Education, Finance, Investment Advice

How to Evaluate a Real Estate Sponsor

smartland-how-to-evaluate-a-real-estate-sponsor.mp3 How successful a real estate investment will often hinge on the qualifications of the real estate sponsor... Listen to this article

Introduction

Some of the most common ways to invest in commercial real estate are through syndication, fund, or real estate investment trust. Each of these investment vehicles is spearheaded by a knowledgeable real estate sponsor who oversees investment activities on behalf of the limited partners, or LPs, who are otherwise passive investors in the deal.

How successful a real estate investment will often hinge on the qualifications of the real estate sponsor. The same exact deal, spearheaded by two different sponsors, can result in two drastically different outcomes for investors.

Before committing any capital to a real estate deal, individuals should conduct thorough due diligence on the real estate sponsor. In this article, we look at some of the key questions to ask a sponsor when evaluating their ability to successfully execute a business plan on investors’ behalf.

The Significance of a Real Estate Sponsor

Before we get started, let’s talk about the significance of the real estate sponsor. The real estate sponsor, which can be an individual or (more likely) a team of people, is charged with running all aspects of the real estate deal. From identifying potential investment properties to conducting due diligence to acquisition and then through to property development/redevelopment, lease-up, stabilization and eventually, refinance or disposition.

A real estate sponsor is best thought of as the captain or quarterback of a real estate transaction.

A real estate sponsor is best thought of as the captain or quarterback of a real estate transaction. They play an “active” role in all aspects of the deal and largely control all decision-making.

Sponsors are the counterpart to the limited partner, who aside from making their equity investment, will otherwise have a passive role and no decision-making authority.

Therefore, before someone invests with a sponsor, they want to be sure that the sponsor is highly capable because after investing, the LPs have very little authority over how the deal moves forward.

Questions to Ask a Real Estate Sponsor

How long have you been in business?

While sheer years of experience alone does not define how qualified a sponsor may be, someone who’s been in the real estate industry for a longer period of time will have simply been exposed to more. They will have seen market fluctuations and will have a stronger ability to forecast how to respond to potential economic disruptions. Moreover, someone who is new to the business will not have as lengthy of a track record to point to when trying to line up investment in their deals.

What sort of experience do you have with this product type?

A sponsor who is raising capital for a value-add apartment deal should have some degree of multifamily real estate experience. If someone’s only real estate experience is with other product types – e.g., retail, office, industrial or hospitality – that should be a red flag for investors. This isn’t to say that a sponsor couldn’t adequately execute a multifamily deal, but it is always best to work with sponsors who know the ins and outs of the product type you’re planning to invest in.

How well do you know this local market?

While real estate can, generally, be impacted by state and national policies, the local market conditions tend to have an outsized role on the success of a real estate deal. It is important for a real estate sponsor to be well versed in the local market. They should be able to describe the local demographics, what’s driving demand for real estate, who the local competitors are, and any local policies or regulations that could impact how well a deal performs.

A sponsor who has not yet worked in a specific market may still be qualified based on their experience with a similar product type elsewhere, but be sure they are otherwise highly knowledgeable about the market before agreeing to invest.

Who else is on your team?

Investors should look at the full breadth of the sponsorship team. This includes the managing principles as well as any team members, ranging from project managers to construction managers, leasing teams, asset managers and more. Sometimes these positions are held by people in-house. Other times, the sponsor will outsource specific roles to qualified third parties. If the management team is not going to be highly involved in the day-to-day, it’s important to know who will be involved and their respective experience.

Aside from direct team members, the sponsor may have other ancillary team members, such as attorneys, architects and lenders, with whom they routinely work. Ask about these relationships and whether the sponsor intends to keep the same people on their team for the projects you’re considering investing in.

Have you owned real estate during a downturn? If so, how have you navigated downturns?

Real estate sponsors who have been around for any length of time will have experienced the ebbs and flows of the market. Those with less experience may have only done deals during the “good” years—for example, between 2012 and 2019 when the real estate market experienced tremendous growth year after year. How they will navigate a true economic downturn remains to be seen.

Meanwhile, sponsors who have a decade or more of experience will have had to navigate downturns. They may have been forced to refinance, sell or rethink their business plan altogether. Looking at how these deals have performed, i.e. how a sponsor managed through adversity, is insightful for those looking to mitigate risk moving forward.

How did your firm react to the COVID-19 crisis?

