Investing in Syndications - A Brief Guide to Investing Like a Pro

[Account Closed]

I get asked often from non-real estate professionals for advice when they're approached to invest as an LP in a syndication. I have  experience working on JVs at the institutional level and have had negotiations with institutional LP funds and investors, as well as looking at deals on the LP side. Here are some guidelines rooted in how institutional investors would look at a deal.

1. Skin in the Game

I know I will catch flak for this one, but my #1 piece of advice is to never, under any circumstances, invest your money with a sponsor who is not putting a meaningful amount of their money into a project. Never. Sorry I'm not sorry. If it is not good enough for them, it's not good enough for you. Deals go bad, it's part of investing. If yours does, you want someone fighting tooth and nail who stands to lose a considerable sum if it doesn't go well. You want your incentives to be aligned with the sponsor to the greatest extent possible. No one who hasn't achieved enough success to participate in a deal financially should be sponsoring a deal, that's the harsh truth. If they have a partner putting the money up that is deeply involved in the management, that's a different story. A "meaningful" amount could mean many things, depending on the size of the deal and the background of the sponsor. I know a handful of LP funds that won't go above 80% of the equity, requiring 20% from the sponsor. Most others look for at least 10% from the sponsor and may go to 5% for the right deal and right partner. If you're working with a younger or less experienced sponsor, a lower percentage still may correlate to a significant portion of their net worth, which is the real key. Ideally, you'd want to see that they are putting in some amount over and above what you're paying in fees. Which brings me to my next point.

2. Minimal Fees

Fees are a legitimate component to a syndication, but they should be viewed in the context of the entire structure of the deal. You want a sponsor to make the vast majority of their money by delivering returns to you, not by collecting fees. Look for deals with the most streamlined and minimal fees involved. I have seen syndications (that were oversubscribed) where there was: Acquisition Fee, Asset Management Fee, Construction Management Fee (for the value-add), Recourse Fee (for guaranteeing the debt), Property Management Fee, Financing Fee (for securing the debt) and a Fund Formation Fee (for putting together the PPM and operating agreement I think?). I wouldn't EVER touch a deal with that sort of fee structure. This sponsor could walk away from the deal if it goes south and still make a ton of money. I suspect that the reason some sponsors go the syndication round instead of seeking institutional LP capital is simply because the fees that they can charge are much juicer than what the "smart" LP money will allow. Fees should truly be just enough to keep the lights on, and any real money should be made by executing the business plan. The holy trinity of fees is Acquisition, Asset Management, and Property Management. Acq fees cover the time and effort of finding, analyzing, and doing DD on the deals. AM fees are really for the infrastructure to execute the business plan and to provide accounting and investor reporting functions. The PM fee should be in-line with what 3rd party managers charge in the market. Balk at additional fees, and press for low fees on the big 3, especially if the sponsor is putting up minimal equity. 

3. Trust, but Verify

Obviously you should never give money to someone you don't trust, that should go without saying. But you also need to educate yourself on real estate and be able to independently vet the sponsor's underwriting and assumptions. Think of it like the stock market: if you don't have the time or inclination to understand an individual company's financials, business plan, competitive advantage, etc., you shouldn't invest in individual stocks, you should buy a low cost ETF. Similarly, you shouldn't invest your money in an individual real estate deal unless you've taken the time to look at rent comps, renovation feasibility, expense assumptions, growth assumptions, etc. etc. If you don't have the time or interest in understanding the deal, you should put your money into a diversified REIT or other investment vehicle. Many LP funds are smarter and more talented real estate minds than the sponsors they invest in.

4. Understand the Exit

Knowing when and how you'll get your money back is paramount. You need to know all of the factors that impact the exit and what that does to your returns. If your sponsor is projecting 3% rent growth and a 6% cap on exit to generate a 20% IRR, I'll bet you'd be surprised at what will happen to your IRR if it ends up at 2% rent growth and a 6.5% cap rate. It doesn't sound like much of an adjustment but your returns will be altered pretty significantly.

5. Have the Courage to Walk Away

Fear of missing out is a real thing. A lot of sponsors create this club-like atmosphere with their investors where only the "cool kids" hang out and do deals together. We are at a stage in the cycle where a lot of the deals that get done now will not work out well. If any part of the deal is not to your liking, walk away. It truly isn't easy, but there will be other opportunities that come along. Having the courage to pass on a deal can sometimes be the best financial decision you can make. Many sponsors weren't  even in business before the crash. They have truly no idea what it means to manage through a difficult market. The chances of you minimizing your losses if a deal goes bad are dramatically increased if you are in a deal with moderate leverage, long term debt, a good cash flow cushion, put together by a good sponsor who hasn't made a ton of money in fees, and stands to lose a boatload if he doesn't figure the thing out. It won't be until the tide goes out that we find out who's been swimming naked. Make your sponsor show you his bathing suit before he jumps in.

