Selecting the right sponsor is a key step toward investing in real estate properties that fall under the commercial category. Since the sponsor will serve as your acquisition coordinator or developer, financial manager, and investment partner for as long as you hold the asset, it’s important to screen your prospects carefully and thoroughly.
Before embarking on your search for a sponsor, however, make sure that you have a solid investment strategy in place. With a disciplined investment strategy, you should be well-equipped to answer these questions: What kind of financial investment do you want to make, and what type of real estate asset do you want to invest in? You should also be able to articulate how your real estate investment aligns with your overall values and financial goals.
Finding Your Place in the Capital Stack
First, determine where in the capital stack you would like to put your investments. Less risky debt instruments such as senior and mezzanine loans lie at the bottom of stack and offer more assured, if also more modest, returns for the investor. As a debt lender, you will be the first investor to receive payment, even if the property loses value.
If you are willing to take on greater risk for greater potential returns, consider looking higher in the stack at equity investment options. As an equity investor, you must wait for other investors such as debt lenders to receive payment before you can start collecting profits. However, there is theoretically no cap on your return potential—in terms of both cash flow and market appreciation—if the property does well.
Real estate partnerships typically structure equity agreements around the concept of preferred returns. All investors receive a preferred return until they reach an agreed-upon annual return threshold (for example, 10%). Beyond this threshold, remaining profits are distributed according to each investor’s allotted share. The sponsor earns a disproportionate share of the profits (for example, 30%), with the rest of the returns distributed among passive investors pro rata. The sponsor’s disproportionate share—also known as the promote—represents a form of compensation for the greater risks and responsibilities assumed by the sponsor over the course of holding the asset.
Choosing a CRE Property Type
Once you have determined your comfort zone in the capital stack, consider the type of commercial real estate (CRE) property that you want to add to your investment portfolio. Understanding the unique benefits and challenges of each property type is your key to making an informed choice.
Multifamily properties consist of multiple units occupied by different households. Examples include apartment buildings, student housing, assisted living facilities, and senior housing.
Multifamily buildings require a lower initial investment than other CRE property types, which can make them suitable for beginning investors with less up-front capital and some familiarity with managing a residential property.
This group describes buildings leased to businesses such as financial institutions, law firms, technology companies, and medical and dental offices. Relative to multifamily properties, office buildings offer greater profit potential in return for a higher up-front investment. Many office rental contracts contain an agreement known as the triple net lease, in which the tenant pays property taxes, insurance, and maintenance bills—on top of monthly lease payments.
Although office buildings enjoy low vacancies, remember that if a tenant does move out, you will probably need to factor in the cost and effort of refurbishing the unit for a new occupant.
The buildings in this property group house stores for clothing, electronics, and other consumer products. Restaurants fall under a special subcategory of this type.
Although the rise of e-commerce has driven some brick-and-mortar retail stores out of business, the market still looks promising for high-end shopping promenades and lower-end malls anchored by a big-box retailer such as Walmart.
This category describes properties of various sizes designed for industrial uses such as research and development, manufacturing, and warehousing. The industrial market continues to benefit from the rise of e-commerce, as retailers add more merchandise distribution centers (DCs) to their supply chain.
Other upsides of industrial buildings include their lower cost of entry (relative to office and retail) and reduced build-out requirements. Downsides include higher turnover rates and the increased risk of leasing out single-occupancy buildings.
Other CRE property types
Hospitality refers to properties like hotels, amusement parks, and golf courses. Since these properties function both as real estate and a business, they tend to offer good yields and are thus viewed favorably by lenders.
Mixed-use developments, also known as live-work spaces, are pedestrian-friendly urban developments that blend residential, commercial, cultural, institutional, and entertainment uses. Different zoning rules can apply to a mixed-use development depending on the municipality, configuration, and use type of the property.
Finding the Right Real Estate Sponsor
In addition to sharing in the investment, a sponsor typically assumes responsibility for finding, acquiring, and managing the property asset on behalf of other investors in the partnership. A sponsor can be an individual but is more often a firm that specializes in real estate private equity and investor relations.
