Part Five of a Five-Part Guide for CRE Investors - Sponsor Due Diligence

Three Puzzle Pieces for Successful Investment

Part 5: What You Should Know About the Sponsor Before Investing in Private Real Estate

You’ve done your homework, and you’re convinced that investing in private real estate is the right move for you. But before you write that check, there’s one more important step you need to take: due diligence on the sponsor.

Why is due diligence on the sponsor so important? Because the success of any real estate investment depends largely on the quality of the sponsor. A good sponsor will have a deep understanding of the market or markets in which they operate, a proven track record of successful investments, and the financial wherewithal to weather any market downturns.

Unfortunately, not all sponsors are created equal. Some may lack experience or be undercapitalized. Others may have a sketchy track record with a history of failed investments. That’s why it’s so important to do your homework before investing. In the final part of our series, we’ll talk about some of the things you should look for in a sponsor and how to do your due diligence.

Executive Summary

Investing in private real estate can be a complex endeavor. Before investing, you should carefully consider the sponsor’s background and track record, as well as the sponsor’s investment approach. This includes understanding the sponsor’s hold period, leverage, exit strategy, yield vs. appreciation focus, IRR expectations, capital structure, equity waterfall, promote structure, and risk/return profile. You should also understand the key personnel roles and the sponsor’s team members. Finally, you should review the past performance of similar assets and projects.

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    Sponsor Background and Track Record

    When researching the background and track record of a sponsor, it is important to consider the following factors:

    Experience with the Property Type
    The sponsor’s prior experience with a similar type of property is important because it gives insight into whether or not the sponsor has successfully executed this type of investment in the past. If the sponsor has a track record of success with this type of investment, there is potentially a greater chance of success. However, if the sponsor has little or no experience with this type of investment, they may not be as successful given a potential learning curve.

    Experience in the Market
    The sponsor’s experience in the specific market in which the real estate is located is important because it gives insight into whether or not the sponsor is familiar with the market conditions. For example, suppose a market is experiencing a downturn. In that case, an experienced sponsor will know how to adjust their strategy to be successful, whereas an inexperienced sponsor may not know how to adjust and potentially lose money or take inappropriate risks.

    Experience Managing Operational Risk
    The sponsor’s experience with managing the two types of operational risk involved in a real estate investment is important because it shows whether or not the sponsor is prepared to handle the risks associated with a specific investment:

    1. Asset management risk refers to the risk that the sponsor will not be able to manage the property effectively. This can include poor financial management, mismanagement of renovations, or failure to properly position the property in the market.
    2. Property management risk refers to the risk that the property manager will be unable to manage the property effectively day-to-day. This can include things like poor maintenance of the property, high turnover of tenants, or difficulty filling vacancies.
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    Sponsor’s Investment Approach

    A sponsor’s investment approach is important to understand because it will provide insight into how the sponsor plans to generate returns to investors. For example, a sponsor who plans to renovate and sell a property may have a different approach than a sponsor who plans to hold onto the property for long-term rental income.

    Additionally, a sponsor’s investment approach can give you clues about their experience and expertise in the real estate market. An experienced and successful sponsor is more likely to be able to navigate through market fluctuations and find growth opportunities. Conversely, a less experienced or successful sponsor may not know how to navigate market fluctuations which could potentially cost investors money.

    Hold Period
    The length of time that a sponsor intends to hold an investment can significantly impact the overall return. A longer hold period generally provides more opportunity for cash flow appreciation, while a shorter hold period may provide more opportunity for a faster return of your original investment plus additional returns.

    Leverage
    Using financial leverage (borrowing money to finance an investment) can magnify both returns and risks. It is important to understand the extent to which a sponsor is using leverage and the terms of any debt financing.

    Exit Strategy
    Another important part of the sponsor’s investment approach is the exit strategy. The exit strategy is how the sponsor intends to exit the investment in property when they have executed on their business plan. For example, the exit strategy could involve selling the property to another investor or refinancing the property.

    Yield vs. Capital Appreciation Focus
    Some sponsors focus primarily on generating income from an investment through distributions, while others focus primarily on capital appreciation. Income-seeking investors may be more concerned with stability and predictability, while capital appreciation-seeking investors may be more willing to tolerate higher levels of volatility in pursuit of higher returns.

    Capital Structure / Equity Waterfall
    The capital structure of an investment includes the mix of equity and debt financing used to finance the purchase. The equity waterfall refers to the order in which different investors are repaid from the periodic distributions and proceeds of a sale. It is important to understand both the capital structure and equity waterfall to assess an investment’s risks and potential returns.

