How Are You Syndicators Doing Your Underwriting ?

Question

I thought I would ask from the perspective of the syndicator, what metrics are you looking to hit?

I am familiar that there can be different structures , ( i.e. acquisition fee, mgmt fee, disp fee, pref returned , varied back end splits). On the front end, what are you syndicators looking to hit on your front end numbers? Do you want to see 15% CoC ( Ie so you can do a 8% pref and 50% splits of excess ) Do you want to see 30% upside in value so you can do a back end split of 60/40 after projected 5 year return.

I have heard the phrase from Jerry Puckett about marketing like a wholesaler. I think it would be equally valuable for investors to underwrite like a syndicator in terms of targeted returns /metrics for their own deals, with their own capital without underwriting. I was trying to do some searching on past write ups and primarily could only find the proposition to the investor but the not front end metrics you are looking to hit.

Thanks in advance.

Brian Moore · Answer

Account Closed

I believe you are asking what metrics that a syndicator wants to hit for his own profit / income. First I would say that is never how I would underwrite a real estate deal. If the deal works for investors, it will work for the syndicator. The syndicator will get an acquisition fee, some management fee(s) (property, asset, etc) that is relatively small and some larger percentage of the back end once a hurdle rate (usually an IRR of 10-20% depending on deal - see below) is met. Since the syndicator is confident in the deal (why else would he bring it to investors) he is confident that there will be a sufficient profit upon disposition of the asset. This also aligns the syndicator's interests with the interests of the investors.

So what does it mean that the deal"works" for investors? First a syndicator must identify a property and come up with a strategy for profiting from the property. This may mean purchasing a stabilized asset, in Class A location and condition with a high-credit tenant on a long-term lease and earning a 2% cash yield annually (this would be a low-risk, wealth retention strategy). On the other end of the spectrum is a gut rehab / new construction in a speculative location (this is high-risk, opportunistic strategy). There are too many factors for me to address in a forum post (cash flow vs appreciation components of return, investment duration and liquidity, interest rates, etc) but there are books written on how to assess real estate investment risks and how to price risk via investor returns.

Low Risk = Low Return (IRR of 5-10%)

High Risk = High Return (IRR of 15-30%) [Note: I have done a deal with a 30% IRR hurdle rate and it returned above that to investors]

Meeting the investors' risk/return expectations are a key job of the syndicator. These expectations change with the market and with investors' perception of risk/return from other investment alternatives (stocks, bonds, REITs, gold, etc). There is always some measure of "selling" the deal to investors but it must be grounded in a clear-eyed analysis of the risks.

Being able to create an accurate financial model / proforma is probably a syndicator's most important skill. Using too aggressive assumptions (high rents & rent growth, low rehab costs & expenses, etc) will demonstrate a great return on paper but will inevitably disappoint investors when the deal fails to meet expectations. On the other hand, being too conservative on assumptions will result in no deals meeting your return threshold.

In summary, to underwrite a deal I use strictly an IRR-based return metric (others may use an ROI or equity multiple, but these don't take the investment duration into consideration so they are inferior means for evaluating an investment) . The IRR must exceed a fair return to investors for the use of their funds to compensate them for the real estate risks.

Finally, the syndicator is doing this as a full time job and thus, an IRR calculation is not an appropriate measure to determine if the syndicator's compensation is appropriate. An IRR shows an investor what his MONEY will earn with no active participation, whereas a syndicator is putting in his valuable TIME and EXPERTISE and FINANCIAL RISK (often personal guarantees backed by personal assets) to generate the return and must be fairly compensated for these contributions.

David Thompson · Answer

Jack,

What I've learned is that many value add syndicators I've interfaced with in the large apartment space look for min 10% CoC and 20% IRR targets.  Deals will be in and around that number.  Preferred returns of 8% to the investor are common meaning 100% of distributions to to the investor first before sponsor gets paid.  I work with a lot of investors and both these return targets and preferred returns are attractive and get attention.  Strongly agree w/Brian that you want the deals you are looking at from sponsors to be conservatively underwritten.  Take a careful review of the assumptions being used especially around occupancy, rental rates, financing and cap rate exits.  Does the business plan make sense?  Is it straight forward ?  The over riding factor for me is the market the deal is in.  If its killing it w/job and population growth, I can feel comfortable that when the sponsor creates a more attractive community w/renovations and efficient management the residents will want to be there and more will want to come.

For the sponsor, outside of common acquisition fees and asset management fees, incentive type fees designed by the sponsor are set around out performance metrics.  This could be a waterfall that further incites the sponsor to outperform certain metrics, typically around IRR hurdles for any cash out refinance or sale.  A waterfall typically is around a IRR hurdle, where splits would change providing the sponsor a graduated higher return.  I've also see incentives if the refinance gets "x" amount of money back to the investor beyond some hurdle and that hurdle typically is a "home run" type hurdle.  Example:  when a cash out refinance occurs, if 75% or greater of the investor money is returned the sponsor gets 2% say.

When talking w/investors and sponsors, I like to see incentive targets but they should be for strong out performance and kept to a minimum to avoid complexity.

Brian Moore · Answer

Account Closed Sorry for digging up this old thread but I just expanded on my prior answer in a new blog post titled Does This Syndication Deal “Work”? The RIGHT Return for Every Deal

I thought it might be helpful to you.

Account Closed · Answer

@Brian Moore  Thanks for all of the insight

Doug E. · Answer

Got it, thanks, so comparing a larger carry after a pref, vs. no pref and a 80/20.  Obviously a different market, but institutional RE tends to follow a pref, then 80/20--sometimes with a GP catch up, sometimes with a second higher carry split after a certain return threshold, etc.

Nick B. · Answer

Depending on the formula, waterfall model would give 25%-40% of the profits to sponsors leaving 60-75% to investors. 80/20 would give 20% to sponsors and 80% to investors.

That assumes over 120% of project level ROI.

Doug E. · Answer

Waterfalls/prefs require a minimum return (over equity) be given the investor; a basic 80/20 split appears to give the sponsor carry payments right away.  How are you saying that leaves more profit for investors?

Marc C. · Answer

I note that a lot of the PPM's and LLC operating agreements I read have two classes of membership interests in the title-holding LLC: Class A for investors, and Class B for managers. 80/20 or 75/25. Class B units appear to be "given" to the managers from the start of the deal; but they are free to buy Class A units as well. Seems like a fair way to do it.

Nick B. · Answer

@Marc C., I know more than on syndicator that uses 80/20 profit split. Some even do 82/18 or 81/19. This is 20% profit split, not equity. E.g., if total investor equity was $1M and the project had 0 profit, investors would get their original capital back and sponsor would get nothing except for asset management fee (usually 1-1.5% of collected rents)

From an investor perspective, it is much easier to see what your take is vs. overall property performance. Also, it leaves more profits for the investors. Personally I prefer this formula to waterfalls, prefs, etc.

How Are You Syndicators Doing Your Underwriting ?

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