The sponsor quality check examines the person’s experience, track record, and skin in the game and subjects them to the “death by Google” test. In this article, I’ll tackle them one by one!
(As is customary, I am an investor wanting to express my personal views, not a financial advisor. Please consult your financial professionals before attempting to make any financial decisions.)
Important Covid-19 update: This information was posted before anyone realized we were facing a global pandemic. As a result, it may lack the critical information required to make a successful investment today. Some of the material may be ancient, faulty, or irrelevant.
This article is the fourth in a four-part series on how I choose conservative real estate investments for my portfolio. Due diligence can be approached in various ways, and I’ve established one that works well for me. My strategy is challenging, beginning with thousands of deals in my inbox each year. In the end, maybe 2 to 4 of my investments survive.
This series discusses why and what I look at. I value feedback from other conservative investors and will include suggestions in future publications. Furthermore, active investors should find that this assists them in better understanding and assessing the more massive risks they assume. (As a non-accredited investor, much of this information is irrelevant to you.)
Let us begin.
Here’s a basic rundown of the series:
Part 1: Portfolio Matching (takes seconds per deal.) Portfolio matching is the selection of investments with payouts that correspond to the liabilities of an individual or organization. It is a form of commitment strategy in which expected returns on an investment portfolio are matched to pay forecasted future liabilities.
Part 2: Sponsor Quality Check (takes over 15 minutes per deal.) This topic will be discussed thoroughly in this article! Anyone wanting to invest in real estate should recognize that several parties are engaged in completing a project. A transaction may involve multiple parties, including the general partner (GP), limited partners (LP), contractors, financiers, appraisers, attorneys, and others. On the other hand, the deal’s “sponsor” is the most critical player.
Part 3: Basic Properties Due Diligence (takes time for each deal.) This section is about “Pro-forma popping,” sensitivity analysis, and “delay and see.” One of the pitfalls of investing in rental property is that you are also purchasing the seller’s issues. Due diligence in real estate helps you prevent a sizeable financial error by studying as much as possible about the income property you’re acquiring before you purchase.
Part 4: Advanced property analysis (takes time per deal.) This section covers recession stress testing, legal document analysis, and other topics. Advanced property analysis is becoming increasingly significant in our life, allowing for better decision-making by discovering and studying property indicators.
Let us now discuss the sponsor quality check. Are you ready?
After pinpointing my portfolio matching technique in Part 1, I need to get many deals. So, I join up for all of the top-rated crowdfunding platforms (and non-accredited investor offerings).
Unfortunately, the vast majority of transactions on crowdfunding platforms will fail to meet my rigorous due diligence criteria, so I can’t rely only on them. So I’m constantly networking and asking folks what they’re investing in and recommending.
Also, I keep an eye on real estate news and contact companies that appear to meet my criteria. If you don’t have the leisure like me, you can enter an investment club and hitchhike off other people already doing it.
Instead of a trickle of bargains, I now have hundreds in my inbox each month. Then, before drinking from the fire hose, I employ the filtering process described in Part 1 to eliminate 75 percent or more of them (after looking at them for just a few seconds). Following that, I perform my second filtering round on the sponsor.
Anyone wanting to invest in real estate should recognize that several parties are engaged in completing a project. A transaction may involve multiple parties, including the general partner (GP), limited partners (LP), contractors, financiers, appraisers, attorneys, and others. On the other hand, the deal’s “sponsor” is the most critical player.
A sponsor’s responsibility begins early, usually a month or two before investors are even aware of a potential venture. The sponsor frequently finds the deal, whether on or off the market. The sponsor then negotiates the conditions of the buy and selling agreement. They will create investor marketing materials and the equity and loan funding required to acquire (and eventually restore) the property. The sponsor is also responsible for all pre-acquisition activities, including due diligence.
Again, you may be surprised, but I ignore 99.9 percent of the deal even at this stage. Instead, I scrutinize the sponsor and look for meaningful track records and skin in the game.
