Sponsors And Syndications: What You Need To Know
Capital call. That was the subject line in a recent email hitting my inbox. The email was sent from the sponsor on a syndication I am invested in. The sponsor on a syndication is the person or group that is managing the investment. Another apartment syndication is in trouble and this sponsor is calling on the investors to throw more money at the project. This is the second one of these I have received in the last six months. The current interest rate environment is killing commercial syndications. Between the higher debt costs and the interest rate insurance, it is getting tougher and tougher to keep these projects successful. The good news is, I believe I have chosen great sponsors to invest with and I am being kept up to date with the struggles and the plan to get through this challenging time. I have a high level of confidence these projects will be successful. That is not the case for other passive investors that I know.
As we work our way through the changing economy, more projects will struggle so I would expect to see more commercial opportunities. Savvy syndicators will be back in the game buying properties at Black Friday prices. Banks should start lending again and sponsor groups will be looking for cash to do their deals. You just might be the perfect investor to help them, so keep an eye out for passive investment opportunities. This will be a great time to consider some of these passive investments but just because a deal looks great, does not mean it is a safe investment for your portfolio. The best deals often fall apart simply because of how they are managed.
Obviously, you will want to do your best to invest in viable projects. This will include looking at the projections to be sure there will be profit and then challenging those numbers. You will verify the numbers in the proforma to include rent amounts, taxes, rising insurance costs, and all the other expenses. I find that maintenance and vacancy projections are often underestimated. If there is any repurposing or conversions in the plan, you may want to check for viability. Is it zoned correctly or will the city allow a different use? Often you can get all this information in a feasibility study which I highly recommend any time there is a conversion in the plan. You will probably want to see any other diligence reports that the sponsor has which could include environmental reports, soil testing, and an appraisal. Some passive investors want to see the asset so if that is you, make a plan with the sponsor to tour the target property.
Review The Structure Of The Offer
After reviewing the project, assuming it is one you would like to invest in, I would review the structure of the offer. This would include any profit splits and distribution waterfalls. A waterfall in real estate is a detailed list of how and when all cash will be distributed. I would never consider a deal that pays a manager a fee before investors are paid a return. Preferred returns are very common in syndications, so I stick to those. One of the most important sections I focus on when reviewing the documents is the capital call provision. A capital call is when the sponsor asks the current investment group to add to the investment which is exactly what is currently happening across the industry. Some syndications can force an investor to contribute or have heavy penalties on the investors who are unable to. Some are much more flexible in that they could dilute noncontributing members but would not otherwise penalize them. And some allow the manager or friends of the manager to loan the company money, which could come with extraordinarily high-interest rates. Look at all of this so you know what happens to you and your investment if the project needs additional capital to survive.
Underwrite The Sponsor
Finally, what I would consider the most important step is to underwrite the sponsor. Most sponsors are great and honest asset managers. This is why I am happy to invest with many of them. I said most because, unfortunately some are either dishonest or they are not experienced/capable of managing the project that you are investing in. A bad manager is far worse than a bad project in my opinion. It can be tricky to underwrite a sponsor because much of what you are looking for may not be readily available. Fraud is a tough one to see coming for example. The absolute best way to do this is to speak to other investors who have worked with them in the past. I would try to find an investor who has worked with a sponsor when things did not go to plan. If the sponsor tells you everything has always performed as planned, I would question how much experience they have or if they are being honest with you. If it is true that each of their deals has always worked out, I am not sure I want to be the guinea pig when something does not go as planned. I always like to Google the sponsor group and put keywords behind their name when I do like “complaint,” “lawsuit,” or “scam” or other words that can flush out if they have deceived or hurt investors in the past.
Don’t Forget To Diversify
Once you are comfortable with the deal, the structure of the deal, and the sponsor group, it is time to make the investment and cross your fingers. Once the investment is made, you have very little control and there is virtually no liquidity. You are now on the ride. I suspect most will be successful and passive investors will be making great money again. This is especially true if the sponsor is disciplined and purchasing quality assets. Some will not of course, which is why you should take the final step in protecting your portfolio, which is to diversify. Obviously as a lender, Pine Financial does not offer syndication opportunities, but I think investing in them is smart and something you should highly consider, especially as we start to see more opportunities. With that said, I would never recommend investing a considerable amount in any one project or one asset type. It is true you can make a lot of money as a passive investor in other people’s projects but having some stable fixed income investments is a great way to balance out a real estate portfolio. A mortgage debt fund may not pay as much as the projections on a syndication, but it will give you some stability without the capital call risk. Fixed income debt is something we can help with. If you are interested in diversifying into assets secured by real estate that are stable and liquid let us know.