The Inside Track to Vetting A Multifamily Deal Sponsor

Commercial real estate investing is a relationship business. The investor is investing in the deal sponsor (also called the syndicator) first and the deal second. Hence, serious investors must scrutinize the deal sponsor from multiple angles to ensure there is a fit between the investor’s need and the syndicator’s strategy.

True alpha, excess returns generated over and above the market returns, is hard to attain. It becomes challenging, in advance, to pinpoint which syndication teams will generate alpha as commercial real estate deals can take years to mature.

From 2009 onwards, the commercial real estate market has been on a tear. Many syndication teams will point to their recent results (2009-2016) as proof of their superior strategy to charge above average fees.

We wanted to provide a framework utilizing our experience in vetting syndicators. But before we begin, it is important to understand that all deals – regardless of industry, asset or strategy – center around three main points:

1. Deal
2. Market
3. Deal Sponsor/Syndicator

It is ideal to hit a home run on all three points. But we strongly believe that the last item – deal sponsor/syndicator – plays the most significant role. In our experience, a good sponsor can turn around a mediocre deal but not vice-versa.

This post focuses on the last item. We have provided our framework to assist in analyzing quality syndicators.

Company, Background and Team Experience

• First impressions count. Does the syndicator interact professionally and consistently across the board – meetings, online presence (website, social media), offline presence, communications?
• What is the investment strategy? How is it presented? (see: “Investing Strategy – Determining the Sponsor’s Edge?”)
  • Contrary to widespread belief, the most efficient operators are not everything for everybody. They focus on a specific niche where they have developed world-class expertise.
  • Within our preferred strategy – value-add multifamily – we prefer stable income returns with a forced appreciation potential.
• How is the team structured?
• We prefer teams with cross-functional abilities but clearly delineated roles. One individual should not be wearing too many hats nor spreading themselves too thin.
• Do the key partners (KPs) have their bios listed along with their experience?
• Has, at least, one partner (preferably more) been through more than one market cycle?
• How was their performance through the entire business cycle?
• What is the tenure of the KPs?
  • There are exceptional managers with long tenures working with new sponsors. We do not see this as a problem. This is a relationship driven business where skills are transferable
• What/how is the syndication team’s online and social media presence?
  • Reputation matters – a lot.
  • Do a quick Google, LinkedIn and social media search to better understand all KPs in a syndication team.
  • We are looking for honest, high integrity folks with stellar character. Sponsors should manage their reputation zealously – online or offline.
    • We look out for bankruptcies, felonies and regulatory (SEC or state) violations.
• Can the team provide references?
  • Who have they worked with before?
  • How is their reputation within the community?
  • What do they referrals say about them?
• One-person shops suffer from key person (KP) issues. Ideally, you want to know that there are multiple people managing your capital.
  • Ask a simple (if morbid question): How would the investor’s capital be protected if something were to happen to the syndicator?
• There is no substitute for trusting your gut.

Investing Strategy – Determining the Sponsor’s Edge

• Can the syndicator concisely articulate the investment strategy?
• Is there intellectual rigor backing the strategy?
  • Although back testing is critical, it is important to have a forward-looking outlook to determine if the strategy can be consistently applied across multiple deals.
• Does the syndicator suffer from the shiny object syndrome?
  • Sponsors can chase after the “flavor of the month” and lose focus. We prefer to work with sponsor with clearly defined niches who can easily articulate their strategy.
  • To paraphrase Charlie Munger, “if someone can’t describe what they do in a few sentences, then they don’t know what they’re doing.” We agree with Charlie’s assessment.
• How has the investment strategy played out in the real world? If applicable, how has it performed across the business cycle or multiple deals (see: “Sponsor Experience in Asset Class and Sub-Market”).
  • Reality has a nasty habit of interfering with highfalutin strategies. We prefer to base our decisions on historical numbers and compare against forecasts.
  • Our preferred method is through detailed performance attribution reporting to understand the multiple factors composing the net return numbers.
• How confident is the sponsor is their strategy?
  • We are looking for confident but humble teams. The best laid plans can and do go to waste. Home runs are home runs in hindsight only. During a deal, it is best to have a skeptical outlook and to challenge all assumptions rigorously.
• We also look at K1 statements and investor communications. This helps us in determining how the sponsor handles the investor capital.
  • This is especially important for non-institutional investors. It is imperative that a sponsor should develop a relationship based on respect and focused on education. This helps the investor develop a deeper understanding of the business model.
• As of writing, at this stage of the real estate cycle, conservatively underwritten, large multifamily deals are averaging between 15-18% IRR. We get concerned when we see sponsors consistently underwriting deals at 20%+ IRR. Warren Buffet’s annual gains (1965-2012) were slightly above 20%. We highly doubt most sponsors can deliver better long-term results than the greatest investor of all-time. It pays to under-promise and over-deliver.