    Promote Structure
    The promote structure is the incentive fee that a sponsor stands to receive for achieving or exceeding certain return targets. Understanding the terms of the promote is critical to assessing the sponsor’s incentives and any potential conflicts of interest between a sponsor and its investors.

    Risk-Return Profile
    Some investors may be willing to accept more risk in exchange for a higher potential return because they have a longer time horizon, and can afford to take on more risk because they have time to recover from any losses. On the other hand, investors with a shorter time horizon may prefer to avoid more risky investments in order to protect their capital.

    Underwriting Assumptions
    Loan underwriting assumptions in commercial real estate are the set of conditions that a lender requires before approving a loan. These conditions can vary depending on the type of investment and the loan size, but usually include a minimum down payment, a maximum loan-to-value ratio, and a minimum debt service coverage ratio.

    Key Partnership Roles and Responsibilities

    When investing in private real estate, it is important to understand the key personnel roles and responsibilities. The three primary personnel roles are the general partner, limited partner, and manager:

    1. The general partner is responsible for managing the day-to-day operations of the property. This includes financial management, leasing, and marketing. The general partner typically has their own equity stake in the property and has unlimited liability for any debts or obligations of the property.
    2. The limited partner is a passive investor in the property. The limited partner owns equity in the property, but has no personal liability for any debts or obligations of the property and limited decision-making power.
    3. The manager is responsible for managing the day-to-day operations of the property. This includes financial management, leasing, and marketing. The manager typically does not own a stake in the property and has limited liability for any debts or obligations of the property.
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    Past Performance of Similar Assets and Projects

    The sponsor’s experience with developing and managing similar properties can provide insight into their ability to successfully execute the project offered. Furthermore, a track record of successful projects can provide comfort that the sponsor has the necessary skills and knowledge to navigate potential challenges that may arise.

    Similar Assets
    When a sponsor has a track record of success with similar assets, it gives potential investors confidence that they will be able to do the same with the current project. This is especially important when considering private real estate investment opportunities, as these are often complex projects requiring great experience and expertise. Sponsors with significant experience developing and managing similar assets are more likely to successfully complete the project on time and on budget, which is key to ensuring that investors realize the maximum return on their investment.

    Development and Management Experience
    To get a sense of a sponsor’s development and management abilities, look for previous projects similar in scope and size to the one being offered. Additionally, consider the property’s location and the target market’s demographics. If the sponsor has successfully developed and managed similar assets in the past, they are likely to have the necessary skills and knowledge to do so again.

    Track Record of Successful Projects
    In addition to experience with developing and managing similar assets, it is also important to consider a sponsor’s track record of successful projects. A history of successful projects demonstrates an ability to navigate potential challenges that may arise during development or management. This can provide peace of mind that the sponsor knows what they are doing.

    Key Personnel
    Another consideration for choosing a sponsor is the experience and qualifications of their team. It is important to understand who will be responsible for actually executing the investment strategy following acquisition. An acquisition and execution team should have significant relevant experience and be able to handle the demands of this particular asset and business plan. The team should have experience working together and not be overly reliant on any one individual. There are also certain business plans, including development or repositioning, that require more specialized skills in order to competently execute and eliminate excessive risks for those types of investments. Researching the qualifications of the sponsor’s team can give insight into their capability and ability to meet their project goals.

    Closing Thoughts

    When investing in private real estate, your sponsor is a crucial piece of the puzzle. Therefore, it’s important to research and analyze their background, track record, investment approach, and past performance with similar assets and projects. This will give you a better understanding of the potential risks and rewards of the opportunity and help inform your investment decision.

    Investors should also consider how a sponsor’s past deals and projects align with their own investment strategy and risk tolerance. For example, a sponsor may have a successful track record, but if their approach does not align with your own goals and objectives, it may not be the right fit for your portfolio.

    If you’re an investor interested in passive income and diversifying your portfolio, consider exploring the RealtyMogul platform, one of the most popular real estate investing platforms. Investors can choose to invest in many different types of real estate projects that meet their personal risk profile.

    Project sponsors list their offerings on the RealtyMogul platform. Sponsors provide thorough due diligence materials to help investors make informed investment decisions. In addition, RealtyMogul monitors the performance of each asset throughout the entire investment cycle, from acquisition to disposition, helping investors stay informed on the progress of their investments.

    This article is for informational purposes only and is not a recommendation or offer to buy or sell securities. Information herein may include forward-looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is not indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment.

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