is going to make money in addition to the profits that the project generates. That said, hopefully if a project goes well, the bulk of the money the operator makes is going to be aligned with the investor in that it's the profits from the deal. Awesome. Yeah, I think this is a really important point. And, you know, I'll use a $100 million deal for easy math here, but $100 million deal, the operator might make a million bucks just for buying the thing. Then they might make, if it's $35 million in equity, they might make $700,000 a year.

and management fees. And then if they're able to increase the value to $135 million, that $35 million in profit, they might split with the investors 80, 20. And so that's a big pile of money. We're talking about $10.15, I think it's $13 million in this example. That's going to the operator and or the folks that are working on the deal there in that outcome. So not a bad system. It has a proven way to align interests in some cases, but you're going all in on growth in a lot of cases. And I love your point about how if the operator is co-investing a lot of their own cash, perhaps a significant chunk of their own net worth in the deal, that's a good way to couch the risk there. So the incentives are not all for growth, but the preservation as well.

Absolutely. Yeah, you want to make sure that the operator, and again, we talked about this in the last episode. I highly recommend anybody that's interested in this particular topic, go back and listen to the last episode, which was all about vetting operators and vetting deals. But this is a great way to ensure that your interests are aligned with the operator as a passive investor, that the operator is investing some or a bunch of their own capital into the deal. Okay. Now we're looking at rising interest rates. We're looking at potential issues. What are the biggest risks to syndications today? Yeah. So from what we're seeing, there are three big risks in the syndication world.

And the projects that are having issues these days tend to, to fall into one of three buckets. Number one, interest rates have gone up. No surprise to anybody. We were seeing interest mortgage rates at three or four percent for these types of big real estate projects a couple years ago. Now we're at seven, eight, nine percent. For those investors who've gotten what are called floating rate loans and floating rate loans are loans where the interest rate is going to fluctuate based on the federal funds interest rate or other other benchmark rates, they're going to see as interest rates go up every month their cash flow is going to go down because they're going to be spending more and more money as interest rates go up on that

interest cost, that principal and interest payment that they're making to the bank. And so there's less money left over for their investors. Now, the problem is if interest rates go up too high, there's going to be such a high interest cost every month that there's going to be no money left over for investors. There may not be enough money left over to even pay the bills. And so the number one risk is with deals that have these floating rate loans where the interest rates go up so high that investors can't afford to make any other payments to pay their bills or even to pay their mortgage. That's number one. Number two, a lot of these floating rate loans are actually short-term loans.

And the reason we get floating rate loans in the big real estate world is a lot of times if you have a property that has occupancy, the number of tenants in there is less than 90%, meaning the deal is distrable. distressed, it's a deal that needs some renovation and management improvement. A lot of times, banks and large institutions aren't going to be willing to lend fixed rate loans for loan periods of time. So for these types of distress deals, we have to go out and get these floating rate loans. Now, these floating rate loans, like I was saying, are often two-year loans or three-year loans or maybe five-year loans, which means in some short period of time after you get the loan, you're going to need to either sell the property or refinance into another loan. Well, since, since, uh, since COVID, a lot of people got these loans back in 2020, 2020, 2021. And now they're starting to

come due. We're hitting that two or three year mark where a lot of these deals, a lot of these loans are coming due. And the operator either needs to sell the property, which they're having trouble doing in this market, or they need to refinance. And the problem with refinancing is because values have gone down, banks aren't willing to lend as much money on a refinance. And so in order for an operator to do a refinance right now, they actually have to bring money to the table. And so that's a very difficult thing for a lot of operators to do. They don't have a million or two or three or five million dollars sitting around to do a

refinance and bring money to the table. So that's the second risk. The third risk is in this thing called rate caps. Rate caps are basically an insurance policy against rates going up. If you get a floating rate loan, you can buy this. insurance policy that will allow you to basically maintain the same mortgage payment every month. And if rates go too high, then the insurance company is going to eat the difference. The problem is these insurance policies are typically one or two or three year policies.

