I recently attended a real estate conference where several speakers talked about investing in syndications. (Groups that pool money from multiple investors to flip big real estate projects for quick profit.) Syndications all go “full circle,” meaning they will collect capital, purchase a property, fix it up to raise its value, and sell the property. Once the property sells the syndication will distribute the proceeds, less their fee for managing the project, to its investors. After paying the capital gains taxes, the remainder of the money can then be invested in another project.
As I thought about this concept, I realized a couple of big flaws in this process. The money invested is completely out of the market for extended periods of time each time a project goes full circle. And with each cycle a tax payment is required. During the time between syndication investments, while a new syndication is being vetted and while that syndication is waiting to collect all the money needed to purchase their intended property, the money is out of the market. Investments are not earning rental income, paying down principal, nor appreciating during this time out of the market.
I know how detrimental being out of the market is for stock investing and wondered what effect it would have on real estate investors that don’t stay in the market.
Many of you are familiar with the old story of a penny doubled every day being worth more than $10 million dollars by day 31. But if you don’t have your money in the market to double, you will lose a tremendous amount of money. If you miss only four of the doubling events, you would only have $671K on day 31. A loss of almost $10M.
So here is how it would play out if my friend invested in syndications and needed to reinvest frequently, as opposed to me, who bought a similar type of property on my own and let it grow. Think about every day in the penny example as a period of time. And we will change the scale to $1 invested instead of a penny.
Period 1: I invest my dollar buying a rental property. My friend invests her dollar buying into a real estate syndication.
Period 2: My investment doubled so I have $2. My friend is waiting for the syndicator to get all the money together to make the deal, so she still has $1
Period 3: I have $4. My friend now has her money invested and growing, it is now worth $2. She got a letter telling her the investment has returned 100% during this period.
Period 4: I have $8. My Friend now has $4 and got a letter telling her the investment grew another 100% for a second period in a row and was sold for a handsome profit of 400%. She received a check for $4 saying the syndication has gone full circle.
Period 5: I have $16. My friend paid her capital gains taxes so now she has $3. She is looking for a new syndication in which to invest.
Period 6: I have $32. My friend has found a new syndication she likes and sent in the money. She has $3 invested.
Period 7: I have $64. My friend is waiting for the syndication to finish collecting all the capital for the deal, so she has $3.
Period 8: I have $128. My friend’s new syndication has been working hard and doubled her money during this period and sent her a letter saying she got 100% return on her investment so far. She has $6.
Period 9: I have $256. My friend’s investment is still doing well and returned another 100% this period and was sold for a 400% profit. She got a check for $12.
Period 10: I have $512. My friend was quicker to turn around this time and found a new syndication right away. After paying $2 in capital gains taxes she invested her $10.
Period 11: I have $1,024. My friend got in on the tail end of the money collection this time, so the money was invested right after sending it in. She now has $20 and a letter telling her they are up 100%.
Period 12: I have $2,048. My friend had a similar result and had another period of 100% return. Her investment is now worth $40.
Period 13: I have $4,096. My friend got a letter telling of the smashing 3 periods in a row of doubling the initial investment. Because they are now up 800%, they sold the property for a handsome profit and sent her a check for $80 resulting from the $10 she invested with them.
Period 14: I have $8,192. My friend paid $10 in capital gains taxes and invested $70 in her new syndication.
Period 15: I have $16,384. My friend has doubled her money again and has $140 and a letter telling her of the great returns they are getting.
Period 16: I have $32,768. My friend doubled to $280 and another nice letter of congratulations for 100% return during this period.
Period 17: I have $65,536. My friend doubled her money for a third period and they once again sold her holdings for an 800% return on investment. She received a check for $560, paid $60 in capital gains taxes and now has $500.
I don’t think we need to continue any farther, as you can clearly see the pattern and the problem that being out of the market and continually paying capital gains brings. My friend will keep getting her investment back every few periods, as selling the property for a profit is how the syndicator makes their big bucks. They are not in the business of generating long term passive income. Syndications tend to be interested in collecting appreciation as soon as they raise the value of the property. Then because the property sold, my friend will have to pay long term capital gains taxes on the profit as well as recaptured depreciation.
There will be another time delay as she looks for another investment and vets the syndication. If she is lucky, the syndication she has already used has another project in the works and she will need to do significantly less work to vet their next offer.
But the combination multiple episodes of being out of the market, owing capital gains taxes, paying closing costs for the sell, and paying the syndicator their profit take a big toll on her returns. In this simplified example she now has $500 and I have $65,536. This also does not allow for market fluctuation, if the market is down, the syndication being a short term investment, her returns will be down as well.
