Limited Partner’s Guide to Investing in the Right Deal
As an investor you are looking for products that can provide solid return, be relatively safe and provide tax advantages. With real estate we are able to hit all of those marks. We can also miss all of them. Success will depend on purchasing an asset at the right price, in the right location, with a solid business plan and the correct team in place.
With a demanding job or business and a bit of a personal life, passively investing in real estate may be the right avenue for many. Gaining the knowledge, finding the markets and deals, building the team, lining up the financing and executing the business plan takes time, effort and money. Doing it yourself is great, if that is your passion and you can fully commit to it, however, many are better off passively investing and earning great returns with much less effort.
In a syndication, there is a general partner (also called the sponsor) and a Limited partner. The general partner is the one that chooses the market, finds the deal, puts it under contract, completes the due diligence (inspections, underwriting, etc), putting together the team, forming the business plan, securing the financing, both debt and equity, closing on the deal, signing on the debt and then executing the business plan, communicating with the investors and eventually selling the asset. In other words, the general partner is responsible for the transaction from the start to the finish. The limited partner provides the equity and is not responsible for anything day to day.
It’s important as a limited partner to be sure that the sponsor/general partner is qualified and that the deal and market are a fit as well. So how do we protect our money by qualifying a Sponsor?
Experience:It is important to look at the history of the sponsor. You want to be sure they have dealt with investors’ money before and been able to provide them with returns. Have they done a deal using investors money that has gone full cycle? You also want to find out what kinds of issues they have had and how did they handle those issues with the investors.
The other questions that I would ask is how many investors have done multiple deals. I am proud to say that I have investors that have been with me since my very first deal. Syndicators that have investors that keep investing deal after deal indicate that they are trustworthy and follow through. These are great referrals as well to call or email.
Look at other things like their presence online and how they handle themselves online and on forums. Do they appear well connected online and in real life? Doing a search online can reveal a lot about a person’s character and knowledge. If they have a lot of posts, podcasts, blogs, etc, their character will shine through.
The overall business plan: It is important that the sponsor has a detailed and well thought out business plan. You should be able to read through the business plan and understand why they like the deal, why they like the market and what they are going to do with the property that will make everyone involved money. The business plan needs to tell the investors what the problem with the property is, what the positives are and what are they going to do to make a positive impact on the tenants in order to provide a great place to live, while also providing good returns to the investor.
Underwriting: This to me is very important as the market continues on its upward cycle. I see sponsors that are projecting rent growth that is normal in today’s market, but is very high by historical standards. The same thing happens with sale prices in 5-7 years (or whatever their hold time is). Many sponsors are using todays cap rates (this determines sales price) and then just adding a few points each year. This gives the illusion of being responsible, but it tells us nothing. The real question to ask is, what are the historical cap rates over the past 20 or 30 years in that market? Using this data is a better guide.
In my opinion underwriting needs to be based on the current market with future projections based on historical data. If you follow that principal, you are less likely to be caught with your pants down during a downturn.
The other important factor to look at is the amount of reserve capital that the sponsor is raising. It is prudent to have 9 months of mortgage payment allotted as an initial reserve account. If the property needs capital improvements up front, it is important that the amount raised exceeds the budget by 10-15%.
I can’t say enough about underwriting. Really look to see what scenarios could derail the investment. If a downturn happens and rents go down 15% as well as occupancy, can the investment weather the storm for a few years or will it go back to the bank, with your money being flushed down the drain? We can never predict every bad case scenario, but we do need to be aware of the breaking points on each deal we invest in. Make sure you and the sponsor both know that.
The team: As a limited partner, it is important to understand the experience of the property manager, contractors and any other members of the team. We want to make sure that they understand the type of property that is being purchased and they have the ability to execute the business plan.
Sponsor Investment:I think it important that the sponsor invests at the very least the minimum investment or $50,000, whatever is more. In my opinion it is ok if they don’t put in the lions share, but having some money in the deal ties them to the property and helps incentivize them to make the deal a win.
Profit for the sponsor: It is important as a limited partner that you get paid, but you also want to be sure that the sponsor is getting fair compensation. If a sponsor is in a deal and not making any money, where is their motivation when things start to go wrong and take up more of their time? They know that working their tail off to be sure they right the ship will only make them a few measly bucks. The deal doesn’t need to make them filthy rich, but there needs to be enough margin in the deal that you feel they will work hard for you at all times.
Alignment: Make sure your goals align well. Also, it is my philosophy only to do business with people that you like and trust. If you question their intentions or if they are honest and ethical, then don't do business with them. I don't care how good a deal looks on paper, doing business with the bad people will not end well. Let me know what you look for when looking to invest in a deal.
To your success!