These 9 questions will help you evaluate the sponsor and decide whether the investment opportunity is right for you.
Investing in commercial real estate syndication is a powerful strategy to generate passive income without the hassles of property management. However, as with all investments, it is important to do your due diligence and ask the right questions upfront. In this article, we’ll explain the basic structure of these types of investments before providing nine essential questions to ask before deciding if you should invest with a commercial real estate syndication sponsor
Real Estate Syndication: A Brief Overview
A centuries-old concept, real estate syndication is an investment vehicle that pools capital with other investors in order to purchase property. With their collective buying power, real estate syndication investors are able to purchase what would otherwise be cost-prohibitive commercial properties.
Real estate syndications are typically structured as a limited liability company (LLC) or limited partnership (LP). Investors—also known as “limited partners”—own an interest in the LLC or LP and provide most of the financial equity. As passive investors, limited partners don’t contribute any time or “sweat equity”— they need only to sit back and collect ongoing passive cash flow after their initial financial investment.
Real estate syndication deals are typically overseen by a sponsor (also sometimes called the syndicator, asset manager, general partner, GP, or operator). A sponsor is an individual or company who acts as the manager and operator of the deal. It is the sponsor who scouts out the opportunity, raises the funds, executes the purchase and acquisition, and is responsible for the day-to-day operation of the investment.
Vetting a Real Estate Syndication Opportunity
Because the success of a real estate syndicate relies heavily on the sponsor team, you should make sure you not only understand the specific investment opportunity, but also have a clear picture of the sponsor’s track record, strategy, and philosophy. Here are 9 critical questions to ask before investing with a commercial real estate syndication sponsor:
1. What is the sponsor’s track record?
As the primary decision-maker, a sponsor can make or break a real estate syndication deal. While an inexperienced sponsor can botch a promising investment, a seasoned sponsor can steer a project towards success even in adverse circumstances.
When deciding to work with a real estate syndication sponsor, ask them about the deals they have sponsored in the last two years. Find out whether they have sponsored similar deals in the industry and location before, and ask how those deals performed. Request to see a portfolio of previous projects and compare the actual and projected performance of past full-cycle deals in order to find out if they are likely to achieve the results they predict.
2. What is my projected return on investment?
As a passive investor in a real estate syndication deal, there are two primary ways you can make money: free cash flow and the profit upon sale.
Put simply, free cash flow is the profit you make on a property from income generated from occupancy after you factor in operating expenses. When free cash flow per year is expressed as a percentage of the total initial cash investment, it is known as the cash-on-cash return. Free cash flow is typically paid out in the form of distributions to investors on a monthly or quarterly basis. While returns may vary vastly depending on factors like investment approach and market, a solid cash-on-cash return for commercial multi-family properties is around 8-10% per year.
In addition to free cash flow, investors profit from the sale of the property after the projected hold period, which is typically a few years. When the property is sold, investors receive their share of equity from the sale, profiting from any appreciation and equity remaining after paying off the principal balance on the loan. The expectation for return of principal at the end of the investment period, when combined with the free cash flow from above, is typically expressed as either an internal rate of return (IRR) or an equity multiple (EM). IRR may vary greatly depending on the holding period and market factors, but you can look for IRR in the 10-20% range with syndicated commercial multi-family properties.
3. When can I expect distributions?
The distributions you receive are typically calculated by multiplying the quarterly cash flow by your ownership percentage of the deal.
Distributions are generally paid out quarterly, though some sponsors may pay them out monthly or semi-annually. Some value-add commercial real estate syndication deals that involve investments to increase occupancy or make repairs may postpone dividend payments until the cash flow of a property can cover them. In the end, dividends are distributed at the discretion of the sponsor and may be interrupted by unanticipated expenses or vacancies that occur during the holding period.
4. How much capital is the sponsor committing?
Inquire as to whether the sponsor is putting their own money into the syndication. A sponsor who does not invest in their own deal is often an indication they may not have faith in the opportunity.
5. What are the fees associated with my investment?
Some sponsors may charge upfront fees (these are sometimes called sponsor fees, acquisition fees, or due diligence fees) as compensation for the time and money invested to find and vet the deal, obtain funding, and organize the syndication. Most sponsors may also charge asset management fees for the time and costs incurred in keeping the property operational. An additional fee that may be charged by the sponsor is carried interest (also known as promoted interest) which increases the share of profits earned by the sponsor, above their ownership percentage, for achieving certain hurdle rates or return thresholds on the investment that also mean increased returns for investors.
Such fees should be expected but they can reduce your total return, so it’s important to be aware of them and their impact before committing capital.
6. What is the exit strategy?
A good sponsor will be upfront with an exit strategy and a projected hold period, contingent on market conditions. Value-add deals often have a briefer hold period as most of the value is created within the first few years after completing a renovation, leasing up a property, or fixing an operational issue. On the other hand, stabilized deals are often lengthier in order to take advantage of stabilized free cash flow, rising rents, and potential appreciation of the investment.
7. What are the risks and how are they being mitigated?
When evaluating a specific opportunity, thoroughly review the Private Placement Memorandum (PPM). Sometimes referred to as an offering memorandum or offering document, a PPM should include a comprehensive summary of the investment objectives and risks — including general risks common to similar investments as well as risks unique to the specific syndication opportunity
In addition to detailing risks, a sponsor should be able to explain how they will tailor their strategy to avoid, control, or mitigate these risks. An experienced sponsor should also be able to explain their course of action if things don’t go according to plan.
8. How do you communicate with investors?
Your sponsor should provide monthly or quarterly updates with a summary of the previous period in the form of emails, webinars, and/or videos. Updates should include information on any renovations, occupancy rates, and anything newsworthy about the property or market. In addition, your sponsor should inform you if expenses are aligning with projections and if the business plan is on track. If anything is not going according to plan, your sponsor should be able to explain what is being done to address these issues.
9. What is the investment strategy?
Speaking generally, there are two primary strategies to investing in commercial properties: turnkey and value-add. With turnkey investments, the buyer does not make significant changes to the property, instead focusing on maximizing free cash flow. With value-add investments, the buyer may plan to increase profits by investing additional funds into renovations, adding amenities, reducing costs, and other methods of improving the property. Value-add deals typically generate higher returns than turnkey deals, but carry the risk of not being able to increase revenue or decrease expenses as planned in the event of unforeseen market changes or management errors.
To understand a sponsor’s investment strategy, you should also ask why they have chosen to invest in a certain market—for example, growing demands, rising room rates, etc. In addition, different sponsors will have different appetites for risk. Some may look for high returns without much concern for the potential risks involved, while others may be more conservative and opt for lower returns in exchange for fewer risks. It’s wise to work with a sponsor whose investment philosophy aligns with your own.
Lifeafar operates on the principle that our success is based on the success of our investors, and we have long been considered one of the hotel real estate syndication sponsors in the industry. Are you interested in investing in commercial real estate syndication? Browse our current opportunities or get in touch with our team to learn more.
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