The success of a multifamily real estate investment is highly dependent on the team managing it, also known as the “sponsor.” The sponsor is responsible for all aspects of the deal, including sourcing and underwriting, making investment decisions, managing operations, and ultimately selling the property. In private investment structures, the sponsor is typically the General Partner (GP) and investors are Limited Partners (LPs).
There are hundreds of established sponsors with large portfolios, so selecting one to invest with can be a daunting task. There are even more smaller-scale investors focused on smaller properties. The property or portfolio of properties is important, but the quality of the sponsor is a critical variable that materially impacts the risk of the investment. An inexperienced sponsor can cause even a great asset to underperform, while an accomplished sponsor can maximize value and navigate market challenges.
Whether you are new to investing in private real estate offerings or are an experienced LP, asking the right questions is a crucial first step to conducting thorough due diligence. This list of questions covers critical areas, from deal strategy to the sponsor’s background and operational professionalism.
Business Plan & Strategy
- Can you clearly explain how you will create or capture value at this property?
- The sponsor should be able to articulate a clear and compelling narrative for why the investment is attractive and how they will create value.
- Are your operating assumptions grounded and conservative?
- Can the sponsor support their projections based on today’s data and conservative estimates for the future?
- What is your primary method for sourcing deals?
- Does the sponsor have a competitive advantage in sourcing off-market deals and securing proprietary deal flow? How will they stand out against other buyers?
- What is your asset management strategy?
- Beyond routine maintenance, can you provide specific examples of how you actively manage properties, such as adjusting pricing strategy; setting, and holding operations teams accountable to the budget; and navigating capital improvements?
- Is your exit-capitalization rate (valuation) reasonable and supportable?
- Beware of sponsors underwriting lower cap rates than current market transactions. In these cases, underwritten returns are derived in part through capital markets speculation rather than fundamental income growth at the property.
- What is the exit plan and what liquidity options exist?
- Has the sponsor thought of alternative exit options if market conditions change? They should be able to explain stress testing (sensitivity analysis) around projected exit values, and provide debt terms suitable to capitalize on market conditions at the opportune time. Ask if there is a mechanism for secondary market sales (to liquidate your interest in an active deal).
Experience & Track Record
- Do you have relevant experience?
- Can the sponsor provide examples of past deals that are similar to the current offering in terms of sector, strategy, geography, and size? How did the actual outcomes compare to the original projections? Deviation outside of a sponsor’s expertise is a red flag.
- Is the team structure appropriate for the new offering?
- Does the team’s capacity support the successful sourcing and managing of this investment? Think about key-personnel risk and the capacity of the sponsor to effectively manage the increase in responsibilities – especially in new markets.
- What is your track record?
- Ask about the Distributions to Paid-In-Capital (DPI) and estimated Internal Rate of Return (IRR) for active partnerships, and the realized IRR and Equity Multiple (EM) for sold properties. For both, check that the deal profile is relevant to the proposed offering. Past performance is no guarantee for future success, but it is a relevant data point to assess a team’s ability to execute full-cycle investments.
Alignment, Fees & Structure
- Are your fees and carried interest appropriate?
- How do they compare to industry standards? As a rule of thumb, alignment is better when the sponsor’s compensation is derived more from “carry” (upside performance) rather than fixed or upfront fees.
- How large is the sponsor co-invest?
- Are our interests aligned? The more cash equity a sponsor contributes to a deal, the more “skin-in-the-game” they have in the investment’s success. Also, “rolling” fees into the deal is a plus, but is not a replacement for cash contributed. Look for cash contributions in the 5%-15% range.
- Are the returns appropriate for the leverage contemplated?
- Higher LTVs and/or floating-rate debt should command higher expected returns, all else equal. The higher the leverage and cost of debt, the lower the debt-service-coverage-ratio, and the more the principal is at risk. Also, longer loan terms create more runway for potential operating income growth before a required capital event (sale or refinance). All else equal, a 10-year loan is safer than a 7-year loan, just as a 5-year loan is safer than a 3-year loan.
Operations & Investor Relations
- Any past or pending sponsor litigation?
- Litigation could signal legal troubles or unethical business practices.
- Are the reports, distributions timely and of the highest quality?
- Consistent, high-quality reporting should be expected as a passive investor. Look at samples of previous reports. You want a team that provides an honest assessment and does not bury bad news.
- Is the IR team accessible if I have questions?
- A responsive Investor Relations (IR) team is important for getting clear answers and support when you need them. No one likes to be left in the dark. An accessible IR team is vital in long-term, illiquid investments such as private real estate.
- Have you ever been late providing K-1s?
- Late tax documents can create filing headaches for investors and can reflect lack of back-office organization.
- How is the NAV determined?
- The Net Asset Value (NAV) is the equity value of your investment. On what cadence is it updated? Are market values informed by 3rd-party opinions such as an appraisal or broker opinion of value (BOV)? Especially when shares trade on a secondary market, you do not want a sponsor who is either under- or over-reporting fair market NAVs.
- Have you ever issued a capital call?
- If so, why, and what was the outcome? A capital call can be warranted, and ultimately the best decision for the partnership. However, multiple capital calls indicate a lack of operating expertise and a theme of overly-optimistic underwriting practices.
- Is the management team known for integrity?
- Ask to speak to current investors. Trust takes years to build and only a moment to lose. Sponsor integrity should never be a risk variable for your investment.
- What is the reputation of the property management company?
- This is relevant particularly if the company is vertically integrated. The returns from the investment partnerships matter, but should not come at the cost of poor resident experience. Ideally, you want to have pride in your investment sponsor, and know that they are providing a great living experience for their residents. You can verify this by checking their properties online “star” rating, or their industry “reputation score.”