Some sponsors decided to remain on the sidelines altogether during the depths of the COVID-19 pandemic. Others decided to pursue opportunistic plays for the benefit of their investors. Existing property owners may have been forced to renegotiate loan terms with their banks; others may have renegotiated tenant leases to provide more flexibility and to ensure rent collections remained high. There is any number of ways a sponsor could have reacted to the pandemic depending on their property type and where they were in terms of business plan execution. There is no “right” or “wrong” way to have reacted. Instead, potential investors should look at the sponsor’s thought process and ability to preserve investors’ capital during otherwise trying times.

What is your overarching real estate investment strategy?

There are many different real estate investment strategies, ranging from ground-up development to investing in already stabilized assets that generate steady cash flow. Some sponsors have a long-term, buy and hold strategy whereas others look to stabilize and then refinance or sell. Among those who choose to refinance, they may or may not allow investors to stay in the deal. Understanding a sponsor’s investment strategy is critically important for any individual as you want to be sure your objectives are aligned.

What is your company’s approach to leverage?

Most commercial real estate is acquired and improved using some form of leverage (typically, a bank loan). Some sponsors are comfortable being highly levered and in turn, will finance up to 70 percent or more of the property costs. Other sponsors, meanwhile, prefer to take a more conservative approach and will use significantly less leverage. The thought is that, if property values decline, it will be easier to refinance or sustain the payments on a mortgage with a lower loan-to-value ratio. A sponsor’s approach to leverage is generally indicative of their risk tolerance, overall.

Do you invest equity in deals as well?

Most, but certainly not all, sponsors will have some of their own equity invested in a deal as well. In addition to GP (general partner) equity, they may also have LP (limited partner) equity invested. The degree to which a sponsor has equity invested in a deal is telling. It’s not the sheer dollar amount or percentage of equity that matters, per se. Instead, the equity should be sufficient enough to matter to the sponsor. For example, an institutional investor who puts $1 million into a $50 million deal may not be particularly pained if they were to lose some of this equity. A small investment firm, however, may not have as much equity to invest and therefore, if they invest the same $1 million may want to closely protect every penny.

Seeing that a sponsor has “sufficient” equity invested in a deal is a good way to ensure that a GP and LPs’ interests are aligned. In other words, the more meaningful the equity a sponsor has invested, the more skin in the game they have with any particular fund or transaction.

What is your fee structure? How do you earn your income?

Sponsors can earn their income in many ways. Some will earn returns on their equity investment, just as passive investors do. Others will collect some combination of dividends and fees. For example, it’s not uncommon for a sponsor to charge an acquisition fee, a construction management fee, an asset management fee, a refinance and/or a disposition fee. These real estate sponsor fees can range from 1 to 5 percent, depending on the sponsor’s business plan.

It is important for any prospective investor to know a sponsor’s fee structure. Fees that are structured to be paid out earlier on in the process may create a misalignment of interests where the sponsor is no longer motivated to work as diligently on investors’ behalf (this is especially true if they have little to no equity in a deal and are overwhelmingly earning their profit through fees).

Can I tour some of your current or previous projects?

Experienced real estate sponsors are usually proud of their work and accordingly, will be more than happy to bring investors on a tour of current or previously completed projects. This will give investors a sense of an asset’s quality, both physically and operationally. It also helps investors fact-check some of the claims a sponsor has made. For example, if a sponsor claims to be tech-oriented and provide cutting-edge resident amenities, one would expect their previous work to feature some of these tech-oriented solutions the sponsor has described.

Where do you see the company in five, ten, and twenty years from now?

A good way to wrap up an interview with a sponsor is by asking them where they see the company headed into the future. While it’s anyone’s guess where any of us will actually be 20 years into the future, this question probes as to what the company sees as its trajectory, growth plans (or not), and plans to raise capital for future endeavors. Don’t expect a sponsor to have this question entirely figured out. Instead, look at their thought process and rationale, even if aspirational, to determine whether they have a mindset similar to your own.

Conclusion

It’s often said that no two sponsors are created equally. There’s definitely an underlying truth to that statement. As noted earlier, two sponsors may take radically different approaches to investing in and managing the same rental property. The different approaches can lead to wildly different outcomes. So while investors need to weigh the merits of each specific deal, they should also be conducting thorough due diligence on the sponsor who will be overseeing the deal on their behalf.

Ultimately, how, how much, and with whom are all critical things for a real estate investor to take into consideration. Investors will want to be sure that a sponsor has their best interests in mind. To do that, the due diligence process should be a two-way street. Just as an investor works to get to know the sponsor, a sponsor should be getting to know prospective investors. It is through this relationship-building process that the two parties can ensure that their interests are truly aligned.


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