Sponsor Experience in Asset Class and Sub-Market

• Experience in one asset class/sub-market – offices in Miami – does not translate into guaranteed success in another asset class/sub-market – multifamily in Dallas.
• The market fundamentals are a function of location and local economics. It is important for a sponsor to be well informed about interplay of local economic drivers. This governs the 3 – 5-year outlook.
  • For e.g. a value-add sponsor would face a tough time if new inventory was coming to the market which was direct competition. The additional inventory would put revenue pressure (decrease in NOI) as the sponsor’s asset will be competing against newer supply.
• It is possible that a sponsor might not have the right relationships within the local broker community, as this is a relationship business. The lack of strong, local relationships would leave the sponsor out of juicy, off-market deals. It will also limit the pool of prospective buyers once the business plan has been executed.

Marketing Materials

• Are the marketing materials professional?
  • Marketing materials include: deal summary, pitch decks, videos, webinars, conference calls and other communication packages.
• Are all major questions thoroughly addressed?
• Is there consistency in the way the business plan is marketed and the way it is presented on the marketing materials?
  • We also ask for a copy of the private placement memorandum (PPM) for past deals. The PPM is a legal document required by the SEC document that covers risks, partnership roles and other facets of the investment.
    Reading through the PPM is also a great strategy if you’re having trouble sleeping.

Underwriting Discipline

We follow Warren’s Buffet’s investing rules:

Rule #1: Never lose money.

Rule #2: Never forget Rule #1.

• Conservative underwriting is the rock on which this business is built. During underwriting, sponsors must maintain intellectual discipline and not get swayed by emotions. All numbers must be backed by logic and research.
• Capital preservation is essential. It goes together with conservative underwriting. This business has a very attractive risk/return profile. There is no need to embellish numbers to stretch the truth.
  • For a recent transaction we analyzed, 25% of the units were renovated at purchase. The seller was getting an additional $100/month in rent increase across all renovated units (studio, 2×2, 3×2).

    The market comps for renovated units of a similar vintage were an additional $115-125 per unit. That deal was underwritten at a $71 increase in rent per unit. This meant that there was $44-$54 spread (or margin of safety).

    The Sponsor could have been aggressive and budgeted for a $100 increase in rents to show better-projected returns. But they did the right thing by being conservative, under promising, managing expectations and over delivering.

• Sponsors should provide sensitivity analysis alongside the financials. These should be accompanied by commentary on the major drivers – vacancy, rent upside, loan terms and exit valuation. This allows the investor to map out the best, medium and worst-case scenarios to determine if the deal is a good fit for their portfolio.
  • The deal described above was underwritten at 90% occupancy. The sub-market was at 96% occupancy and purchase occupancy was at 95%. The sensitivity analysis showed that in the case of a market downturn, the breakeven occupancy would be 81% or a 14% occupancy margin of safety.

    This went a long way in answering investor concerns as well providing them with additional confidence in the sponsor and the merits of the deal.

Financial Reporting, Legal and Audit

• In our experience, many investors forgo this step. Given our experience in public and private markets, we know the importance of quality ongoing financial reporting, as well as information on the legal and auditing teams.
  • If possible, request the financial reporting, legal and auditing packages from past deals.
• The legal and audit teams should be well respected, third party vendors with no history of disciplinary action or regulatory violations. They should also be practicing in their area of expertise. A divorce attorney does not make a good securities attorney.

Fee Structure

• Unlike capital markets, private markets are fragmented, lightly regulated and have murky reporting standards. This means that an investor must do extra work to understand the fee structure to ensure that the sponsor is not being compensated for under-performance.
• Return conversations should focus on net returns only. The sponsor must be able to walk an investor from gross returns to net returns by explaining the impact of all expenses and fees.The investor is trying to understand the flow of distributions. How do the investor and sponsor split distributions? Cross-reference this with the waterfall structure.
• What is the anticipated timing of fees and returns?
  • What frequency will they be incurred and paid – monthly, quarterly or annual?
• We believe that a properly structured waterfall aligns everyone’s interests. A waterfall is where a certain hurdle rate must be reached before the sponsor can split profits with the investors. Coupled with a preferred rate this establishes a floor below which a sponsor will not make any returns.
  • As of writing common waterfall profit splits range between 20-40% (sponsor) and 60-80% (investor), preferred range between 8-10%.
• We’ve observed “club investors” focus on working with sponsors that take a 20% straight cut of the profits. In these deals the investors are not seeing a preferred return.

  One does not have to be a math genius to realize that this is not a good strategy. It takes a significant return in the mid-teens (or higher) before an even trade-off between 20% of the entire deal breaks even with a lower return waterfall structure (mentioned above).

  This structure can also reward a mediocre sponsor as they start taking a cut of the profit before reaching a high-water mark.

Sponsor Fees

Asset Acquisition Fees: One-time, ranging between 1-3% of purchase price. They are paid to the sponsor at closing and compensate for the legwork required to close a deal. On average, for each completed deal a sponsor is underwriting 50-100 deals.

This also accounts for all the expenses leading up to the closing. These include: staffing, administration, analyst fees, marketing and database subscriptions.

Asset Management Fees: Ongoing between 1-3% of monthly revenues. It can be paid at any interval but is usually paid quarterly to the sponsor. This covers the costs associated with ensuring the business is executed.

Loan Guarantees: Required by lenders as key sponsor(s) net worth must equals or exceeds the loan. Key people who guarantee the loan want to get paid for the risk (even with non-recourse loan).

