Looking for Passive Income? Buyer Beware!

Lured by an increase in valuations and rents, many small investors jumped into real estate syndications without understanding the risks.

By Ben Dolan, CFP®

The term “passive income” has grown in popularity over the past decade. In general, the term describes an investment that continually generates income without requiring the investor to monitor the position or holding. Unlike ordinary income, passive income may be subject to more favorable capital gains tax rates.

The most popular passive income investment is real-estate. To many, especially in 2020 and 2021, US residential real estate seemed like a can’t miss passive investment opportunity with both rental rates and valuations on the rise. Enter the real estate syndicator, ready to cut you and thousands of other small investors in on the passive income opportunity of a lifetime.  

In yesterday’s online edition of the WSJ, Will Parker, Konrad Putzier and Shane Shifflet uncover the troubles with Applesway Investment Group, owned by Jay Gajavelli, the first of many real estate syndications facing serious financial hardship. Having built a real estate portfolio worth $500 million in four years, in April the company lost more than 3,000 apartments to foreclosure in “one of the biggest commercial real estate blowups since the financial crisis.” Investors, many of them individuals that had seen Jay pitch real-estate deals at conferences and on YouTube, lost millions.

In short, Applesway mismanaged the debt owed on the real estate by utilizing floating rates that adjust each month. When interest rates increased rapidly in 2022, the firm couldn’t handle the increased payments and the banks foreclosed on the properties.  

As the authors point out, many of Applesway investors may not have known how bad the situation was given the structure of the investment: “Syndicator investors have few legal protections, said Joan MacLeod Heminway, a securities-law professor at the University of Tennessee in Knoxville, Tenn. Unlike Public companies, syndicators in many cases aren’t required to give regular updates on their buildings’ financial performance, she said. As limited partners, investors have no say over the spending. Some who lost their investment never knew the properties were in trouble until they were near foreclosure.”

Should a property fail, the syndicators may not be in such a bad spot. According to the authors, “Syndicators generally invest little of their own money. They collect acquisition fees from investors that typically go from about 2% to as high as 5% of an apartment building’s purchase price…Syndicators often profit even if the investment is a failure, which real-estate analysts say encourages excessive risk-taking at the expense of inexperienced investors.”

On April 4th of this year, Jason Zweig, writer of the Intelligent Investor column for the WSJ, provided an outline of his seven virtues of great investors, one of which is skepticism. There is little doubt that many of the investors in the Applesway syndication were swept up by the promise of quick double-digit returns. Had they practiced the investment virtue of skepticism, perhaps they would have asked a few pointed questions about fees and financial reporting. The answers to these questions likely would have given the investor pause.

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Ben Dolan and Michael Foster are investment advisor representatives of Dolan Capital Advisors a North Carolina state-registered investment adviser. Investment advice offered through Dolan Capital Advisors, Inc.