When you begin passively investing in syndications, you’ll often hear about the importance of vetting a sponsor. I’ve heard it for years, and I understand the underlying perspective. A great sponsor should be able to get more out of a deal than an average sponsor, while a bad sponsor can turn a promising deal into a bad investment. However, the challenge with placing such a strong emphasis on vetting a sponsor is that it tends to undervalue the deal, or assumes a good sponsor can turn any deal into a profitable one.
If the current market correction has taught us anything about commercial real estate, it’s that well-structured real estate will maintain its value. While a good sponsor is likely to only pursue sound deals, there are certain areas of analysis that I categorize under “deal analysis,” even if they fall within the realm of sponsor decisions.
The common rating system — Class A, Class B, Class C, etc. — is highly subjective. While many investors associate high crime areas with lower class designations, defining “high crime,” or even determining what constitutes high or low income, can vary widely.
Because one person’s Class B might be another person’s Class D area, I focus on examining the average incomes of the immediate area. I like to see median household incomes of $75,000 or more. This figure generally determines what type of area the property is located in. For instance, a sponsor may tout a property as a great Class B in a Class B area, but if the median income is only $40,000, it raises questions about the area. Is it relatively urban/suburban with high crime rates, or is it rural, prompting concerns about demand dynamics from tenants and potential buyers upon exit?
Generally, income provides residents with choices, such as selecting a residence based on school district quality, proximity to employment or entertainment areas, or the desired level of safety in the neighborhood.
Moreover, higher incomes lead to greater price elasticity, particularly when it comes to rent bumps or renovation premiums.
Given the recent market slowdown, many sponsors are holding onto assets for a more extended period than they initially intended. Longer holds increase the likelihood of encountering unbudgeted CapEx. Even if immediate repairs aren't needed, buyers are increasingly seeking higher CapEx allowances from sellers as they plan for longer-term holds. While the option to sell before CapEx becomes a concern still exists, it’s becoming less likely.
As such, I am seeking groups who intend to sell within five years but are planning for holds exceeding 10 years. For example, if roofs are expected to last another 10–15 years, I wouldn’t necessarily expect to see a roof replacement in the five-year CapEx budget but would expect it in the 10-year CapEx budget.
This approach involves a sensitivity analysis of longer-term CapEx items. Are there sufficient reserves to cover these costs? How will it impact overall returns?
It is front-page news that a surplus of floating-rate three-year-term loans taken out in 2021 is causing substantial cash flow issues for sponsors holding those assets. However, even some fixed-rate loans are contributing to cash flow challenges for operators. Why? Because many sponsors take on interest-only loans. Even with long-term fixed-rate loans (typically 10 years), the initial five years often involve interest-only periods. Consequently, assets bought in 2019 are now entering amortization periods, significantly impacting available cash flow.
Similar to the CapEx risks listed above, a comprehensive loan term analysis is crucial for assessing the deal. Will the net operating income (NOI) during amortization still be adequate to maintain distributions, and at what level?
When assessing any investment, particularly in the wake of the current market correction, understanding the nuances of the deal will help mitigate a lot of the risk. Sponsors may evolve their business plans or deal execution strategies over time, making relying solely on track records and past deals insufficient to grasp current deal structures.
At the end of the day, comprehending the specifics of the asset and its structure serves as a significant risk mitigation measure in your investment. So, while you should spend time vetting a sponsor, I would argue that the actual property — the purchase price, submarket strength, current condition, and financing — will make a bigger impact on your final investment than the sponsor of the investment vehicle.
About the Author:
Evan is the Director of Investor Relations for Axia Partners, a diversified real estate fund operator, focused on recession-resilient assets. With over 16 years of real estate experience, Evan spends his days working with investors to understand their investment goals and backgrounds better Please feel free to connect with Evan on LinkedIn, where he shares his insights into the syndication space.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.