And as they expire, the rate gets reset. And so the cost of these insurance policies have gone through the roof with interest rates going up, with volatility going up. And so a lot of operators can't afford to pay for these insurance policies any longer because they're so expensive. So those are the three big risks. The one commonality you'll notice with all three of those risks is they apply to floating rate loans. Operators these days that have fixed rate loans where the interest rate is fixed for some period of time,

typically seven years or ten years or twelve years, those operators are in a much, much better position because they don't have to worry about interest rate fluctuations, they don't have to worry about refinancing, they don't have to worry about these insurance policies expiring and have to buy a new one. So I'm not saying that the operators that at fixed rate loans don't have some risks. They do. There's some eviction risk these days. There's some vacancy increase these days, which is impacting things. And there are other risks that impact even fixed rate loan projects.

But for the most part, the big risk these dates are deals that have floating rate loans. Okay. The first thing you said was rising interest rates. Yes. You said that rising interest rates may cause the operator to not be able to. to pay all of their bills. What happens in that scenario? I'm an LP. I have invested in Bob's syndication, his interest rate rose, and now he can't pay everything. What happens to me? Well, remember, you are a partner in the deal. And so if that deal struggles, you potentially have some risk there,

some financial risk. If the deal struggles to the extent that the property struggles to pay its bills and ultimately gets foreclosed upon, well, you could lose some or all of your investment. Now, there are steps in there that come between not paying bills and getting foreclosed upon, but at the end of the day, an operator who is struggling with a deal essentially has one of two options. They can either sell that deal. hopefully they're going to sell it for a profit, but they might have to sell it for a loss to save some of your capital. Or if they struggle long enough and they can't sell the deal, they're going to have to face repercussions from the bank, which could be a foreclosure. So a lot of operators these days are facing those two scenarios where they're selling properties for less money than they were projecting in some cases for a loss, in which case their investors are taking a financial loss, or they're getting foreclosed upon, in which case their investors are often taking a full financial loss, losing their entire

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I have so many more questions for you. Then you said floating rate loans. You can sell sometimes for less than what you wanted to sell it for. You can refi and in some cases you have to bring money to the table. if my GP refies and has to bring money to the table in order to refinance, am I expected to kick that in since you keep saying I'm a partner in all this? Yeah. So there are a few things that can happen.

So let's take a deal where we got a loan for $10 million. And in two years, that loan terminates and we have to refi into a new loan. The value of the property is dropped. and now we can only get a loan for $8 million or refinance for $8 million. We get a refinance for $8 million, but we still have to pay off that $10 million loan that we had, so we need to come up with $2 million. This is what's called a cash in refinance. Not a situation anybody wants to be in, but this is what happens when values go down and people are forced to refinance.

So in this case, the group, the syndication group, the operator needs to come up with $2 million to put into the deal. A couple ways to do that. One, if the operator could have foreseen this coming, and a lot of times they can, and if there was an opportunity to save a bunch of money along the way while you're heading towards that refinance, for example, not paying investors cash flow, telling your investors a year before this situation occurred that, hey, we have a feeling in a year from now we could be in a bad situation where we're going to need to save a million or $2 million to put into a refinance. we're not going to be paying you distributions for the next year. Well, that's one option. And that's actually one reason why good syndicators will say, hey, we're not going to be paying you distributions for some period of time or we're

going to reduce distributions for some period of time. This isn't always a red flag. Sometimes operators are doing this proactively because they foresee a situation like this. So that's one option, that they actually save up the money. Maybe they have money in reserves. Maybe they can use other money that they've raised in the deal that they were going to use for something else. So instead of building that dog park for $2 million, they're going to take it and put it into the refinance.

So basically coming up with the money themselves in the deal. So that's number one. Number two, and again, you're going to want to read your documents, but for a lot of syndications, operators have the right to get a loan. Either they can loan money to the syndication themselves or they can go out to a third party and raise money, additional money through a loan that can carry them over for something like this refinance. So that's a second option. They can put the money in themselves.

