Without a doubt, the most lucrative sector busy entrepreneurs can be involved in, is private investments, especially in the real estate space.
With big public companies listed on major stock exchanges, paying 20x, 50x, or even more than 100x a company’s annual profit is not uncommon. But with private companies, you pay a fraction of the price and have direct access to the decision-makers.
In the past, these lucrative investments had been reserved and shared with only a small circle of people, and if you were not well-connected, you would not have had the opportunity to invest. This all changed when the JOBS Act suddenly allowed private investment companies to start advertising and sharing these amazing opportunities with the general public.
Of course, with this opportunity came great responsibility to do your homework, not only on the investments themselves but on the people running them. As a real estate Syndication attorney, our firm works on hundreds of real estate syndications every year. We are often asked about what passive investors should be asking deal sponsors prior to investing in those deals.
Most of the information you need should be in the project’s Private Placement Memorandum and Operating Agreement. But some information requires a little more digging.
Here are the 10 questions we would recommend asking every deal Sponsor so you can properly evaluate and determine whether the investment is right for you and your family.
Ask any experienced passive investor, and without a doubt, the Sponsor’s experience and track record are the most important factors to consider prior to making an investment. The project could be the best investment out there and in the best sub-market, but if the Deal Sponsor isn’t very good, they can take a great investment and turn it into a dud. Conversely, a great Syndication Deal Sponsor can take an average or above-average investment and turn it into a great investment. Or they may possibly save an investment.
Now a critical nuisance is to make sure that the Sponsor or someone on the Sponsor’s team has the experience and a good track record in the particular asset class you are investing in. Is your Sponsor’s track record in multifamily apartments, but this particular investment is the Sponsor’s first venture into self-storage?
You will want to ensure that at least one person on the team has the necessary experience and track record in the asset class you are investing in. Ask thorough questions, like “have you invested in this specific sub-market before?”, “Have you taken any prior investments ‘full-cycle’ in this asset class and market?”, “Have you previously gone through a market downturn like 2008?”
Ideally, you should verify this information by speaking with some of their investors. Even better would be to talk to repeat investors. In fact, just knowing what percentage of their investors are repeat investors will give you some great insight as repeat investors don’t generally return if the Sponsor hasn’t done a good job with the investment and their communications.
The deal sponsor you are talking to (ie: the one you know, like, and trust) may not be the same person who will be engaged in the project's day-to-day operations. It is not uncommon to have multiple deal sponsors in a project and some sponsors are more involved than others. Your trusted source may have a diminished role after the close of the offering. So understanding who the asset management team will be and what level of involvement the person you have been talking to is important.
You want to know who is responsible for executing the business plan and what that person’s level of experience and track record is in that particular asset class and market. Are their boots on the ground or will the asset management team be managing this project remotely?
Similarly, how long have the sponsors worked together, and what are their clearly delineated roles? As mentioned above, it is increasingly common these days to see Sponsor teams that don’t work with each other on every deal. They often jump from one sponsor team to the next. So, find out what the synergy is with the team.
Your personal investment philosophy and the Sponsor’s investment philosophy must align. If you are conservative and are primarily looking for a consistent stream of income from day one, then investing with a Sponsor who is aggressive and looking for high value-add in a speculative, tertiary market may not be a fit. Same for a ground-up development that won’t cash flow for 18- 24 months. Nothing wrong with either; there is just no alignment.
This is more of an issue if there is only a single Sponsor. With multiple sponsors, the other team members would likely continue the management. But in either scenario, asking for the transition plan is a good idea. And if there isn’t one, that could be a red flag.
If nothing is specified, it is possible that the spouse or the children of the deceased could take over and possibly have a controlling interest. And they may have very different plans (including liquidation) if they were to take over the project or if the appropriate buy-out price cannot be arranged. Most co-sponsors have a ‘buy-out’ agreement with each other that provides the road map of what happens in the event of death or disability. So pay close attention to the Manager’s operating agreement and make sure it is addressed.
