Why Alignment of Interest is Crucial when you Invest

Question

There are numerous advantages to investing alongside a syndicator, such as having access to more investment opportunities, diversification, enjoying high returns at a lower risk, etc. But as a passive investor, you need to make sure that the syndicator’s interests align with yours.

Alignment of interest is crucial, since syndicators receive fees or managing the deal and managing investors’ money part of their compensation. The most common fees are:

~ acquisitions fee (paid to syndicators once the deal closes)

~ asset management fee (paid yearly/quarterly from property’s net income)

~ disposition fee (paid once the property is sold)

This fee structure can bring a conflict of interest between the syndicator and you, the passive investor. You want to make sure that the syndicator purchased the property because it was a great deal, or sold it at the right time to maximize investor’s returns, and not because the fee was tempting. Sometimes it’s not black and white; I’m not saying that syndicators buy or sell properties just to get fees, but they will be more careful if they had some skin in the game. The question is…how do you make sure of that?

In one of my previous blogs I wrote about syndication and how it works, but before you get to that, there are a few things you must pay attention to. When you are looking to take the leap into a new investment venture and invest passively, choosing the right syndicator is key.

Here are just a few ways you can make sure the syndicator’s interests are in line with yours.

1. The Syndicator Invests His/Her Own Money in the Deal

Always ask the syndicator if he/she is investing in the deal. When a syndicator invests his/her money in the deal — you know their interests are aligned with yours; after all, they put money from their own pockets in the deal and have the same risks as you. This is how REITs are different than some syndicators — they only take fees and never invest their own money in the deals. Their interests are to maximize their fees and that has a potential for a conflict of interests.

2. Make Sure You Have a Preferred Returns Mechanism

Not all syndicators give preferred returns, but as a passive investor, having such a mechanism is in your best interest. The preferred return is a return on investment that the syndicator offers to investors with the purpose of mitigating the risk associated with investing capital in the deal. Typically, you, as a passive investor, will be promised to get first dibs on profit at a rate of X%, as long as the partnership generates enough cash flow to pay it. Preferred returns are usually 6%-8%. The preferred returns is paid BEFORE the Syndicator receives any fees associated with the investment. Hence, the syndicator is extremely motivated to work hard to make the investment as profitable as possible.

3. The Syndicator Signs on the Loan as A KP (Key Principal) and Becomes a Loan Guarantor

By doing this, the syndicator is putting their balance sheet on the line, since even though most commercial real estate loans are non-recourse, they will become recourse if the syndicator commits a fraud. In that case, the lender is able to collect 100% of the loan balance from the syndicator’s personal wealth. As such, signing onto the loan is a way for the syndicator to vouch for their character. They have a lot to lose, and their interests are aligned.

To conclude, I cannot stress the importance of making sure you end up with the right syndicator and looking at these three ways will guide you in the process. Once you do choose the right syndicator, it is up to you to oversee the investment.

Bryan Hancock · Answer

An alignment of interest is certainly key and some good points were made above. Creating a failsafe structure is hard. The easiest way a passive investor can protect themselves and see what the sponsor is made of is to invest small amounts to start out and increase their passive investment as the relationship forms. Building trust and credibility takes time and can be lost in an instant.

AJ Shepard · Answer

@Bryan Hancock is right about getting to know the sponsor. So much of this business is off of relationships and trust. Anyone investing your money with an operator requires some amount of trust. Starting small and building that relationship can take years in some cases. Though, it does have to start somewhere and generally that is getting on their list and watching what projects and deals they are doing. Get comfortable and be confident that the sponsor is going to be able to do what they say they can do. I think all points 1-3 are great things to consider when vetting a sponsor and their deals. I would also consider asking for reports on previous deals and ask to see how the money was actually split up on a working deal. Get comfortable and know what you are getting into, like Brian said, start small and work your way up.

Yannik Cudjoe-Virgil · Answer

@Greg Scott Understood. It's a sponsor by sponsor preference. Our money is always at risk as well. I've never had anyone question the legitimacy of acquisition fees. The most important thing is making sure that there is an alignment of interest with all investors.

Greg Scott · Answer

@Yannik Cudjoe-VirgilI am a syndicator and our most recent deal was $16M purchase. I respectfully disagree. I put a year into looking for that deal. Tons of time and effort.I have no issue with the syndicator getting reimbursed for up-front expenses (related to that deal) at closing. Making a profit at closing is like spitting in the face of your investor and gives the appearance of a lack of faith in the project. My money is always at risk, right alongside my investors.

Yannik Cudjoe-Virgil · Answer

These deals take a lot of time and energy to put together upfront before closing. There is a lot of heavy lifting. Syndicators who have a team need to compensate their team for their time. I think acquisitions fees between 1-3% are fair. Disposition and capital transaction fees can be negotiable. I wouldn't do a construction management fee though.

AJ Singh · Answer

@Ellie Perlmangreat points especially # 1 and #3 about syndicator's own skin in the game. Right now capital raisers are frequent part of the deal sponsor teams. Why do we need big groups of deal sponsors to run an asset and also need to engage a property management company to execute a business plan of exterior and interior rehabs to bump rents...

Steve Morris · Answer

Problem is that most syndicators want to preserve cash and while they need to remain in the deal, they may be a 2% share.After that, it's asset management fees until the deal is unwound. Since you need all signatures at close, if they want to make more, that 2% can be a lot more than 2% if they're the only one saying no (I've seen it happen).

Greg Scott · Answer

I agree with most of what you say here, but not the preferred return. A preferred return can absolutely create a misalignment of interests. If a deal is performing poorly, the property might not be making enough to cover the preferred return. In that case, the syndicator is not making money for themselves. They are not getting paid. How much effort are they going to put in turning around that deal if they have 2 or three others that are doing well? On the other extreme, if a deal turns to be a grand slam home-run, the syndicator takes most of the profits The passive investor who put of most of the risk capital walks away with a better-than-expected return but they did not get the risk-adjusted return they should have for potentially losing all of their investment.A much better deal structure is where the syndicator takes a straight percentage of the profit. I agree they shouldn't get acquisition fees, disposition fees, capital event fees, or construction management fees. With a straight percentage of interest the syndicator's returns are completely aligned with the passive investor. Both get returns proportional to the performance of the property.