Keep in mind that when operators put money into a deal through a loan, typically they're getting a decent interest rate, 6, 8, 10%. So you want to find out, like, what's the interest rate they're going to get paid? Because you don't want to incentivize your operator to lend money to the deal just to earn interest. But that's the second way. The third way and the most drastic way is what's called a capital call. And this is where operators go back out to all their investors and they say, we need you to put more money into the deal. deal. Your capital call will either be a voluntary capital call or a mandatory capital call. A voluntary capital call is where basically the operator says, we need more money for this deal.

In this case, we need $2 million. And we would like all of our investors to put in extra capital to basically help us raise that $2 million. But as a voluntary capital call, you're not required to do that. You can choose not to put more money in. If you choose not to put more money in, well, somebody else can put your share of the money in. The operator can put your share of the money in. Another investor can put your share of the money in. They can go out and find a new investor to put your share of the money in. You're going to get most likely diluted.

Your investment percentage in the deal is going to get diluted by whatever amount you choose not to put in. You're not going to lose your investment. You're not going to be shut out of the deal. You're not going to be penalized any more than you might get diluted. That's a voluntary capital call. Or you can put the money in as requested and you don't get diluted. you'll maintain your equity share. The second, the mandatory capital call is a little bit more draconian.

And that's where the operator has said up front in the documentation, if we do a capital call, you are now required to put more money in. If you can't put more money in, there's going to be some severe consequences, potentially as much as losing your entire investment. And so for a deal that has mandatory capital calls, you're going to want to make sure that you have money sitting in backup to put into that deal if things go south. This is especially important if you're investing out of, let's say, a retirement account because retirement accounts typically, you can't just add money to it willy-nilly. You need to have that money there already. And so if you're in a situation where there's a

mandatory capital call, you've invested through a retirement account, you need to re-up your investment and you don't have any money in your retirement account, you could be in a situation where you're forced to lose or get penalized to some degree in that investment. Yeah. Going back, just with the purchase of commercial real estate. I am under the impression that commercial real estate doesn't have fixed rates for like 30 years, like a residential. It's more like an arm where there might be a fixed period of time, but then it resets. Am I correct?

So that is the example of the rate resetting. That's the floating rate loan. And typically it's resetting every month based on some bench. mark. And so, yeah, as rates go up and down, your mortgage is going to go up and down. Sometimes it's fixed for a year or longer, but often it's on a monthly basis. But there are actually, it's actually pretty common for there to be fixed rate loans in the commercial real estate space. So we still get loans from Fannie Mae and Freddie Mac to large conventional lenders. And the most popular types of loans that we would get from Fannie Mae or Freddie Mac are seven, 10, 12 years,

fixed rate loans. Now, they're amortized over 20 years, typically maybe 25 or 30, which means at the end of seven or 10 or 12 years, the loan won't be fully paid off. And if you still have that loan, you're going to have to either refinance or you're going to have to pay it off. But the interest rate is typically going to be fixed for that seven or 10 or 12 years. So you don't need to worry about interest rates going up in that period of time. Now, one third of the market is on variable interest rates. And that creates a huge problem. So one of the things we haven't talked about, We talked a lot about how interest rates are putting pressure from a financing perspective on existing syndications. They're also putting pressure on valuations and the exit valuations of those in the form of rising cap rates.

I'd love to ask you about that. And to pile on to that question, I'd like to ask you about the pressures that outside of financing syndicators are seeing on NOI growth in the form of rents not coming in as expected. Austin, Texas, for example, to pick on one market, rents are down year over year. And costs are going up for insurance, for labor, for those types of things. So can you talk about how interest rates coupled with these NOI pressures are hurting valuations? Yeah, absolutely. So when we talk about valuating commercial real estate, how we determine how much a piece of commercial real estate is worth, we care about two numbers because there's a formula. And the formula is net operating income, basically the amount of income the property is generating,

