Vetting A Real Estate Syndication Operator:
5 Questions And 9 Red Flags You Need To Know
When you bought your last home you probably interviewed a series of real estate agents before you settled on the right one. You likely chose a licensed real estate broker because of their expertise in the local market where you want to buy a property. Likewise, when you decide that you want to invest in real estate syndication deals you want to find a deal sponsor (sponsor team) who is aligned with your investment goals.
When you decide to start the investment process and pursue a real estate syndication it’s important to do your due diligence and research as well. You should research the locations of the real estate projects, the age of the investment property, the type of commercial property (the asset class), and many other details.
The Real Estate Syndication Sponsor
Beyond property and market details, you’ll need to review the real estate operator carefully. A real estate syndication sponsor or operator is a team of individuals that conduct all aspects of the syndication process. The real estate sponsor is responsible for everything related to the acquisition of the asset such as raising capital from passive investors, conducting the sensitivity analysis with the underwriters, looking for potential risks in the acquisition, putting together the debt structure, overseeing the professional management of the real estate assets, and liquidating the asset at the end of the investment period.
Additionally, the real estate syndication sponsor is responsible for distributing all legal documents and the private placement memorandum to potential investors for their review when a real estate syndicate opportunity has been released.
First and foremost the main role of the sponsor is capital preservation. They must understand and be prepared for worst-case scenarios and take every step possible to apply risk mitigation standards to protect their group of investors. In a nutshell, the syndication sponsor conducts all of the hard work on behalf of the investors.
In this article, we will discuss how to vet a real estate operator and what red flags you should be looking for before you invest in a commercial real estate syndication.
How To Vet a Real Estate Operator
Commercial real estate investing can provide some great returns to investors. However, understanding how much passive income you will receive each month or each quarter and how the cash flow distributions will be achieved through the business plan is imperative for the passive investor to understand.
So, that’s why it’s important that the first thing you do before you jump into an investment opportunity is that you thoroughly review the business plan that the real estate sponsor has presented in a potential deal. Make sure that your values and goals are aligned with the sponsor and that the business plan, fee structure, and investment strategy make sense.
Due Diligence Process: Choosing the Operator
Questions To Ask The Operator
1. What is your investment philosophy?
Are your goals aligned with the investment philosophy of the real estate syndication sponsor? It’s not enough just to be expecting a certain return on investment. So you need to ask yourself, does the sponsor team’s approach resonate with you and align with your financial goals?
For example, real estate investors who have a higher risk tolerance and who don’t need cash flow probably wouldn’t want to invest in a multifamily syndication that is a value-add deal with forced appreciation and stabilized cash flow in a fast-growing real estate market like the asset types that PCRP Group looks to invest in.
The most important thing in your quest for finding a real estate sponsor to invest with is the alignment of goals and synergy with that team.
2. What does the company invest in?
What types of assets does the deal sponsor team invest in? If you are only wanting to invest in multifamily apartment buildings and they only invest in self-storage facilities, then that particular real estate sponsor may not be a good fit for you. On the other hand, if you like the idea of investing in a multitude of commercial properties to capitalize on diversification in your investment portfolio then working with several syndicators may be the best approach for you.
Additionally, some syndicators, such as PCRP Group, locate the best real estate sponsors for our real estate investors in various asset classes, so that our investors can meet their investment goals under one roof.
There are many different commercial real estate investment opportunities, and you want to make sure you understand the asset classes that the deal sponsor team invests in and why they invest in these particular assets.
3. Is the OPERATOR competent?
Does the deal sponsor team have the experience to demonstrate their competence? Have they ever experienced an economic downturn? It’s imperative that you understand the track record of the real estate syndication sponsor and how long they have been in business.
Some of the questions you may want to ask are: how many deals have they done? How many deals have they taken full cycle and exited from? If they exited early, how were the investors taken care of through that process? Have they ever had a deal go south? If so, did they lose a lot of money or were they able to maintain capital preservation throughout the process?
You want to invest with deal sponsors and operators who have enough experience through a multitude of deals and economic headwinds.
4. Does the company work with sophisticated and/or accredited investors?
Does the real estate sponsor work with accredited investors or sophisticated investors? Do they have a preference or do they work with both accredited investors and sophisticated investors? If they are investing in 506c deals, then they are working with accredited investors only.
To qualify as an accredited investor for a 506c offering then you must meet certain criteria. You must earn $250,000 a year individually for at least the prior two years or if you and your spouse jointly earn $300,000 annually then you would qualify as an accredited investor. Alternatively, if you have a million dollars net worth excluding your primary residence, you qualify as well.
On the other hand, if the operator offers a 506b offering to investors, then that means that they have an allowance of no more than 35 sophisticated investors that can invest in the real estate syndication.
5. Listen. How does the company respond to you?
You want to have a deal sponsor who is available to answer any questions that you have. How do they respond to you when you do have questions? What kind of feeling do you get from them? Are they helpful or are they dismissive?
After all, you will be in a partnership and a business relationship with them for a minimum of 5 – 7 years, so it’s important that you have a good feeling about their communication style up front. If they don’t communicate with you promptly or in a manner that you are comfortable with, then this will give you an idea of how they will conduct business with you in their investor relations role.
Additionally, you should be able to find a great deal of answers to your questions on their website, so start there before compiling a list of further questions you may have about the deal sponsor. All investments have potential risks, so it’s important to be thorough and have the best team handling your investments.
Due Diligence Process: Operator Red Flags
Red Flags to Look Out For With Sponsors
Let’s review some of the red flags that you should look out for when vetting a real estate syndication sponsor.