[Ian Ippolito]

Every investor has their own process. Here's the process that I use. Background: I'm a very conservative investor and may look through a hundred deals a month, and at the end of the year only invest in 4-5. So things that are a red flag for me may be fine for someone who is more aggressive, etc..

1) Portfolio matching: (takes 30 seconds per deal)

a) Have an educated opinion on where you think we are in the real estate cycles (financial and physical market cycles)

b) Then only then pick the strategies, capital stack, and specialized asset subclasses that make sense for that opinion. For example, I think we are late cycle, so I lean toward the safest part of capital stack which is debt (or debt free equity). I won't go with the riskiest opportunistic strategies, and will stick to core and core plus mostly with some value-added. I won't be investing in the riskiest/most supportable asset subclasses such as hotels, and tilt my portfolio the ones that have historically been more stable such as multifamily and single-family housing. I also don't want refinancing risk, so any deals with only 3 to 5 year debt are out for me. For someone that's not as conservative, or a different view on the next recession, they might have a different opinion than me on all of this

2) Sponsor quality check: (takes about 45 minutes per deal)

I believe that a great sponsor can take an average looking deal and make it great, and that in mediocre sponsor can take a fantastic looking deal and make it bad (especially if there is a severe recession). So I start with the sponsor first. Again, others might disagree.

a) Track Record: Get the entire track record for the strategy. As easy as this sounds, it's not simple and usually like pulling teeth. Many times they will claim it's wonderful and then try to hide their worst deals by only showing completed deals. Make sure to get unexited deals. Or if they are doing value-added multifamily, they will show you their hotel experience. That doesn't cut it for me. I want a specialist that's an expert, and not a jack of all trades and master of none. Also, in a mainstream asset class like value-added multifamily, I see no reason to take a risk on a sponsor that doesn't have full real estate cycle experience and didn't lose money. Again, other might feel differently here.

b) Skin in the game: as a conservative investor, I understand that the dirty secret of industries that the waterfall compensation is in the line with me and incentivizes sponsors to take more risk. So I require skin in the game (average is 5% to 15%) to offset this. Contrary to popular belief, this is not set because I believe it will give me a higher return. I believe it tends to give me a slightly lower return, because the sponsor is going to be more careful, and if there is a severe downturn will prevent me from taking catastrophic losses. Someone that is more aggressive, may want lesser even though skin in the game. Also, if the sponsor is new, I am fine with less skin in the game as long as it is significant to their net worth. On the other hand if they are a sponsor that is experienced in stopping a skin in the game, that's a huge red flag for me.

c) how open to scrutiny are they? I always discuss investments with others in an investor club because other people might think of things that I might miss. And even though virtually every sponsor agreement allows me to share investment information with others who might be advising me on it (especially when club members are bound by an NDA), I still ask the sponsor if I can share it, because it's a test. Most are fine with that, but a few will have problems with it and claim there are legal issues, etc.. That's a red flag for me.

d) death by Google: I Google everything I can about the sponsor. I check the SEC, FINRA, ratings websites for inside information on the principals in the company. I also look for lawsuits and see what happened in them. Many times it's an easy red flag. Sometimes it's ambiguous, but even then, why should I bother with the company that has numerous unresolved lawsuits, versus another company that is virtually the same but has none. Again, others might feel differently here.

3) property level due diligence: (takes seconds to weeks per deal): here is where I drill in with the low-level details.

a) pro forma popping: I examine all the assumptions, and see if they are overoptimistic or not. I look at every single item in the pro forma and imagine that it is complete BS, and see if I can challenge it. If there's a hole, it may be a red flag.

b) sensitivity analysis: I examine all the assumptions, and make sure I can live with the worst case scenarios.

c) "Stall and see": if they are getting money over multiple years, and there is no penalty for investing later, I would usually wait so I get some real performance data, versus having to look at theoretical pro forma information.

d) Recession stress test: I will not invest in anything, until I subject it to recession level stress and see if I can live with the result. And I take the worst recession I can find in the recent past. Sometimes there is only great recession data, and that recession was pretty mild on some asset classes, versus previous recessions. So I will usually 1.5x or 2.0x the stress. If the deal collapses and I would lose everything, I'm out. Others might be fine with taking risk, but least by doing this a person can get an idea of what might go wrong.

e) Legal document analysis: it will usually take a few days to go through the legal document properly, as almost inevitably there are tons of gotchas that either have to be explained, or mitigated with a side letter.

That is the very short summary of what I do.