divided by cap rate. And cap rate is basically just a multiplier in the market. It's expressed as a percentage. So a higher cap rate actually means values are lower. Lower cap rate means values are higher. And yes, people are getting, and when I say people, I mean deals and operators and investors are getting squeezed on both sides of that equation today. So we'll start at the top of the equation, the net operating income. So your income that the property is generating is influenced by two things. how much money you're bringing in and how much you're spending on expenses. And certainly when you have a softening market, you're going to be bringing in less money for a couple of reasons. One, rents aren't growing as quickly. And a lot of times in these deals, we're projecting that rents are going to continue to

grow at two or three or four percent a year. But in a lot of places right now, we see rents growing at zero percent a year or one percent a year or negative even in some markets. And so we're seeing less rent growth than we were expecting, and that's hurting our projections. Number two, vacancies are going up. A couple years ago, we were seeing properties where literally 98, 99, 100% occupied most of the time. These days we're going back to the historical averages of vacancy, which is occupancy, which is 92, 93%. And so we have more units empty and we're not collecting rent on those units. But even on those units where we aren't empty, where we have tenants, we're seeing more default on rent.

rent. A lot of people are starting to struggle because rents are going up. People are getting their hours cut. A lot of people aren't making nearly as much money as they were relative to inflation a couple years ago. And so we're seeing this thing called economic vacancy, which means we have people in the units, but they're not able to pay their rent. And this is actually worse than regular vacancy where the units are empty because we can put a new person in the unit. But with economic vacancy, somebody in the unit who's not paying, we're not going to get any money out of that unit until we evict them. And we're seeing a huge issue with evictions these days. I invest a lot in Houston, Texas. Right now, the backlog of evictions in Houston is over 80,000 people. There are 80,000 cases in front

of judges for evictions, which means invictions are taking four months, six months, eight months, to get people out of units. If they're not paying in that time, that unit is basically, not only are you not getting any revenue for that unit, but most likely the tenant is doing damage to the unit. There's going to be more renovation when they actually do leave. And so, yeah, there's a lot of problems on the revenue side. Then on the expense side, we're seeing insurance rates go through the roof. So people are paying a lot more for insurance than they were a couple years ago and more than they were expecting.

With valuations having gone up the last couple of years, we're seeing property taxes in a lot of areas start to go up. What we see is in a lot of areas, property taxes aren't reassessed. every six months or every year, it might be every two or three or five years. And so we're seeing a lot of places where property taxes are jumping up because values are so much higher than they were three or five years ago. And then labor and material costs for renovations, for maintenance, payroll costs. So for a lot of large commercial properties, we have leasing people who sit in an office all day to meet tenants. We have maintenance people who are there on call 24-7 to

deal with maintenance issues, they get paid a salary and salaries and payroll are going up. So on the income side of things, we're seeing a drop in income. We're seeing an increase of expenses. And so this number called net operating income is dropping. So that's one side of the equation. The other side of the equation is cap rates. And again, that's just some multiplier in the market that tells us how much a property is worth. And as you pointed out, Scott, cap rates have been going up. And there are a lot of reasons for this that we don't have to go into or we can if you want. But the fact that cap rates are going up means that values are going down. The multiplier for property in a particular market is dropping. And so values are just less than they were based on the

same amount of income a year ago or two years ago or five years ago. And so both sides of these equations are getting hit, which means the value of these properties are dropping significantly. We've seen 20 to 25 percent value drops for a lot of, at least in the multifamily real estate world, office space has seen a drop even higher in a lot of markets. Self-storage is starting to see a lot of softening and values coming down. So across a lot of different asset classes, we're starting to see values drop considerably. And it's a result of both income and cap rates changing. And I'll also talk about supply, which is a major factor.