1. No Business Background
A good sponsor will most oftentimes have both a real estate background and a business background. Make sure people on the sponsorship team have the necessary experience and expertise to navigate various economic cycles. They also need to understand how to navigate interest rate increases, and vacancy issues, and they must possess the ability to be an outstanding property manager or successfully oversee all aspects of property management.
2. Part-Time Operator
Make sure that their real estate syndication “business” is not a side hustle. If they are not doing this business full-time, then do yourself a favor and find another syndicator. The syndication business is not a part-time job, it is a full-time endeavor if it is to be managed well.
In exchange for your hard-earned investment capital, you should seek full-time, dedicated operators who will make these investments their only business priority.
3. One Managing Partner
You want more than one managing partner. To manage a large property such as a 300-unit multifamily real estate asset there has to be a team of people. One managing partner even with a 100-unit property is simply not enough. What would happen to the asset and the management of the asset if something were to happen to that “one” managing partner? How does the deal continue to be managed well? How would the business plan be executed without them?
There are just too many variables and pitfalls if an investment has only one managing partner, so it’s best to find a sponsor team with competent multiple managing partners for that reason. This allows for a solid succession plan in the event one managing partner becomes incapacitated.
4. No Preferred Return
A Preferred return (“pref”) is oftentimes offered because the sponsor team has the confidence that it can hit the projected returns for the limited partners.
It doesn’t necessarily mean that it is a bad deal if there is no preferred return, but you want to review the deal and ask why there is no preferred return on that particular real estate syndication opportunity. There are good reasons sometimes as to why a pref is not offered, you just want to understand why.
5. Includes Refinances In Projections
Check to see how they would handle a refinance. Is a refinance in the underwriting projections? How are the investors taken care of in that instance? You may want to make sure you understand what happens to your capital and your position in the deal in the event of a refinance.
Additionally, if their underwriting is reflecting a refinance to meet their projections that is a red flag because no one should be predicting the economic cycle we will be in when a refinance is projected to occur. Moreover, a refinance should never be how a real estate sponsor is hitting their projections. The real estate syndication team should be able to achieve their projections independent of ANY refinance event. For this reason, you don’t want them to rely on a refinance to make their returns.
6. Distributions are Return of Capital
Determine if the distributions the real estate sponsor is projecting are a return “on” your capital or a return “of” your capital.
You need to fully understand how the returns are being calculated and when you can expect to receive your cash flow distributions. Equally important to understand is when you can expect to receive your initial investment capital returned. These are important distinctions that need to be outlined by the sponsors and delivered succinctly to the investors.
7. No Skin In The Game
Do the real estate operators have skin in the game on the project you are thinking of investing in? Hopefully, it is the real estate sponsor team’s practice to be investing alongside their limited partners and their equity investors.
Most all real estate syndicators and general partners will invest in their own acquisitions because number one: it shows their faith in the success of the project and number two: they reap the extraordinary tax benefits that this type of investment vehicle can provide, but only if they’re invested in the project.
If an operator is not willing to invest in their own project, then that is certainly a red flag, so think twice about moving forward with that syndicate operation on any kind of investment opportunity.
8. Encountered No Challenges
As we mentioned earlier all investments have risk, right? So, that said, if an operator has NEVER had any challenges with their acquisitions, then that tells me one of two things. They are either not being truthful, because if you have been in business for any substantial amount of time, then you will have experienced challenges at some point. That’s just the nature of any business.
On the other hand, they may be truthful in saying that they have not experienced any challenges at all, in which case that tells me that they are possibly too green or they have only invested during a “hot” real estate market in either case, they are not who I want to have handling my investment capital.
I want a real estate syndication team to have had challenges at some point and have weathered some storms because that shows me that they have withstood the challenges, and now have more experience on how to deal with troubles that may lie ahead.
9. Dodges Questions
It’s not necessarily a problem if an operator doesn’t have an answer to a question as long as they are eager to find the answers to my questions. That’s not a problem. What is a problem is when an operator is dodging a question or is disinterested in answering the questions you may have. If you find that you are asking a question in different ways and are still unable to get a straight answer it may be time for you to move on. Don’t ever let an operator try to skirt around an issue you are inquiring about.
So, the bottom line, is that it’s a red flag if you’re not getting a direct answer to your questions or you don’t see their willingness to get you the answers you deserve. Don’t waste any more of your time on that particular sponsor, just move on.
There you have it!
Ten red flags you can look out for during your due diligence process as you research and vet operators. If a real estate opportunity seems too good to be true, it probably is.
However, the one thing to remember is that the deal sponsors (like all of us) aren’t perfect, so it’s important to conduct your due diligence to make sure you have a good fit for your investment goals. It’s safe to say that there probably isn’t really any perfect syndicator or general partnership team, but a good “gut check” can be a great start.
It’s been said that people do business with people they trust. If your gut test is telling you this deal sponsor is not the right fit and you fundamentally don’t trust them, then it’s best to find another investment opportunity.
Gathering and implementing sound advice during your due diligence phase will help you gain and maintain confidence in the real estate syndication investment process and will likely lead to better returns and a better investment experience overall.
Until next time, Earn Passively & Live Abundantly!
Ready to Learn More?
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Through the PCRP Passive Investor Club, you’ll get a priority review of all the deals we offer. We’ll work with you to determine your investing goals and then present you with the best deals to meet those goals. We’ll then guide you every step of the way as you invest in those deals.
So if you’re ready to start investing passively in institutional-grade, commercial real estate in fast-growing, climate-resilient markets in the U.S., join the PCRP Passive Investor Club – IT’S FREE! – and get started on your path to EARN PASSIVELY and LIVE ABUNDANTLY!
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