Construction Management Fees: These compensate the sponsor to oversee the capital improvement implementation plan. They are not found in every deal.

Disposition Fees: Average 1% of sales price. These are paid to the sponsor to compensate for the costs related to selling an asset. Often it is an optional fee.

Refinance Hurdle: Average 2%. These compensate a sponsor for creating additional value such that when a refinance is done a sizable portion of the investor capital is returned. We prefer the return of capital to be in the 40-80% range.

For the investors this is tax efficient return of capital. The refinance is treated as a return of capital and not a return on capital. Hence, it is not taxed as an income/profit distribution.

Returns should always be presented net of fees (see: “Fee Structure”). Fees should not impact the net projected results, but it is best to double check. An investor’s marketed returned should not go down due to fees.

We also like to see sponsor commit their personal capital to deals (also called, sponsor investment commit). The idea is for all parties to have skin-in-the-game. At a minimum, it should be a six-figure investment. More is better.

But it is also unreasonable to expect a sponsor to invest sizeable chunks into every project. There is a ton of “sweat equity” that goes into finding, operating and divesting an investment. The sponsor investment commit is a good symbolic gesture but should not always be expected.

If a sponsor has 6 multi-million dollar deals in a year, their financial planner would not be advising them to invest in every deal. It would be akin to employees blindly investing in company stock (re: Enron, WorldComm, Bear Sterns, Lehmann Brothers).

Investment Duration and Exit Strategies

Understanding the investment duration allows an investor to better to determine if an asset is a good fit from an asset-liability match perspective. This also helps in understanding if an investor is being adequately being compensated over the duration of the investment.

It is important to map out exit strategies before an investment is made. An investor should understand a sponsor’s Plan B, C and D as to understand possible courses of action that can be taken if things go awry.

Property Management

In acquisition mode, it is considered best practice to hire a professional property manager (PM). The PM team ensures that the operational plan is executed in a timely manner. It is the duty of the sponsor to manage the PM.

The sponsor must:

• Review the PM team
• Run background check
• How many units the PM team is managing?
  • Bigger is not always better.
• Verify the track record of the PM including history in the sub-market where the asset is being acquired
• Ensure that the PM team manages a similar class/type of property as the one being acquired
  • PM teams specializing in Class D properties will not be a good fit for Class A properties
• Tour their other properties to get a better idea of their management style
• Verify references

Good PMs focus on creating a community atmosphere. Numerous studies have shown that this increases tenant engagement leading to better care of the property by the tenants as well as lower vacancy. This also creates a more harmonious tenant/landlord relationship.

It is important to take note of qualitative impacts as they have quantitative effects.

Asset Management

• The sponsor is responsible for overall asset management and being an effective steward of investor’s capital.
• We like to understand the key plans and how they will be implemented in managing the asset efficiently.
• A key facet of asset management is communications. We prefer sponsor teams to provide regular communications. In this business, over communication is preferred. The communication does not have to be extensive. It could be as simple as a few bullet points outlining operational details, major wins (and losses) and how issues are being handled.
• The point of regular communications is to make the investor aware of how the sponsor is working with the property manager to address current and emerging issues.

Investor Relations (IR)

• Effective IR is the glue that binds the sponsor/investor relationship. As an investor, we want to know how the sponsor will take care of us after we’ve invested. Will they have time to answer our questions/concerns?
• Investors are wooed during the capital raising phase and neglected afterwards. Quality sponsor do the exact opposite. They know that open lines of communication are the catalyst to long-term relationships.
• We like sponsors to provide ongoing education and answer all reasonable questions an investor might have. No point is too trivial.
• We also like to understand the quality of the answers. As sponsors ourselves, we prefer to engage in lively debated with educated investors. This keeps us on our toes and leads to better long-term relationships. The investor is an equal partner and communication should be treated with utmost importance.
• We also look at the communication schedule. Good sponsors can provide examples of their past communication and schedules.
• We also consider it a positive if a sponsor gets back to us on a question they do not have the answer to. The key is to acknowledge a request, treat it with respect and promptly deal with it in an effective manner.
• As part of the IR process, we prefer to line-up property tours for our investors. This provides a better, more quality experience.

References

This is essential. Sponsors should easily provide references. In our case, we offer to connect new investors with our current investors or with other members of the sponsor group. By providing varied references, an investor is able to get multiple perspectives to better understand if they are a suitable fit. Some questions to consider:

• How have the investments performed vs. projections?
• What has the sponsor promised but not delivered?
• What has the sponsor promised and delivered?
• What is the communication frequency?
• How does the sponsor handle unforeseen issues?

An investor should always seek to work with sponsors who are a good personality fit. Initially, this can be hard to observe. But using our framework and asking the right questions, an investor can get deeper insights.

In the end, it is all about forming holistic relationships with win-win solutions. Everyone – sponsors, investors, tenants, property managers, lenders, brokers and the community – should come out as a winner.

This article can also be found at: https://www.boardwalkwealth.com/2018/03/the-inside-track-to-vetting-a-multifamily-deal-sponsor/