Given the significance of the role that your sponsor will play throughout the lifecycle of the investment, it is critical that you perform due diligence in carefully researching, interviewing, and vetting your list of candidates. As you go through the screening process, consider these essential qualifications.
Company track record
First and foremost, you’ll want to establish that the firm has a solid investment history and record of success with CRE holdings. Ask to see documents that detail the company’s portfolio holdings, operating history, and financial results. A reputable sponsor will readily furnish this information to you upon request.
As you examine the data, look for indicators of stability and reliability in the sponsor’s performance. Has the company delivered consistent average returns across all its investments, or do results fluctuate from year to year? Does the company have experience with a broad variety of property types, or does it specialize in a certain market, niche, or geographical area?
A good firm will have the data to back up its reputation as an experienced, trustworthy, and successful sponsor of CRE investments.
Alignment of interest
It’s also essential that the sponsor’s goals and self-interest in the investment align with your own.
To ensure alignment with other investment partners and engagement with the success of a project, a sponsoring firm should be investing a significant amount of its own capital in the asset. Furthermore, the company should be motivated to earn the bulk of its compensation through actual investment returns, as opposed to transaction fees.
In short, a truly aligned sponsor should win when its investors win and lose when its investors lose.
Networking and negotiation skills
The CRE industry has traditionally depended upon face-to-face relationships—between sponsors, investors, underwriters, brokers, property managers, and other professionals engaged in the profitable negotiation and management of an asset.
The principal of your sponsoring firm should have strong interpersonal skills and an extensive network of associates, family members, and other valuable connections that he or she can go to for resources and support. When you meet the principal in person, try to gauge his or her negotiation style and discover how skilled he or she is at closing favorable (and ethical) deals.
Once a deal is settled and the new asset has been added to the portfolio, how will the sponsor manage the investment? Does the sponsoring firm handle property management in-house, or does it outsource those duties to a third-party vendor? And does it have a strategy in place for periodically evaluating the portfolio’s performance and making corrective adaptations to the market when needed?
Look for a company that safeguards the overall portfolio against losses and seeks to boost its value by increasing net operating income. Also, look for a sponsor that has the financial know-how to adjust for variables such as expenses, inflation, property taxes, and interest rate.
Sponsorship fees and compensation
For a comprehensive outline of the sponsor’s fees and terms of compensation, ask to see the private placement memorandum (PPM). In addition to information about compensation, a PPM typically discloses the firm’s background, the terms of agreement between the sponsor and the investor, and the risks of specific investments.
As mentioned earlier, most of the sponsor’s compensation should come from an agreed-upon share of the overall investment earnings, known as the promote. This incentivizes the sponsoring firm to maximize its own performance and keep its investment goals in alignment with yours.
Besides the promote, you can expect to pay your sponsor an assortment of transaction fees associated with the administrative costs of handling a CRE deal. These costs typically amount to a few percentage points of the property’s sale price and may include acquisition, committed capital, investment management, setup and organization, debt placement, refinancing, and wholesale marketing fees, among others.
Communications and digital platform
Last, but not least, consider how you expect to receive communications about your investments. Do you prefer paper or digital statements, or an option to receive both? Will the sponsor report information about your portfolio’s performance on a quarterly or monthly basis? Or does the firm have a digital platform that allows you to access and monitor your portfolio account at any time of day or night, from your device of choice such as a desktop computer or smartphone?
As an investor, it’s important for you to receive timely and accurate information about your holdings. A good sponsor will not only communicate updates to you regularly and transparently, but also ensure that you have a way to access your account information whenever you need it, wherever you are.
The final move
After you have gathered the relevant information and met the top candidates in person, follow up by checking references. Speak with current or former investors, as well as professionals such as brokers, accountants, and attorneys that have worked with the sponsor before, and find out what they have to say about their experiences.
When you feel confident enough to finalize your decision, you can begin the long-awaited working relationship with your new sponsor by asking to see a list of current CRE offerings.
We hope you find this article insightful and meaningful. Our team is available to assist you with your real estate financing and capital solutions. We look forward to the opportunity to serve you in the near future. You can reach us or call us here!