Why start with the sponsor rather than the deal? According to studies, most talented, inexperienced sponsors perform well as long as the cycle continues. But the cycle will always turn at some time. And if we have a terrible downturn, the mediocre and rookie sponsors will be scrambling to stay afloat, while the experienced and long-term sponsors are ready to weather the storm. As a conservative investor, I’m content to go with a high-quality sponsor with an average anticipated return.
Given the importance of a sponsor, the sponsor must be highly competent. In most cases, the sponsor brings unique expertise to the project, whether it is about the local market or the asset class.
Investors should have confidence that the sponsor has a sterling reputation, a track record of success, the necessary loan, equity relationships, and all other essential skill sets to manage the project throughout its entire lifecycle.
Experience, Experience, and More Experience
I first consider the sponsor’s experience in the deal’s strategy. Almost always, the sponsor (and, if applicable, the crowdfunding platform) exaggerates/overstates their expertise.
They’ll claim things like, “We have 20 years of experience!” That seems like the ideal situation: a sponsor who has withstood many downturns. When you delve deeper, you’ll see that they’re adding up to four people with five years of expertise. These types of sponsors have no prior downturn experience.
Another common occurrence is that one individual had 20 years of real estate experience, but they were doing something extremely separate. Two decades of experience insuring hotel agreements for a bank isn’t particularly beneficial or remarkable when their new position is managing a fund that buys and renovates mobile home parks. So, I always look into things thoroughly, especially if there is even the slightest hint of ambiguity.
Once I determine how much expertise I have in the given method, I must decide whether or not it is sufficient.
Every month, there are hundreds of competitive deals in mainstream asset classes and strategies such as multifamily, office, and retail, which I take advantage of. I will not accept a sponsor until they have completed at least one cycle and have not lost any money. (Like the three most experienced fund manager All-Stars, I prefer an audited track record, although there are several perfectly valid old-school single property funds that were not generally handled in this manner.)
I can’t be as picky with other asset classifications. For example, while mobile home parks are a relatively new “found” business, there aren’t many deals available, and it’s impossible to locate someone with full-cycle experience. So, I consider stuff like that.
When you talk about a person’s, company’s, or product’s track record, you’re referring to their previous performance, accomplishments, or failures. Are they good? Do they pass your requirements? The majority of agreements will fail the last filter. But if they do, I look at their complete track record.
Again, most sponsors (and crowdfunding sites) will inflate this, so you must go deep. Many will claim, for example, “we have great x percent historic IRR over 50 deals!” However, as you go down, you will notice that they are just presenting their completed deals. Because they can’t be ended without losing money, bad deals generally sit on the books for years. As a result, it’s critical to grasp the type of track record you’re looking at and to force them to give extra information if they haven’t already.
It is critical to obtain a list of all available deals rather than relying solely on an average. A gain, I want to see at least one whole cycle experience and no investor money lost in a primary asset class and approach. During great times, anyone can make money. Still, I’I want to know if adversity has tested them and what transpired there.
I look at how much skin the sponsor has in the game. (The amount of money they are investing alongside investors.) What is the significance of this? Paul Kaseburg has been on both sides of real estate transactions totaling more than $1.7 billion. He illustrates that the industry’s secret is that every sponsor says their performance-based incentive aligns with you.
However, it does not. (See Part 1 of Black-Belt Real-Estate Strategies from Investment by Paul Kaseburg.) They benefit disproportionately if the fund performs well, but you bear all the risk if it does not. This movement encourages risk-taking, which no conservative investor likes to hear.
In other circumstances, the sponsor, like an investor, may reduce this risk by putting a significant amount of their own money into the venture. Then they share the downside risk with investors, which checks the incentive to increase risk.
However, as is customary, many sponsors/websites will inflate the amount of skin in the game. Cash is the actual skin in the game and is invested on the same terms as investors. However, if you dig deeper, you’ll often discover that they didn’t put any money in but rather a “fee” that they collect from fund investors. While it’s nicer than nothing, it’s not much of a deterrent to excessive risk-taking.
