4 Tips for Crushing It as a Limited Partner
Investing passively in commercial real estate as a limited partner (LP) can be a great way to make money.
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If you’ve been reading up on syndication, the limited partners are the folks who provide the bulk of the equity for a deal, while the general partner (GP) is the person or company that finds the deal, raises the capital, and manages all of the details around structuring, closing, and asset management.
In a syndication, this often includes dozens of individual LPs, each contributing $25K to $150K or more.
In the institutional world, a joint venture can follow a similar structure, but typically the LP will be one firm rather than multiple retail investors.
I’ve been charged with evaluating hundreds of millions of dollars worth of potential LP investments in my career as a single LP at the institutional level. I’ve also reviewed many syndication offerings for myself and on behalf of friends and family.
Below are a few of the pros and cons to investing in this structure, followed by four tips to consider if you’re thinking about LP investing.
What Are the Benefits of Investing as an LP?
- Less Risk – As an LP your investment is limited to what you’ve put into the deal. If the sponsor’s How to Quit Your Job and Make Millions Syndicating Real Estate with Other People’s Money book failed to teach him how to keep the bank from owning your deal, you aren’t on the hook for repaying the debt. None of your other assets are at risk.
- Diversification – Unlike what you learned in high school health class about “partners,” LP investing is less risky when you’re active with multiple partners. You can spread your money around multiple asset classes, several geographic areas, different sponsors, and various risk profiles. Putting $100K into 10 different deals vs. $1 million in one deal reduces your risk significantly.
- Scale – Investing in a syndication allows for exposure to larger deals. If you’ve got $200K to invest, would you rather own 100 percent of a four-flat or 5 percent of a 200-unit complex?
- Expertise – As an LP, your only job is to cut a check to the sponsor. Theoretically, the sponsor will be an experienced real estate expert with a strong track record. Investors that don’t have the time or inclination to do all of the blocking and tackling can still gain exposure to real estate by tapping into the sponsor’s expertise.
What Are the Drawbacks to LP Investing?
- Control – As an LP in a syndication, you have virtually no control over the investment. Decisions on management, refinancing, sale, and so on are decided by the GP. You’re just along for the ride. If you are participating as the sole LP, as my firm looks to do occasionally, you will have the opportunity to negotiate some level of control into the joint-venture agreement regarding when a sale can occur and under what circumstances the LP can step in and assume control. But no such luck if you’re one of many LPs.
- Economics – The returns you’ll get are, in theory, lower than if you had found the investment on your own. The GP will collect fees and a “promote” that will water down returns to the LP. (A promote is simply a mechanism that allows for the GP to be entitled to a greater share of the returns than his original equity stake.)
- Liquidity – You’re not able to decide when your money comes back to you. Never invest funds you think you’ll need within the next few years. If the sponsor doesn’t sell, there’s pretty much nothing you can do about it.
Before I spout off any advice, please remember that this is just one guy’s opinion. People have different views about what’s fair, what to look for, and how to go about the whole real estate investing thing. That’s the beauty of it.
Only you can decide what is right for you! But here are four pointers that may help improve your chances of success.
1. Gauge the Sponsor’s Skin in the Game
If the sponsor/GP is not putting a serious amount of money into the deal, walk away. End of story. If s**t hits the fan, you want a sponsor that will scratch and claw like a wounded badger to salvage every dollar, including his own. (That gives me an idea for a company name: Wounded Badger Capital. Thoughts?)
Anyway, this is one of the quickest screening tools to weed out the pretenders and newbies from the experienced pros. If a sponsor doesn’t have funds to put into their deals, they are in the wrong game.
What is the right amount to require from a sponsor? This varies depending on the deal and the sponsor. The key is that it should be an amount that would hurt to lose. Five to 10 percent of the equity is a good starting point. Or if it is a newer, younger sponsor who you trust, $30K is probably enough to terrify him into giving it his all.
Are there exceptions? Of course.
If you know real estate really well and believe in the deal, and you’ve worked with the sponsor before and trust him explicitly, maybe you take that risk. I wouldn’t, but hey, it’s your money.
I’m probably ticking off some GP sponsors out there by saying this. I’m sure they spend a lot of time and effort convincing investors they don’t need to have money in a deal. But guess what? They’re wrong. Sorry, not sorry.
2. Familiarize Yourself with the Fee Structure
Probably the biggest difference between an institutional deal and a syndicated retail deal is the fee structure. Some of the fees associated with syndication are absurd. A modest acquisition fee (1 to 2 percent) is legit. This sufficiently covers the GP's time and effort in sourcing the deal, performing due diligence, and keeping the lights on.
Asset management fees are also typical and fair. Something like 1 percent of effective income is fairly standard.
A financing fee can be legitimate, depending on the deal and the difficulty getting it financed. One percent of the loan amount is about as high as I would pay.
Here is where it gets dicey. I’ve seen syndications that include a guarantee fee for signing on the loan, a refinancing fee for the loan, a disposition fee, a construction management fee for the value-add, a fund formation fee for putting it together, and other funky little fees.
I’ll spare you and avoid going through each individually. However, with all those fees, the sponsor may effectively have no skin in the game. He could therefore make a boatload of money no matter what happens in the deal.
I would recommend you push back, as many of the fees serve no real purpose other than making the sponsor rich. You want the sponsor to get rich off the deal—don’t get me wrong. But you should want it to happen so that you also get rich in the process. And that’s why they earn the promote!
Here’s one last point. Occasionally, I hear of a sponsor that buys a deal and actually marks up the price before syndicating it. So, they get the deal at one price, and sell it to investors at a higher cost. Talk about a misalignment of interests.
Be on the lookout for this. If you see it, don’t walk—run in the other direction. This is so ethically wrong it borders on fraud. Expose these people and shame them out of the business.
(Sorry, got a little fired up there.)
3. Ensure You Know Your Stuff
It’s nice to be able to rely on the expertise of someone else. But you should always be able to roll up your sleeves and understand the details of the investment for yourself.
That being said, independently vet the assumptions of the sponsor.
Think of it like investing in stocks. You shouldn’t buy an individual company unless you’ve spent time learning the ins and outs of the business plan, financials, industry, etc. If you decide that doing all that legwork isn’t for you, buy an ETF instead.
In the institutional world, LP money partners are usually as sharp, if not more so, than the sponsors they work with. Educate yourself.
4. Understand the Exit
As a general rule, these types of investments are IRR-driven. What that means is that, while cash flow matters, most of the returns provided to the LP will be dependent on the ultimate sale price.
On a five- to seven-year hold period, there are a handful of underwriting assumptions that will drastically swing the projected internal rate of return (IRR). If the sponsor is projecting 3 percent rent growth and a 6 percent exit cap rate, but the deal turns out to have 2 percent rent growth and is sold at a 6.5 percent cap, the IRR you get will be significantly below what you thought you’d get.
Ask the sponsor for some stress testing and sensitivity tables, which show what would happen under various scenarios. Make sure you'd be comfortable with the outcome if things don't go as planned. As a general rule of thumb, the projected exit cap should be 10 basis points higher than the current market cap rate for every year of the projection.
Do you have experience investing in this capacity? What would you add when it comes to getting it right as an LP?
Bring up anything I forgot in the comment section below.