We consistently meet with individuals and families, and one of the most frequent questions we receive is whether to invest in real estate. Over the past decade, real estate values have soared which has increased the promotion of the real estate industry. Nearly everyone knows someone who has “made a fortune” in real estate and touts it as a “can’t miss” opportunity.
At Prairiewood, we believe in the ability of real estate to generate long-term wealth. The unique characteristics of real estate including leverage, forced savings, value appreciation, and tax depreciation can produce generous after-tax returns over time. For those interested in more details on the unique characteristics of real estate, please refer to our August 1st, 2022 blog post titled: Should You Invest In Real Estate.
While real estate is a valuable addition to many investment portfolios, all real estate is not created equal. Real estate is an industry just like anything else, and those who have devoted careers to it are much more likely to succeed than those who simply dabble with the hope of making a quick return.
Since most individuals with a full-time career in another field do not have the time or desire to spend hundreds of hours developing the skills to succeed in real estate, the majority of individuals are best served by passively investing in real estate deals led by professional real estate sponsors.
These sponsors raise capital from investors to purchase properties and then manage the properties with the goal of generating a return for their investors. In simple terms, a sponsor is paid to use their expertise to invest in real estate on the investor’s behalf.
However, like most things in life, there is a wide range of quality in sponsors. Some have significant, long-term track records and have created value for their investors during full real estate cycles (including recessionary periods). Others are simply focused on the opportunity to sell deals that sound good to unsuspecting investors in order to earn high fees. Individuals who invest in passive real estate must be able to differentiate quality sponsors from those who amount to little more than salesmen.
This blog post will provide a framework for identifying quality sponsors and explain the thought process and factors to consider that can help weed out sponsors that are not worthy of your time. This framework is just the starting point, and those who are interested can dive deeper.
A great option to start diving deeper would be reading “Investing in Real Estate Private Equity” written by Paul Kaseburg under the pseudonym of Sean Cook. This book provides great detail on evaluating real estate deals and sponsors and has helped shape the framework discussed below.
Evaluating A Real Estate Sponsor:
When evaluating a real estate sponsor, there are five areas that can help individuals separate quality sponsors from those who are primarily focused on lining their own pockets. While these five areas are not an exhaustive list, they serve as a great filtering mechanism to eliminate low quality sponsors which creates more time to investigate better offerings. When evaluating sponsors, consider the following areas:
- Experience
- Track Record
- Sponsor’s Personal Investment
- Leverage
- Fees
As with any filtering mechanism, the filter’s primary role is to remove the bad options even if a few good options are removed as well. Any attempt to set a filter that is broad enough to keep all the good options will invariably fail to filter out the bad options. While no filtering mechanism is perfect, we believe these five tests will significantly reduce the risk of investing with a low-quality sponsor.
Key Takeaway:
Investors need to have an efficient filter that allows them to separate low-quality sponsors from those who are worthy of further research.
Experience:
Evaluating the experience of a real estate sponsor requires close attention to detail. Many sponsors will advertise decades of experience, but often when you dig into the details, you will find something similar to the following:
- The sponsor will show 30+ years of experience, but when you investigate further you learn 30+ years is the combined experience of their entire executive team with each individual having only 5 years of experience individually. Often none of the individuals have experience through a difficult real estate market.
- The years of experience advertised aren’t directly relatable to the type of real estate they are planning to invest your money in. For example, they may be raising capital for a large multifamily apartment acquisition, but they include their time managing their own portfolio of single-family rental properties in their years of experience.
The key point is that it is very easy to make experience look good at first glance. Investors need to dig deeper to determine whether the experience presented is an accurate representation of reality. While there isn’t a magic number of years that it takes for someone to develop the necessary experience, it is always best to see that someone has experience through a full market cycle in the same type of real estate that they will be investing your money in.
Key Takeaway:
The best sponsors will have significant experience through full real estate cycles in the same class of real estate they are currently offering.
Track Record:
The sponsor’s track record also should be a key focus during evaluation. One of the reasons the sponsor’s track record is so important is because the sponsor controls the investment and the investor is typically just along for the ride.
Frequently the best indication of a sponsor’s ability to generate returns for investors is whether they have been able to do it consistently in the past.
Similar to evaluating a sponsor’s experience, it’s important to make sure that the sponsor’s track record includes a full market cycle. If the track record is only five years and real estate values only went up during that period, there is no indication that the sponsor is able to weather a downturn.
Those who invest for long-term results will face downturns; so investors need to make sure they are investing with sponsors who are prepared to navigate recessionary periods and have proven they can in the past.