Some sponsors, for example, will offer hundreds of funds on the market while putting no real money into them. Even if only a tiny percentage of them do successfully, they will profit tremendously even if every other fund fails. It’s a different scenario if you’re invested in a failed fund. I’m looking for money, not a fee.
Another ruse is that they will put money in on different terms than regular investors. For example, they may receive a higher preferred return than you or engage more effectively. In situations like this, I have to ask myself, “If you’re not prepared to invest in your fund on the same terms as me, why should I?” Those are red flags in my book. Regardless of your view, it’s critical to inquire and understand whether the skin in the game is in cashing in on the same conditions as investors or not.
Are they willing to be scrutinized (or do they “lawyer up”)?
No investor, including me, understands everything. So, if I’m serious about investing, I’ll always run it by other members of a high-quality investment club. Often, someone has pointed out a minor detail or fact that I had overlooked, saving me from making costly blunders.
To see the specifics of the investment, sponsors will always ask me to sign a nondisclosure agreement (NDA). However, I’ve discovered that most trustworthy sponsors make an exception for those that advise me on my investment (including not just licensed professionals but also my spouse, business partners, and an investment club). This is especially true in an investment club when everyone is sworn to confidentiality by an NDA.
Regardless, I always advise the sponsor that I intend to share the information with club members. This approach is made as a favor and also as a test. Most people have no issues with it and pass the test. (Many of the sponsors of the more appealing deals will be enthralled by the prospect of referrals.)
However, approximately 2% will “lawyer up” and claim that you cannot share information with anybody else. In the past, I’ve given these corporations the benefit of the doubt, assuming they were overly cautious legally. But when I delved deeper, I usually found something either horrible or tragically wrong (regarding the deal itself or the sponsor). I’ve stopped bothering with such sponsors after 9 or 10 times. If my peers refuse to be evaluated, I consider it a red sign and carry on.
“Death by Google”
I Google anything I can think of about the sponsor to find any dirt. This step may appear simple, but it takes time to master.
I usually begin with the simple ones, such as “sponsor name> fraud”, “sponsor name> ripoff”, and “sponsor name> lawsuit”. If there are a lot of controversies, I usually pass. They may get smeared, but I usually believe I don’t need to take the risk because another sponsor with a clear brand is doing something similar.
I also double-check all of the principals’ names. For example, one principal I discovered had been named in a local newspaper as being involved in a property tax evasion incident. Several have received fines for client fraud from FINRA (Financial Industry Regulatory Authority). The SEC is another valuable place to look for any actions.
I also look at reviews such as Yelp, Glassdoor, and others. I learned a lot of inside knowledge about sponsors running substandard businesses in this manner.
According to Glassdoor, most evaluations are positive, and the same characteristics that make the sites beneficial to searchers also make them essential tools for recruitment.
I check any claims made by the sponsor. One sponsor, for example, claimed to have written a thesis before graduating from Harvard Business School, while in fact, he had only received a certificate from a 4-5 week program. Some investors ignore such details since they believe all sponsors are salespeople! There are salespeople with ethics, and I only do business with them. I also use the “roach test,” which states that if I identify one ethical flaw in open sight, I know there are potentially hundreds more hidden in plain sight.
This test may have ruined some profitable investments, but it’s also spared me from some disastrous situations.
It doesn’t take long to complete the tasks listed above (about 15 to 45 minutes, depending on how much probing I have to do and back and forth with the sponsor). And it usually eliminates around 90% of the deals.
If an investment makes it through this, I finally get psyched. Perhaps this is one of the gems, and it’s worth investigating more.
Research can provide solutions to previously unknown questions, bridge knowledge gaps, and change the way people should act. We have our phase to achieve this step. Don’t be pressured, and calmly proceed to each step with caution. You can do this!
Part 3 will go into greater detail regarding this.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.