A lot of multifamily construction begins one, two, three years in advance. And it goes through permitting processes and long. long processes to get approved by the city and plan out design and build. And we actually have 900,000 multifamily units currently under construction in this country. And again, this is all regional. So some of this supply is going to really hit in certain regions, which can impact your rent growth to a large degree as well. Do you agree with those points, those additional points? Yeah, absolutely. I mean, there are so many variables that come into play here that it's really hard to kind of predict where things are headed. But it's very obvious that today that a lot of things

are conspiring to make it very difficult for these large commercial deals to continue to operate. I like to say that the issue isn't necessarily a bad market because in a lot of cases, commercial real estate investors are used to a bad market. High interest rates. We talk about interest rates or mortgage rates being at 6, 7, 8%. Well, historically, they're at 6, 7, 7, 8%. So 6, 7 or 8% is not necessarily a high number. The problem isn't that number or any other number that we're talking about. The issue is that we've seen such a radical change from a year or two ago when people were buying these properties. They went in with certain expectations because mortgage rates were low, vacancy was low, rents were going up quickly.

And so they projected that things would keep going the way they were going. But here we are two years later. And a lot of things have changed. And so it's the change in economic conditions that are causing a lot of these problems, not the conditions themselves. Okay. So I'm in one other question here around this. I'm an LP. I'm in a deal. Let's use my $100 million deal example that we talked about earlier, right? I have 35 million in equity. You said it might be down 20% in some markets. Now we have $80 million in asset value and $5 million in equity. That's obviously really bad news for me. In the REITs, we saw REIT valuations crash over the last 8, 19, 20 months, right? We saw them go down 33%. We just talked to UC Escola from Seeking Alpha, who is a great analyst in that space.

When I think about the syndication market, these are private investments and private funds. They're not publicly traded, so they're not valued on a continuous basis. How should I think about that as an LP if my. syndicators not, like they're not, of course, they're not going to get it appraised on a daily basis. But like, how should I think about that in terms of understanding my position and whether I'm in trouble or not? It's a tough question. And I feel like there's two questions in there. There's one, how do you value your interest in a particular deal? And for that, I would say that's, that's above my pay grade. We all have to do things differently. For a lot of syndicators,

a lot of operators, we will provide valuations at the end of the year. But we will, We're not doing formal appraisals because a lot of retirement companies, self-directed IRAs, are going to ask for a valuation. That's a requirement. And so we will provide those. But in a lot of cases, we'll basically just provide the same number that we bought it at. We'll say that the value hasn't changed. Even if it's gone up, we're going to say it hasn't gone up.

It's whatever we bought it at. So asking your operator what the value of the property is, typically you're not going to get a good answer because, as you mentioned, they're probably not going through some form. appraisal process, even on an annual basis. So that's number one. But from the perspective of how do you know how an asset is performing, this is where it's important to have done your homework up front. It's really important to have found an operator that communicates well, an operator that has been in situations before that they've had to handle difficult situations and to find out how they did that. we rely on our syndicators, our operators to be communicating to us.

And I'm a passive investor in a lot of deals. And so I've seen the gamut of those syndicators who communicate really, really well, who are going to tell me all the problems. Probably they're going to tell me more than I want to know. I'm probably one of those as well. I probably tell my investors more than I should because I'm just, I'm a blabber mouth, and I like to sleep well at night. And I like everybody to know everything.

Not necessarily a good thing, but that's what I do. to the other end of the gamut where operators that don't communicate at all until there's a major issue. And so you need to decide what level of communication you're looking for. And that's something you need to vet early on or before you actually make the investment to ensure that the level of communication that you want is the level of communication you're going to get. Unfortunately, I don't have a good answer for after the deal has been done because there are rarely any requirements for, for a syndicator to communicate with their investors. The one exception is if there's a tax audit, a lot of documents, at least our documents all basically say,

if there's any IRS action or an audit, we need to communicate that to all of our partners. But other than that, we don't have any legal requirements to communicate. But, again, good syndicators are going to communicate. So you want to ask up front, how often am I going to get an update? Is it monthly?

Is it quarterly? Are you going to do Zoom calls for your investors on some regular basis so that we can ask questions? Are you going to make financials available? So a good number of operators actually make the full financials for the property available, either quarterly or semi-annually. And so if you have access to the financials, even if you don't hear from the operator themselves, if you're savvy enough, you should be able to look through the financials and see, if not knowing that there's a major problem, at least see trends.