Another trick that can often make a sponsor’s track record look better than reality is reporting only the performance of the sponsor’s round-trip deals (i.e. deals that have been sold/completed). This is often misleading because typically the worst deals haven’t been sold given the significant loss the sponsor would have to take upon sale. Understanding the performance of deals that are still being held can shed light on whether the sponsor’s track record would change if all deals were included.
It’s also important to dig into a sponsor’s returns on a deal-by-deal basis to understand whether attractive performance is consistent deal to deal, or whether the sponsor simply had a few very good investments that have offset other poor decisions.
The bottom line is that investors should perform due diligence on a sponsor’s track record to understand whether they have been able to consistently deliver value for their investors.
Key Takeaway:
The best sponsors have track records that show the ability to consistently deliver value for their investors on a deal-by-deal basis, through full market cycles, over long periods of time.
Sponsor’s Personal Investment:
There are very few things more powerful than incentive. If a sponsor is asking you to invest your hard-earned money in the opportunity they are presenting, it is a fair question for you to ask them how much of their hard-earned money they’ve invested in the same opportunity.
It’s one thing for a sponsor to claim something is a can’t miss opportunity, but it is a completely different thing for them to invest their own money in it. Think about it this way, the sponsor likely knows more about the deal than anyone else. If they won’t invest their own money in it, why should you?
Typically sponsors receive some ownership of each deal as compensation for finding, coordinating, and managing the investment. They also typically receive a portion of the upside if the investment does well. While it is fair for sponsors to be compensated for their time, neither of these represent a personal investment by the sponsor.
In fact, a sponsor can make a lot of money by coordinating only a few successful deals because they participate in the upside of good deals, but don’t bear the loss of bad deals. When choosing a sponsor, it is best to choose a sponsor that puts their own hard-earned dollars in the deal on the same terms (i.e. no purchase discounts, no additional returns) as investors.
Sponsors who invest their own cash in a deal on the same terms bear downside risk together with their investors which aligns their incentives more appropriately.
Key Takeaway:
The incentives of sponsors are often misaligned with their investors unless the sponsor makes a significant investment of their own cash in the deal on the same terms as the investors.
Leverage:
In real estate, leverage is often touted as the secret sauce that generates large returns. While leverage can accentuate returns, it cuts both ways. When markets struggle (and they eventually will), it’s the individuals with too much leverage that get hurt the worst.
Leverage is measured as the total amount of debt used in relation to the value of the assets. When evaluating a sponsor’s track record and projected returns, it’s always important to understand the leverage they are using to generate those returns. A sponsor that has a long-term track record of generating 10% returns with 50% leverage is far more impressive than a sponsor who has generated 20% returns using 80% leverage over a short period of time.
Typically, the investors who lose the most money in real estate are the ones who are forced to sell when the market is at the bottom. In real estate, most loans are financed for a 3 to 7-year period with a balloon payoff required at the end of that time period. If the loan comes due when the market is struggling, it is the individuals with too much leverage that are forced to sell at low prices to get out from under the loan. Investors with less leverage have much more flexibility to wait until a recovery occurs.
Sponsors who use significant leverage can post exceptional returns when the market is good, but they also run the biggest risk of loss when the real estate cycle ends.
Key Takeaway:
Significant amounts of leverage can result in attractive returns, but leverage also increases risk. Investors need to assess the returns a sponsor has generated in light of the leverage and risks they are taking.
Fees:
Sponsors don’t work for free; so understanding the fees that they charge is important to understanding the true economics of the investment.
The first level of fees investors need to understand is any selling commissions on purchasing an interest in the investment. Often the sponsor uses a network of investment brokers or “salesmen” to bring in investors. Typically, the individual selling the investment is paid a significant commission which can amount to as much as 6% of the amount invested. Make sure to understand any commission that is being paid to the individual selling the investment. Also keep in mind that high commissions often are an indication of a product made to sell versus a product made to make the investor money.
The second level of fees represent fees charged by the sponsor for acquiring, disposing, or arranging financing for the asset. Acquisition and disposition fees are charged whenever buildings are purchased or sold. These fees are often 1-2% of the property value but can vary from sponsor to sponsor. The sponsor also typically charges an additional financing fee to arrange the loan. The financing fee typically ranges from 0.25%-1.00% of the loan value. Generally, the financing fee percentage should be smaller for larger loans.
The third level of fees represent fees for the ongoing management of the property. The sponsor will typically charge an asset management fee which represents their fee to manage your investment assets within the fund. This fee can be based on multiple factors including the total asset value of the fund, the net asset value (i.e. equity value) of the fund, or a percentage of the gross rental revenue. In a fund where debt is involved, it is important to understand how the fee is calculated because there is a significant difference if the fee is based on total assets versus net assets (total assets minus debt). Asset management fees are typically in the range of 1% of net assets.
