By: Joel N. Jacobson and Randall P. Sanders
July 2001

Fifteen years after the Tax Reform Act of 1986, there are still thousands of investment real estate syndications. Many of these entities were formed after 1986. The incentives have changed with tax-driven transactions largely eliminated except for low-income housing tax credit packages. More popular have been syndications based on economics with objectives of substantial cash flow and/or equity build. Most are legitimate business enterprises put together by well meaning sponsors with a good history of prior success.

Nevertheless, things don’t always work out the way everyone, including the sponsor, would like. When things go wrong, despite the best of intentions, it is a real test of management’s true abilities and commitment.

Is Something Wrong?

Unfortunately, an investor sometimes gets the uncomfortable feeling that things aren’t as they should be. Maybe communications from management have become less frequent, less candid or ceased altogether; cash flow projections aren’t being met in a timely manner or cease; or the stated game plan needs constant revision or entails repeated delays. Worst of all, telephone inquiries don’t get satisfactory responses or maybe get no response at all.

Less common, management will obscure the status of the investment, even if it is forthcoming bad news. In any event, the individual participants that had envisioned a passive role sometimes find it necessary to become more active.

What to Do

Actually taking action is the most difficult aspect of these situations for the individual investor. To take effective action against management (whether it’s a general partner, manager of an LLC, or whatever) is to acknowledge a mistake and that money may have been lost. Nobody wants to admit that might be the case.

Second, with a group of unrelated, geographically diverse investors, it is difficult for them to communicate sufficiently to organize.

Without some level of organization, attempts to communicate with the manager of their investment may be frustrating. If attempts to obtain accurate and meaningful information are not successful, or if the responses indicate serious problems, then further action is sometimes warranted. This may include a change in management. While management changes can often be legally effected by the investment group pursuant to the terms of the investment, someone has to take the initiative. Many otherwise salvageable situations are lost for no other reason than lack of timely action. The ability to face up to the situation and act is a major step in protection of the investment. If we have any complaint about our role, it’s that we always wish we could have gotten involved sooner. Often, the deterioration of the asset (not to mention the cash) accelerates exponentially at the end, like loan amortization in reverse.

Bad to the Bone

If things aren’t going the right way, the initial step toward a solution is to understand where the problem lies. Somewhere between “bad people” and “bad luck” you find “bad structure” and “bad management.” Overriding the “why” is the realization that by the time it’s obvious there is a problem, the reason “why” is probably irrelevant to a large degree. Post mortems on a deal gone sour may have only limited value. More important is the understanding of where things stand today; how it got there is often interesting but not much else.

Bad people are really pretty rare. Much more common are “bad management” and “bad structure.” Bad luck has a role occasionally, especially if the promoters depended upon certain events occurring that do not. However, the lack of a back-up plan arguably has elements from the “bad structure” category.

Why Hold On

A common question on investments that do not appear able to meet their original objective is, “Why hold on, why doesn’t management just sell it and move on?” A logical question and part of the investment experience: some investments work and some do not. This is why investment professionals preach diversification. However, this is looking at it from the investors’ point of view. What about the sponsor?

The original manager may be earning ongoing fees from a variety of sources: property management fees, asset management fees, mortgage renegotiation fees, leasing commissions, etc. Management may have subordinated debt on the property, or other pecuniary interests disclosed or otherwise. Management may therefore have little incentive to sell if it is making money, even if the individual investor is not.

Further, if the transaction hasn’t lived up to its billing, a sale would crystallize the result for the investors, which may not be desirable from the promoter’s point of view. If the loss hasn’t been realized, there’s always hope! Right?

Role of New Management

New management has two important initial tasks. First, to ascertain the investment economics. What can be done in terms of investment recovery? Investors should expect to be provided a realistic picture of the investment as it is today, not as they wish it to be. The role of replacement management is analogous to that of a relief pitcher; you have to work out of whatever circumstances exist when brought in. If the bases are loaded and there’s nobody out, then that’s the way it is. The job of replacement management is often damage control: getting the investor out and mitigating their losses.

The second task is to assess the potential cost of the “fix,” because there is always a cost. The challenge for new management is to come up with a cost that is appropriate in relation to potential recovery and the odds of success.

It is important that the investor group have a clear understanding of the potential for recovery, the cost of that recovery and risk of investing that incremental dollar. The question often phrased is, “Am I throwing good money after bad?” From there, it will be up to the investor group to decide if they want to proceed. In short, what will it take and are they willing to do it? Only then, can new management begin to effectuate the changes necessary.