So certain numbers are trending in the wrong direction. And so that's a really good question to ask your operators before you get to do a deal. Are you going to provide financials? Because if the answer is yes, you're going to have a lot more insight into the deal than if the answer is no. But at the end of the day, once you turn over your money, your opportunity for changing anything has been severely limited. So you just have to hope that you picked a good syndicator at that point. So let's say I'm in a couple of syndications, listen to this. And I'm going to have a couple.

some are going to go well, some are going to be bad outcomes, right, because of the pressure is here. So even great, sophisticated, awesome operators who are making good decisions the whole way can just be a victim of circumstance for the timing of one particular deal or whatever with that. As an LP, how do I, how, what are some things that you would be thinking about like, hey, this is a problem that I should be really worried about because bad bets, bad decisions being made in the part of the person running my money. And this one was really just great bet, great business plan, executed well. The market just worked against us this time.

How do I make that distinction? What are the things that you're looking at and the ones that you're an LP on? Yeah, it's a hard question because you never know what's going through the mind of the person operating the deal. There's so many variables involved that, again, I often get asked the question, why would anybody get a variable rate loan? but when you really understand the mechanics of how these deals work, there are times when you either have to do it or where it may be a smart calculated bet. We have a deal where we did a variable rate loan.

We've faced the same risks as everybody else. We're in a situation right now where that third risk, that insurance policy, that rate cap, we paid $30,000 for our rate cap when we bought it back in 2020. Now that it's expiring after three years, we have to renew and it's low. looking like we're going to pay close to $400,000. So $30,000 to $400,000. And so we had really good reason for why we did that. And our justification, I'd like to think we didn't make a bit. Well, in retrospect, it was the wrong decision, but we didn't have a lot of other options at the time. And so it's not so much about what the decision was early on because a lot of times

there's good rationale for those decisions. And it, I even, I feel like, I'm a pretty good syndicator, but the deals where I'm an LP, I would never question the people I'm investing with. At some point, I had to trust them to make the right decision and to make decisions about things that I just didn't have as much information as they did. The bigger question for me is, how do they handle it? The bigger question for me is, are they proactive? And so not giving myself a pat on the back because we did get ourselves in a situation where we have this expiring insurance policy. But one of the things I like to see from my syndicators when I'm a passive investor. And one of the things that we did was we knew that this was a risk a year ago.

A year ago, we knew that we were a year away from this expiring rate cap. We knew that rates had gone up tremendously a year ago. And so what we said to our investors a year ago was we're going to be cutting our distributions. We're going to be distributing less money. And in fact, we went to zero distributions for much of the last 12 months because we knew how much money we wanted to have saved in reserves as a worst case scenario should interest rates keep going up, which they did. So now that we are coming upon that time where we have to renew our insurance policy and we have to renew for two years, we have $800,000 in the bank that we can use to rebuy that insurance policy.

Sucks for us and our investors that they missed out on a year of distributions. and that's something I have to live with and I have to explain that to my investors. But I would much rather have done that than tell my investors for the last year, everything's great, no worries, don't worry. And then we get to where we are today and say, now we're $800,000 short. What are we going to do? And so we want to see, I want to see that my operators that I'm investing with are being proactive from that perspective.

And so the first thing I would say is just because you see distributions getting cut doesn't necessarily mean it's a bad thing. In fact, it could mean it's a good thing. You'd rather see your operator do that early rather than too late. So again, it's not so much the decisions that operators made a couple years ago. Certainly, there were situations where operators were way too aggressive, made decisions that they probably shouldn't have made. But instead of second-guessing at this point, it's really more important to see how your operated or responding to situations where where they could potentially have a lot of risk. Love it.