In addition to the asset management fee, there will also be property management fees which covers the day-to-day management of the property. Typical property management fees are 2-5% of revenue, but can vary depending on the difficulty involved in managing the assets. A triple net lease investment where the owner has very little responsibility should have a lower property management fee than an apartment building where tenant management is time intensive.
The fourth level of fees are performance-based fees. Most private real estate investments are structured to provide a profit split to the sponsor. The calculation of the profit split is often called a waterfall because it describes how the profits flow to both parties. A typical arrangement is similar to the following:
- The investors receive a preferred return of 6-8% before the sponsor receives any performance-based compensation.
- Once the investors have received their preferred return, any additional return is split between the investors and the sponsor. The split can vary depending on the specific deal, but a very common split is 80% to the investor and 20% to the sponsor.
- There are many nuances to waterfall calculations. Such as:
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- Sponsor Catch-Up: Some waterfall calculations have a catch-up provision where sponsors receive all the profits after investors have received their preferred return until the sponsor is “caught up” to their 20% split.
- Return of Capital: Some waterfall calculations require that all investor capital is returned before the performance split takes place.
- Performance Split Adjustments: Some waterfall calculations have more generous performance splits allowing the sponsor to take a larger share of the profits or may allow the performance split to change if profits exceed a set limit. Generally, real estate investments that require more unique expertise to manage successfully will provide more generous performance splits to the sponsors.
The following graphic demonstrates how a waterfall profit-sharing calculation works.
The fees discussed above are simply an overview of the primary fees that impact investors in private real estate. There are other fees that investors typically don’t see which also impact their return such as real estate commissions when properties are bought and sold.
Given the amount of fees involved with real estate, investors typically are best served to compare the fees on a proposed investment with other similar investments to identify if the fees are in line with market averages. Fees that are higher than normal are not always deal breakers, but they need to be weighed against the value the sponsor brings to the table.
Key Takeaway:
There are significant fees involved in real estate investing. Investors need to understand those fees and compare them to industry averages to understand whether the fees being charged are fair in relation to the sponsor’s skill and expertise.
A Few Other Points to Consider:
Aside from the primary factors discussed above, there are a few points that investors should keep in the back of their mind when considering private real estate investments.
Lockup: Real estate is not a liquid investment. Many sponsors do not allow investors to exit an investment for a certain period of time. Investors need to make sure they understand if and when they are allowed to liquidate their investment before investing.
Time Horizon: Since buying and selling real estate results in significant transaction costs like realtor fees, acquisition and disposition fees, selling commissions, etc., passive real estate investors typically are better off following a buy and hold strategy to minimize the significant fees that occur each time investments and property are bought and sold.
Transparency: If a sponsor is not forthright when asked about their track record, personal investment in the deal, or fees, it usually means there is something they don’t want the investor to know. Investors deserve to work with sponsors who are transparent.
Advertising: If a sponsor is advertising their investment or attempting to attract investors, it is a sign that they don’t have a robust pipeline of interested investors already. There are often legitimate reasons for this, but it is best to understand that many of the best sponsors don’t need to advertise. They have so many satisfied clients who want to invest more money with them as well as word of mouth referrals from those clients, that they don’t need to convince anyone else to invest with them. If a salesman is working hard to sell an investment, at least consider that there might be a reason they have to work hard to sell it.
Tax Reporting: Depending on the legal structure of the investment, investors will have different tax reporting obligations. For example, if the real estate investment is structured as a partnership, the investors will receive a Schedule K-1 which includes the income and expenses they must report on their personal tax return. If the partnership owns real estate in multiple states, the investor may have to file state tax returns in those states as well.
Key Takeaway:
While real estate investing can generate significant value, it is important for investors to evaluate sponsors thoroughly before investing to ensure the sponsor has their best interests at heart.
Conclusion:
Real estate investing has received significant visibility in the past decade as interest rates fell which pushed property values higher. While the increase in values has made many individuals wealthy, it has also created a buzz around real estate that has drawn the interest of many potential investors.
While real estate is a valuable addition to many portfolios, most individuals are best served by investing in real estate passively rather than directly purchasing and managing properties themselves.
With the significant number of sponsors competing for investors, individuals who invest in real estate passively need to understand how to evaluate a sponsor carefully to avoid sponsors who are focused on selling rather than creating long-term value for their investors.
If you are interested in connecting with one of our Family CFOs to learn more about investing in passive real estate and evaluating investment options, we would love to connect to see if what we do is right for you.