The syndicator will feel this is not a correct comparison because they bring to the table their real estate superpowers that allow them to get better returns than I could get on my own. They are professionals who do this all the time and since they can buy bigger deals, they can get more economies of scale. Since the syndicator feels they bring an advantage, they should get a better return than I would get with my buy and hold strategy. So I ran the numbers with the syndication tripling the investment in each period they were invested and I still only got double my investment in each period. The results improved my friend’s investment returns to a little over $26,000 after the 17th period which is less than half of my overall returns of $65,536.
In reality, it is not the absolute numbers that is at issue, it is the concept that higher expenses and time out of the market are very difficult to overcome. My friend is out of the market when I am still in the market and she is repeatedly paying capital gains taxes. I will never pay any capital gains taxes since I plan to leave my property to my kids, at which time they will inherit it with a stepped-up basis. I also don’t need to pay the syndicator a cut or pay for multiple rounds of closing costs when sales occur. Both the syndication and I are paying a property management company to take care of the day-to-day issues so the level of investor involvement is similar.
I would argue that I only had to put time and effort into buying once before handing the keys to the property management company, but my friend has to find another investment to buy every few years, so she may actually be putting in more time than I am over the long run.
Make your investment plans long term like Warren Buffet who said:
“Our favorite holding period is forever.
We are just the opposite of those who
hurry to sell and book profits
when companies perform well.”
My preference is to buy a property and sit on it as the rent increases, the mortgage gets paid down and the property appreciates. Don’t sell off quickly because your property is now worth more than your initial investment and you have quick dollar signs on your brain. It costs a lot of money to be out of the market, not to mention the realtor fees, closing costs and taxes associated with a sale.
This is true for investing in stocks as well. If you are out of the market for only a few days and they turn out to be big winning days, you miss a significant portion of the gains. All long term stock results are recorded based on staying in the market for the entire period, and not jumping in and out of the market.
Don’t be a short term investor. Continue to stay in the market since your crystal ball is not likely any better than mine when it comes to timing the market. If you need to learn how to get started, pick up a copy of my bestselling book The Doctors Guide to Real Estate Investing for Busy Professionals, Who Don’t Think Real Estate is for Them. You can also learn how turn your direct ownership of real estate into passive income with my course, The Doctors Course to Automating Your Real Estate Investments. Whatever your chosen real estate path, get started soon.
4 thoughts on “The High Cost of Being Out of the Real Estate Market?”
Thank you for bringing up aspects that are not obvious to many of us.
Every time I read about a “round trip” it makes me feel like I have missed out.
But, I have acquired a few properties and, like you, intend to hold on to them, realize the income, the decreasing cost of the mortgage, and appreciation, and avoid paying capital gains by making them an inheritance.
Your insight is really appreciated.
Thanks for your comment. I’m glad to be of service.
You forgot many syndications (the good ones?) have 1031 eligible investments ready to go when they sell. This avoids the taxes and the money out of the market issue.
You also didn’t mention the syndication tells you the timeline before you buy in. It is a range but many are 5+ years. So there is no periods 10-17 for the investors in these types of deals.
You forgot to subtract the pending capital gains for your investment unless you plan to give it away (charity or inheritance – in which case you for nothing but perhaps the joy of making someone else richer). Since I 1031 exchanged each new purchase, I also paid no tax (if I also plan to give it away).
Finally, show me the investment that doubles each time period and is capable of having 17 cycles.
Enjoy your blog, but this one might need the delete key. And no, I am not a syndicator (but I do have 10% of my NW in syndication)
Thanks for your comment.
No I didn’t forget any of those things you mentioned, I just can’t cover every variable in a blog post. This post only covers the problem of being out of the market, and paying taxes with each full circle. There are some other variables on the positive side for syndications, like you pointed out, and there are many additional variables on the negative side as well, which you left out.
Yes some syndications will have a 1031 option available.
Knowing the predicted timeline of the investment doesn’t change the fact they will be going full circle and selling at some point.
I did not forget to subtract my pending capital gains. As I stated in the article, I intend to leave it to my kids for a step up in basis so no capital gains will be owed.
No, it is not all for nothing if I don’t sell now and collect my appreciation. I receive passive income checks every month for my entire life that exceed my living expenses.
There is no investment that doubles every time period. It is only an example from the penny a day doubled story as I stated. This article is about missing out on returns if you are not invested. I could have set the return at any amount and the results will turn out the same. The person out of the market is missing out on the exact same return the person in the market is getting, regardless of the actual return percentage.
No, this one will not get a delete key because some people don’t like how the results turn out.
Remember the old saying (I don’t know where it originated): It is not timing the market that counts, it’s time in the market.
I’m sure you will do just fine with your 10% invested in syndications. They often make a decent return.