You know, I know Mindy has a question here. I just want to chime in with this is, it's a, these are bets. Everything that we're talking about is bets. There can be good bets and bad outcomes. There can be bad outcomes. There can be bad outcomes and good outcomes with that. And I think that's, that's where you got to use your judgment and see how folks are handling things, you know, because the new, a new dawn will emerge for this asset class in a

general sense. And you want to be smart about it and understand that. any asset class is going to be cyclical. Real estate, single family real estate, multifamily, commercial real estate, the stock market, all these asset classes are going to be cyclical. And you've got to be able to separate good, bad outcome and the opposite. Here's the thing to remember about these deals. And people often ask, should I be investing a syndication now and what are the risks longer term? Keep in mind, most syndication deals are projected to last somewhere between five and seven years. And,

And if you look at an economic cycle from the worst part of the market to the best and back down to the worst, it's typically five to seven years historically. The last one went 12 years. It was a really long economic cycle. But historically, economic cycles are five to seven years, which means if you can withstand the headwinds of the deal, if you can withstand the worst things that can happen in the deal, there's going to be some point in that deal where it's an optimal time to sell and you're going to make money. So the key isn't so much of is now a bad time to be buying, is now a bad time to be selling. The question is, can you withstand all of the economic headwinds and all the issues that you potentially face in this deal long enough that you can get into the next part of the cycle where things are going to be better and where it's going to be a better opportunity to sell? And if a deal can survive long enough, it's going to make money. So you want to make sure that your operator is in the mindset that we're going to do whatever we have to to survive.

Because, again, whether it takes three years or five years or ten years, eventually there's going to be a money-making opportunity as long as that deal can survive long enough. Okay, Jay, this is something I get a lot. What do you think about non-accredited investors investing in syndications? So to me, and this is a personal opinion, I've met a lot of non-accredited investors who are a lot more financially savvy. than some accredited investors that I've met. And as far as I'm concerned, there's not a direct correlation between being accredited and being a savvy investor. Certainly, there's something to be said if you've achieved a million dollars in net worth

or if you have a couple hundred thousand dollars a year in income, it probably means it's more likely that you have some financial education or some financial savviness. But again, there's not a direct one-to-one correlation. So as far as I'm concerned, I think it's less important. Are you accredited or non-accredited? It's more important. Do you understand the risks? Are you investing a significantly or a nominally small percentage of your portfolio such that if you were to lose that investment, it wouldn't hurt you considerably?

And do you understand who you're investing with and what the investment you're making is? The SEC is looking to revise accredited investor definitions. They're likely to do two things over the next couple years. One, they're likely to raise that million dollar net worth. I've heard if you index it to inflation, it's probably closer to $5 million now, but they're probably likely to raise that to $2 or $3 million. But they're also likely to institute an exception for people that take a test. basically if you can prove that you have some financial knowledge, you're financially savvy

enough that you can meet accredited investor status even if you don't meet it from a financial standpoint. So that to me would be an optimal result, allow people to prove that they're financially savvy enough to make these types investments. I do believe that the government has the right to protect people that don't know what they're doing to some degree. But I just don't think that. that the current definition of accredited achieves that goal. Jay, thank you so much for coming on

to Bigger Pockets Money today. The episode 219 that we recorded with you a couple years ago, one of my favorites of all time, and I continue to get feedback about that from folks to this day because of the value and the good, honest, forthright opinion on how to do some due diligence on that. And I think that it probably saved a lot of people who listen to that show some money, even in the context of the negative pressures in the current environment. And today, to come on as an operator and talk about the realities of the market and the hard times and pausing of distributions and that kind of stuff, as an honest, straightforward approach and humility around that,

I think it just speaks the world of your character and the prospects for your businesses over the next decade or so. So really, really appreciate it and admire you and all that you've accomplished. And your courage to come in and talk about the difficulties in this industry. in the current environment and the way you're playing the game is the best of your ability in that. So really appreciate it and grateful for all your contributions over the years and look forward to seeing what comes next. I appreciate that. And I'm going to end with this, that we talked a lot on the last episode about asking operators

the hard questions. And one of the hard questions is give me a situation where things didn't go the way you expected them to go. And I just want to remind everybody that's listening that. You want an operator to have an answer to that question. It's not bad when they come back and say, here are all the problems that I've had. The important thing is that the follow-up question of how did you rectify the situation, how did you mitigate the risk, that they have a good answer for that.

