And that’s exactly where this post comes from, which was originally published on Passive Income MD.
Take it away, Peter!
3 Important Things to Know About a Sponsor Before Investing
If you’re thinking about investing in a passive real estate deal, whether it’s a syndication or a real estate fund, it’s important to learn how to vet the opportunity properly. That way, you know exactly what you’re investing in.
Note: in case you’re not quite sure what I’m talking about, do a quick read on syndications and funds in this post.
In reality, it takes study, time, and experience to learn how to vet a deal properly. I’ve looked at hundreds of deals over the last few years, and I know it can feel very intimidating at first. If I’m truly honest, for the first few I invested in, I just followed someone else I trusted. I sort of crossed my fingers and hoped for the best.
Now I know much better than to do that, and I’ve found that learning how to choose deals effectively helps you invest in deals that will help you get closer to your goals. It will also help you avoid deals that might take you farther from those goals.
Vet, Invest, Then Rest
These types of real estate deals are often referred to as passive deals. That’s because you’re investing as a “limited partner,” which means you have equity (a piece) in the deal, but it’s really the sponsors or operators who are doing the heavy lifting. They’re the ones managing and operating the deal in order to create returns.
You vet the sponsors and the deal. Then you invest. And then you sit back (rest) and wait for returns.
I find that this is exactly what many physicians want. They don’t have the time, expertise, or desire to actively manage an investment property.
Personally, I think it’s a good idea to diversify and consider having your hands in both, but I can completely understand why a busy professional would choose one way or the other.
Knowing that all the work is done up front to vet these deals, you should definitely know how to vet properly and thoroughly. Isn’t it worth it if you’re investing $25,000 or $50,000 (at least)? The potential returns are well into five figures, so I’d say it’s worth your time.
Again, you have to learn to identify what a good deal is. But maybe more importantly, you need to know when a deal is bad.
Given the value of the vetting process, I thought I’d discuss three things you must know about the potential sponsor you’re investing with.
* Be sure to check out my free download at the end of this post.
Their Track Record
The first thing to ask yourself about a potential sponsor is simple. How have they done in the past?
Have they done a good number of deals? Have they ridden through some hard times and learned what to do?
Because when it comes down to it, the sponsors are the ones who will be piloting the plane. Sure, they know where they want to land, but if stormy weather comes and there’s turbulence (which is almost guaranteed in anything in life), will they be able to expertly navigate through it?
Of course, when you fly, you don’t care about the experience of the pilot until things start going bad. But you don’t want to wait until that point to know who you’re putting your trust in.
As an anesthesiologist, I can identify with this. People often don’t care about our credentials (or even name) until something goes wrong. However, they should care who is expertly managing them during this critical period in their lives and feel comfortable with me as their physician.
You should feel comfortable doing the same with the sponsors. Do not glaze over this.
How They Mitigate Risk
It’s important to make money, but I feel it’s way more important to not lose money. You worked hard for that money and sacrificed time with your loved ones. The last thing you want to do it have it poorly managed.
Again, in great economic times, most every sponsor ends up looking great. But the truly great ones will do a better job managing the downside when the economy is poor or when things go unexpectedly.
So it’s important to understand how the sponsor is mitigating risk. How are they preparing in the case of an economic downturn (as everyone is predicting)?
Are they using conservative projections? Are they taking on financing in a responsible way?
These are all things you should be asking and feeling comfortable about before investing with any sponsor.
What’s In It For Them?
The third thing you should understand is the incentives of the sponsor, and how well they align with your interest as an investor.
Basically, the deal should be structured so that they win really only when you win. This might seem obvious but you’d be surprised.
Once you dig into the fee structure of a deal and figure out how some sponsors are getting paid, you might find that they’re more incentivized to take on as many deals as possible rather than making sure that each deal provides the best returns for investors.
You might also find that the sponsors’ payouts are structured in a way that they’re incentivized to take big risks because they only do well if they hit home runs. Personally, I’m not investing in real estate deals for home runs – boom or bust. That’s what angel investing is for.
I’m investing in deals for a good balance of cash flow, appreciation, and tax benefits. Having gone part-time, I rely on these funds for my daily living, so I’m not looking to only get into deals that encourage huge risk-taking.
How To Get These Answers
So how do you figure this all out? Well, you have to dig into the details of the deal.
What are the projections they’re making and are the conservative? Have their projections been accurate in the past? What are the different fees involved? How and when do you, the investor, get paid? How and when does the sponsor get paid?
Ultimately, learning all of these things helps you gain confidence in the deal. And if you don’t achieve that confidence, then simply don’t invest. It’s all about trust. These are things that don’t come about by looking at a deal for a few minutes or simply following your friends and hoping for the best.
It comes by spending time educating yourself on the topic and applying that knowledge to gain experience. You’ll get better and better with each deal you look at, and you’ll gain more confidence in the process all along the way.
Want to know what the “experts” think you really need to know when vetting a deal? I asked 10 of them to answer this exact question:
“What’s one question that an investor should be asking a sponsor (but often don’t)?
What other things are important to know about sponsors? Let me know below.