The People Behind the Deal — Evaluating Real Estate Sponsors

August 17, 2024

This is Part 1 of a four-part series exploring the 4Ps Framework for Evaluating Real Estate Syndications. For a comprehensive guide, including a glossary of terms and a cheat sheet, download our free ebook: The Apartment Investor’s Guide.

Why Focus on People?

Track Record: Beyond the Numbers

A sponsor’s track record provides a glimpse into their ability to execute deals successfully. However, past performance, especially in a rising market, can be misleading. Here’s what you need to scrutinize:

Full Cycle Experience: Look for sponsors who have completed at least five full-cycle deals, ideally over ten, including through a major downcycle. This experience is invaluable, as it shows they’ve navigated challenging market conditions and emerged stronger.
Under-Promising and Over-Delivering: Sponsors should consistently meet or exceed projected returns. Compare average equity multiples and annual Internal Rate of Return (IRR) against projections for all full-cycle deals to gauge their reliability.
Execution vs. Luck: Was the sponsor’s success due to solid strategy or favorable market conditions? Compare their original underwriting to the final results to see if they met their Net Operating Income (NOI) targets or if rising prices masked poor performance.

Red Flags: Be cautious if you encounter any of the following:

Sponsors who have had capital calls or significant losses.
Sponsors including deals in their track record that they didn’t actually manage.
Sponsors omitting current, underperforming deals from their track record.

Alignment of Interests: Ensuring You’re on the Same Page

It’s essential to ensure that the sponsor’s incentives align with yours as a Limited Partner (LP). If they have little skin in the game, their motivation to protect your investment might be compromised.

Meaningful Co-Investment: A good sponsor should ideally invest 5-10% of the capital on the same terms as LPs, net of initial fees. This shows they have a personal stake in the deal’s success.
Performance-Based Compensation: The majority of a sponsor’s earnings should come from the success of the deal, not from fixed fees. This aligns their interests with yours, but be wary of sponsors who might take excessive risks to boost returns.
Preferred Return: Look for a preferred return of 6% or more, meaning LPs get paid before the GP receives any profit splits. Ideally, this pref should be cumulative, compounding, and free of catch-up provisions for the GP.
Personal Reserves: A sponsor with significant personal reserves can backstop problems, ensuring stability during rough patches.

Red Flags: Watch out for:

Acquisition fees that exceed the sponsor’s capital commitment.
Sponsors who raise excessive capital to pay LP preferred returns, diluting LP gains and misaligning interests.
Non-standard or complex structures designed to favor the sponsor over investors.

Integrity: The Bedrock of Trust

Integrity is the cornerstone of any partnership, especially when it involves your hard-earned money. Although it’s challenging to measure, there are clear signs and red flags to help you gauge a sponsor’s integrity.

Handling Problems: Experienced sponsors who have faced challenges and can demonstrate how they managed their worst deals are often more reliable than those with a perfect record. Look for accountability and investor satisfaction during tough times.
Protecting Investor Capital: The sponsor should prioritize safeguarding your capital and be able to articulate their risk mitigation strategies clearly.
Long-Term Focus: Sponsors committed to long-term relationships and sustainable success often prioritize reputation over quick profits.
Transparency: Opt for sponsors who openly share information, including potential risks, and provide regular updates. Evaluate their responsiveness, especially in difficult situations.

Red Flags: Be wary of sponsors who:

Refuse to share their underwriting models.
Have legal or financial problems uncovered during background checks.
Include capital call provisions that are uncapped or overly dilutive.

This concludes the first part of our series on the 4Ps Framework for Evaluating Real Estate Syndications. Stay tuned for the next article, where we’ll explore the second P: Plan—how to assess a sponsor’s strategy and execution capabilities. For the full guide, including a glossary and cheat sheet, be sure to download our free ebook: The Apartment Investor’s Guide.