If you get an operator that says, no, I've never had any problems, I've never been in a situation where anything's ever gone wrong, that to me is a much bigger red flag than somebody who says, yeah, I have had things go wrong. let me tell you about how I addressed it. So you will talk to operators this year and next year and forever in the future, people that we're doing deals now that are going to have some stories about things that went wrong. Again, that's not necessarily a red flag. And I'm not here to beat up any other operators because we're all going through this.

And the key is that we're doing the right things by our investors along the way. Absolutely. Well, thank you so much. Again, can't give you enough praise and gratitude for. for all you do for bigger pockets in the real estate investing community. And today is no exception. So thank you. Love you guys. Love you more, Jay. Jay, if somebody was looking for you online, where would they find you? It's easy. Jscott.com. Just go to letter j-cott-t-t-com. J-Scott.com. Check him out. He is a wealth of information. Jay, of course we love you.

We love all of the information that you so freely share with our listeners. And our listeners love you too. I'll speak for them. They all love you so much. Thank you. We will see you at BPCon. Everybody who is attending BPCon will see you too. Okay. Scott, that was Jay Scott. And I love him. I love his candor. I love his ability to really share the warts that the syndication space is either facing or will be facing very soon. And I don't feel like he was throwing anybody in particular under the bus and just instead giving an overall, hey, if you're investing in syndications, this is what you need to look out for. What did you think of the show? I can't gush enough about Jay Scott.

Jay is one of the smartest people you're ever going to meet. He's breathtakingly transparent. He has been for 15 years. He joined Bigger Pockets in 2008. And you can go back and see his posts where he documents the detailed outcomes of all of his flip investments. many of which were huge winners and a couple of warts in there. He's been done real estate all over the country and across multiple different strategies. And I believe that he is taking great bets and making great things there.

And even he's struggling and he's willing to admit it and be and continue that transparency around the market. And I just think that there's a lot of sobering lessons in today's episode. I think that a lot of people who are in syndications are going to be facing a lot of trouble as the commercial real estate market continues to face headwinds to the back half of this year into 2024. And we're privileged to have that opinion and perspective. And again, breathtaking transparency from someone in the space that is running funds there and facing those headwinds in there.

A lot of folks, I think, are not going to be as forthcoming. But hopefully bigger pockets can change that. And we can create a community where folks are willing to discuss the troubles and challenges and valuation pressures and cash flow problems that are impacting the syndication space because at some point, maybe it's right now, maybe it's next year, maybe it's in two years, maybe it's in five years, there will be great opportunities again in the space to invest, and this is an asset class that I know a lot of people are interested in. It's all bets, it's all allocation, can't put all your eggs in one basket where you can lose

it all, but it's certainly been tough for syndicators in the past, and again, privilege to learn from Jay. Yep. And like you said near the end, if you're going to be investing in syndications, know the risks. Understand what you're getting yourself into and read every word in the document. Ask the sponsor questions and keep asking questions until you understand the answers. All right, Scott, should we get out of here? Let's do it. That wraps up this episode of the Bigger Pockets Money podcast. Again, go listen to episode 219 when J. just does a deep dive into the concept of syndications in general. This is Scott Trench.

I am Mindy Jensen saying, Can't stay, Blue Jay. If you enjoyed today's episode, please give us a five-star review on Spotify or Apple. And if you're looking for even more money content, feel free to visit our YouTube channel at YouTube.com slash Bigger Pockets Money. Bigger Pockets Money was created by Mindy Jensen and Scott Trench, produced by Kalin Bennett, editing by Exodus Media,

Copywriting by Nate Weintraub. Lastly, a big thank you to the Bigger Pockets team for making this show possible.