Private syndication/portolio investment - thoughts on the deal?

Question

I have an opportunity to invest in a portfolio project in a midwest city by a guy who has a good track record in RE: hes a lawyer who flips, started a management company, wife is a RE agent and has maint/rep/plumbrs etc on payroll now. I've bought and fixed 2 houses with him and they are rented.

He got brought a portfolio of mixed residential and commercial units that are very underented and need mostly cosmetic upgrades.

13 residential, 6 commercial, and a lot currently being used as parking. Its adjacent to an average area but expecting a turnaround as they are building a very large mixed use residential/office/public space buliding / area adjacent to it. the properties are sandwiched between a great commercial / res zone and the large redevelopment

My concerns: he is looking to raise 100% and then keep a 50/50 split after the refinance and the investment is paid back in 24-36 months

They expect to refinance in 24-36 months and be able to return all the investment; 5% interest on the investment until its returned - looks like they get nothing until capital is returned - from where the 50/50 return starts

After that 50/50 split between them and the investors. Expecting at 10 years based on a conservative 8.5% cap sale and conservative rent increases a return of 120%.

It looks like a 19% IRR and 7.4% CAGR** assuming you did nothing with the money given to you through time - based on proforma numbers which I believe are pretty conservative [hopefully better rent increase and sale at a CAP better than 8.5% and better than 2% raise on commercial which are underrented].

Thoughts on this format: them (P1) not investing anything, but preferred 5% return / return of capital in 2-3 years, even split after between them and the investors

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specifics: all units are currently rented, some grossly under rent (3000 sq comm space 1100/mo, some 1 beds 500/mo)

initial invest 615,000, year 2 110,000 additional

ROI sale 5 years = 59%; 10 years = 120% --> capital only locked up for 24-36 months though

current rent ~20k/mo - 244k / year

year 1 cashflow (after expense/debt) = 73k; investor cum = -541

year 2 = 94K - 110k additional investment; investor cum = -556

year 3 = refinance cash flow 585,000 + 117 NOI --> investor cash flor + 667 based on 5% pref return adn 50/50 split of excess to distribute; investor cumulative +120,000

years 4-sell time cashflow 67,000 and up each year - cash flow split so adding 33,000-45,000 to cumulative each year;

projected net proceeds from sale at year 10 = 1 million after debt + cashflow (~94k split = 47k)= ~ 550,000+; cumulative cash flow ~ 900,000 at year 10 on 630,000 invested and capital returned in 24-36 mo

Seems like a pretty good deal, doesn't seem amazing, what are your thougths on this format? On them not putting any money into the deal at all it seems?

Part of the costs are modest management fee (5% in leasing I think), an asset mgt fee of 9,000/year (1.3%), 5,000 / year acct/legal/organization, vacancy/repair/maint/misc util/ tax/insurance.. then the loan which refinances 24-36 mo which hurts cash flow but returns all capital

**[I think you should achieve a 11.3% CAGR by initially investing 630K (615 initial + 110 year 2 minus cash flow), getting that money back and investing it in the market @7% and adding 35k each year till year 10 from teh cashflow. Gives 1,335,000 + 50% proceeds = 1,850,000 after 10 years on initial 630,000 investment = 11.5% CAGR]

Joel Owens · Answer

I see 50/50 upside on smaller deals from a sponsor perspective.Example a 2 million deal to syndicate upside not as much so to the sponsor 50% of upside makes sense.70/30 I tend to see on deals in tens of millions of dollars and higher where sponsor makes a bigger fee of around 2% going in. They might get 30% of upside but instead of small deal where upside is 300k at 50% on big deal they might get 5 million for their 30%.It's all relative.

Taylor L. · Answer

Your interpretation of my position is correct - if the sponsor has no capital in the deal whatsoever or risk other than their time, then I'm out. I do agree with you that it is just my opinion. Others can invest in whatever they so choose. Some of my best, lifelong friends invest in my syndication deals. Without fail, their first question is "Are you investing too?" I do my best to make friends with people who are smarter than me, and if I'm not willing to put my own money up next to theirs then I feel like I'm dropping the ball.In this business I believe proper capitalization, alignment of incentives, and shared risks are critical. However, I also believe in freedom. So others can invest in whatever they please as far as I'm concerned.If I may paraphrase The Dude:"Yeah, well, that's just like my opinion, man."

Andy Mirza · Answer

@Taylor L. I agree with all of your statements and your logic except for the absoluteness of it: If the Sponsor doesn't co-invest, I won't partake in the deal (if I'm understanding you correctly.) Sure, it's a red flag but, to me, it means doing more research to find out why. I understand why it's easier and and less risky to dismiss the offering outright but you may be missing out on the potential to make more money on a "start-up" because that's what many of the offerings are where the sponsors aren't co-investing. I have a substantial amount of capital tied up in a number of rentals that my business partner was adamant about not selling. Now that we're getting really good cash flow, I've come to appreciate that we didn't sell. I have money in retirement accounts that are invested in stock and bond index accounts because I believe in diversification of assets by class. I don't have enough leftover to co-invest in my own Funds yet. Once I do, I will absolutely co-invest as I don't know a better place to put my own extra cash since I know how to make it and have developed an expertise. I respect your opinion. Just wanted to show another opinion :)

Taylor L. · Answer

I understand what you mean, but if a sponsor doesn't have any capital to allocate to the deal then they shouldn't be doing the deal. What if things go south a bit and they need a cash injection? They won't be able to provide liquidity on their own, they'll have to do a capital call, which isn't good for investors.It took investors' time and energy to make their initial capital contribution, so they'll effectively be out time and energy as well, but they are also giving up control over day-to-day decisions that drive their potential to make a return.If they were getting a loan from a bank, said bank would most likely require the sponsor to have money in the deal net of acquisition fees. That's because banks know sponsors will naturally put more work in if they have more to lose than just their time. As humans we're far more averse to loss than we are motivated by upside. We'll work a lot harder to avoid loss than we will to seek upside. That psychological phenomenon applies to real estate sponsors. There needs to be a risk of loss of more than just time, all business ventures have the risk of loss of time.

Ajay Malhotra · Answer

The sponsor has agreed to put money into the deal, I am going to push for a 7-8% preferred rate (which is in effect until refinance and investment is returned, after which all net cashflow is split 50/50)

Roni E. · Answer

I agree that the Sponsor needs to put money and the sponsor should own a min. about 30% of the deal.

Andy Mirza · Answer

@Taylor L. When a sponsor doesn't have money in the deal, I can understand how some consider it to be a red flag. However, to me that just means it's one more thing to investigate. What if the sponsor has all of his or her available investable capital involved in other deals? What if the sponsor has more deals and ability to make money than he has capital for? When you talk about sharing in the downside, how do you account for the time, energy, and effort of the sponsor? What I mean is if the Sponsor fails, yes, the Investor might lose principal or preferred return, but the Sponsor loses any profit and any potential business from that or other Investors and his ability to make money for himself and his family if that's his full time job. Yes, that's not the same as cash but that's something lost nonetheless. Not trying to be combative but just expressing a different viewpoint.

Ajay Malhotra · Answer

Is 50/50 good? I thought it was more typical to see 70/30, but those deals may lock up your money for 5-7 years

Taylor L. · Answer

The fact that he doesn't have any capital invested is a red flag. Additionally, 5% pref isn't great but it looks like the 50/50 split would make up for that. I wouldn't do it just for the fact that he doesn't have capital in the deal. If you want a share of the upside you need a share of the downside as well, that means having a financial stake.