Although this is typically in the offering documents (both in the Private Placement Memorandum and the Company Operating Agreement), you not only want to know what the projected returns are but more importantly, what assumptions underlie those projections. Once you know what the assumptions are, you can then determine whether you agree or disagree with those assumptions and adjust the projections accordingly. For example, maybe the Sponsor is anticipating 5% rent growth throughout the project's life, but you believe 2% is more realistic. You can re-run the projections to see what kind of returns you would actually receive if the rents were to increase by 2% instead of 5%.
This mostly has to do with alignment. You want to ensure that the Sponsor’s interests are aligned with yours. There are 3 primary ways a Sponsor gets paid. Upfront fees, a split of the cash flow, and a split of the profits. You will usually see all three, but if the upfront fees are disproportionate to the others, then there is less of an alignment once the project gets started.
Similarly, you don’t want your Sponsor taking any fees either because you want to incentivize the Sponsor to get up in the morning and do the best job for you and the other investors. And what happens if the Manager dies or resigns?
You will need to attract a new management team, so the fees need to be attractive and included in the underwriting. Although just an example, as of the writing of this report, you should see fees somewhere in the following ranges: Acquisition Fees: 2% of acquisition costs; Asset Management Fees: 2% of Income; Net Cash Flow: 20%-30%; Profit split upon sale: 20% to 30%. These numbers may change if investors are provided with a preferred return ensuring they get paid first.
Communication builds trust, especially if things aren’t going well. Lack of communication is probably one of the most frustrating parts of being a passive investor. So make sure the normal communication is clearly stated and inquire how communication will change if things aren’t going according to plan.
Finding out what the weakest part of the investment is should be part of your due diligence. Then ask the Sponsor to see if they agree and what steps they are taking to avoid, mitigate, or handle that scenario. You may also ask them what factors they stress-test in their underwriting.
For example, at what occupancy level and/or rental rates does the investment break even? If the Sponsor can’t identify any weak spots, that is generally a red flag. Every reputable Sponsor should be able to articulate where the weakest link in the project can be found and what keeps them up at night. Bonus points if you can spot it first and then get confirmation from the Deal Sponsor.
It’s critical that there be more than one exit strategy in case the primary exit is not an option. For example, if the plan is to refinance and get all the initial capital out, what happens if interest rates rise too fast, the property's value has not increased enough, or worst yet, the property's value has decreased? This becomes even more critical now that most projects are being financed on bridge debt (3 years plus one-year extensions) since the inability to refinance into a permanent loan could lead to forced liquidation.
Unfortunately, Sponsors do exist that either don’t use a securities attorney (sometimes they don’t realize they are issuing securities) or use an attorney specializing in another area of law to advise them and prepare the proper documentation. There are many reasons to have a reputable attorney on the team, but from the perspective of the passive investor, the most important one is having the assurance that all the legal disclosures have been made.
After all, the main purpose of the offering documents, specifically the Private Placement Memorandum, is for the Sponsor to disclose all the risks and material facts to the passive investor so that the passive investor can make an informed and intelligent decision as to whether this investment is a good fit for them. Unfortunately, that is not always the case and you could be making important decisions with important information missing or misleading.
If anyone offers you guaranteed returns, turn around and run. Do not pass go. Head straight for the exits. Nothing in life is guaranteed, and in the words of the great Clint Eastwood, “if you want a guarantee, buy a toaster.” It is ok to promise preferred returns or fixed returns but never guarantees.
One of my mentors, Bob Helms (The “Godfather of Real Estate”) used to say, “the information about the relationship is available at the beginning if you chose to pay attention.” This is true about any relationship, but it is specifically true when it comes to investing with a person or company you have never done business with before. Asking these questions should go a long way to helping you identify whether the relationship is worth entering into at the beginning.
This blog post is intended to provide general information and should not be construed as, and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship with Premier Law Group.