In previous posts regarding the LP / GP Relationship and how the GP is compensated above their pro rata share, it's clear that an investment in a physical asset is only as strong as the Sponsor backing that investment. Put simply, investment returns are as much dependent on the asset you are buying as the Sponsor who will be managing the operations and executing the business plan.
There are no shortage of good pieces of real estate to own and similarly, no shortage of Sponsor's actively pursuing those deals AND the required equity (an LP) to invest alongside them in that deal. As one large fund manager explained to me, "We take your 35% IRR and solve to an 8%. We adjust your assumptions such that, no matter how good of an Operator you are, we remove most (but not all) operational risk from the deal. If we can meet that return, we are then confident enough in the asset to move forward with an investment." This fund managers approach, to put it simply, it to underwrite both the Operator and the asset separately.
Underwriting the Asset
Forecasting the future performance of a piece of real estate is straight forward in practice (see: "napkin math") but in practice it's a much more complicated process that is constantly evolving. Both the Sponsor and the Limited Partner must consider realistic underwriting assumptions that are reflective of both the current and future environment, especially those related to revenue and costs. I'll touch more on these various levers in a later blog post, but know that projected rates of return can vary tremendously through even the most modest adjustments to growth rates and debt assumptions.
Underwriting the Operator
For the money partner, having certainty that the Sponsor can effectively execute on its business plan (i.e. running a property) is equally as important as the property itself. In an environment with no shortage of Sponsors, what should you look for when underwriting the Sponsor?
Their Track Record: A Sponsor's track record is more than just their average IRR and equity multiple over their last 10 deals. How do those returns compare to their initial underwriting? A track record is not something you can hide, but it is certainly something you can be disingenuous about. Remember, case studies typically only highlight their best projects. Always dig deeper and try to understand the drivers of their past performance (a rising tide does indeed lift all boats).
The Downturn: The collapse of the real estate market (and economy) in the late 2000's was unforeseen by most investors. At its depths, some prospered, many survived and others went down along with it. What happened to the Sponsor during the downturn is not of particular interest, but rather how they responded to the events is a greater indicator of their character. What mistakes did they make, how did they handle them at the time and, in retrospect, what did they learn?
Their Mistakes are Their Strengths: Mistakes occur in all real estate cycles and not just downturns (see #2). Next time you're interviewing a Sponsor, ask for an example of a recent mistake and how they addressed it. Do they balk and give you a roundabout answer, suggesting they've never made a mistake and everything they touch turns to gold? If so, then run. If they can walk you through what happened, what they learned and what systems have been put in place such that those mistakes aren't repeated - that's a Sponsor worth working with.
The Right Team: Managing an investment in real estate a Sponsor is an involved process. While the captain at the helm certainly sets the direction of the ship, it can only move forward if all of the necessary crew-members are doing exactly what they are supposed to do. Does the Sponsor have a strong property management and construction management division? Is marketing handled in house or contracted out? What is the depth of their accounting and finance department?
What else? We'd love to hear your thoughts about what you look for in a competent Sponsor. Contact us and let us know!