How LPs Evaluate Real Estate Equity Investments
When it comes to making an equity investment, real estate investors typically spend weeks, if not months, performing due diligence. There are many factors to consider when making an investment into real estate. Some investors focus on “location, location, location” and are quick to pull the trigger while others want to dig deeper into the fine details.
More experienced investors typically create a structured due diligence process that touches on all facets of the investment. This process usually includes analyzing the sponsor (lead investor that controls the deal), capital stack, asset type, location, market demographics, risk/return profile, hold period and tax consequences. Whether you’re new to real estate or have decades of experience, the due diligence process usually starts with the sponsor which is where we will focus today.
Below are several key factors to think about when it comes to choosing the right sponsor to invest alongside.
An investor’s primary due diligence should lie with the sponsor. Investors should ask themselves, “why should I give my money to this sponsor?” There are thousands of investment vehicles out there and it can take quite a bit of time to find the right one. Investors can (and have) uncovered what seem like tremendous investment opportunities, only to be disappointed by an inexperienced sponsor who takes a “down the center of the fairway” investment and drives it straight into “the rough”. Investors should ask themselves:
- Who is the sponsor?
- What is their secret sauce?
- Do they have a strong and verified track record?
- Are they capable of assessing risk?
- Do they have experience in this particular asset class, market or strategy?
Some investors set a baseline on the amount of assets under management a sponsor should have, which can start at $25mm, $50mm or even $100mm. Investors will often also want to see several successful exits for the same business plan, property type, or location. There are an endless amount of questions to be asked and investors should try to uncover as much as they can about the sponsor that is leading the project.
Next up is the business plan. Investors should understand what the sponsor plans to do, how they plan to do it, how long it will take, and what risks they might encounter along the way. Sponsors should have detailed pro-formas that show how they plan to provide investment returns for investors over the duration of the deal. Business plans take years to perfect and it’s no coincidence the most experienced sponsors tend to have the most detailed business plans. Investors should be wary of plans that look like they were thrown together last minute or solely for the purpose of attracting investors. Pro formas should at the very least match the duration of the proposed investment. For example, a 5 year investment should have a pro forma that extends out at least 5 years and should show possible exits under various market environments. A business plans is the lifeblood of the deal, and if the sponsor doesn’t take it seriously, an investor should dismiss that sponsor.
Alignment of Interests
Investors should also be aware of how much “skin” the sponsor has in the deal. Sponsors that recoup their investment only through acquisition or other fees should be avoided, because they have nothing to lose if the deal goes awry. Generally, sponsors should contribute a minimum of 10% of the equity, which usually equates to at least 2.5% of the total capital stack, assuming ~65% debt. Sponsors also typically take a share of the profits above a certain hurdle (typically 8–10%). Investors should ensure the sponsor has real capital invested in the deal and is incentivized to make the deal perform.
Use of Leverage
Sponsors incorporate leverage into a deal in many ways; most often it’s used to increase returns. Some sponsors are more conservative and have a senior loan at or below 60–65% of the stack. Others are more aggressive, incorporating layers of senior debt, junior/mezzanine debt, and preferred equity. Each sponsor has their own reason for including debt and investors should understand the cost of that debt and the risk that an under-performing levered asset can drastically impact their invested capital returns.
Lastly, if investors have done their diligence and invested their capital, what would come next? Does the sponsor plan to keep the asset indefinitely, or sell the property once it hits a certain return target? There are many strategies out there and not every one aligns with the investor’s particular interests. There are also tax implications that could affect a sponsor’s exit plan. So, regardless of the plan, investors should fully understand what the sponsor’s exit plan is, how they achieve that exit, and what risks are out there that could derail the exit plan.