When you’re a passive investor in a real estate deal, one of the first tips you’ll receive is to invest with groups with strong track records. This advice is very sound. A strong track record shows that the sponsor has completed successful deals in the past, which implies they have been able to do what they say they are going to do and can continue to execute the current deal. However, that great historical return may be hiding a lot of missteps. As such, it is always good to dive into the details of each sponsor’s track record before you decide to invest with any group. Here are some of the most important questions to ask before investing with a new sponsor:
I work in the syndication space and am also a limited partner with various sponsors. When I am assessing any new sponsor, this is always my first checkpoint. Is the sponsor I am considering sharing gross returns or net to LP returns?
Gross returns will always be higher than net to LP returns because fees and carried interest are not taken into account in gross returns. As an LP assessing a sponsor’s track record, I only really care about the returns that the sponsor has provided to their prior LPs. If I see gross returns, I assume that the sponsor is trying to hide potentially onerous fees or carried interest. I, personally, do not invest in any groups that default to sharing gross returns.
Some sponsors may share case studies instead of overall historical returns. Case studies are typically a sampling of deals and not a full track record. If that is the case, the sponsor may have lost money on deals and simply chose not to share those as case studies.
However, even if they are showing historical returns or overall returns (there is no universal description), these returns could still be of select deals or potentially an average of all deals, both of which could be hiding a mixed bag of returns when looking at every deal on its own.
When you’re looking at a sponsor’s track record, you could ask for confirmation that the track record provided includes every deal the sponsor has ever done. Or if the sponsor provides an average, you can ask for the details that flow into that average, in order to understand if the sponsor is able to generate consistent returns or if there are a few outliers that bring up the average of an otherwise less-than-stellar track record.
As an LP myself, I have been to many sponsors’ websites and viewed many track records. I have seen groups advertise that they have completed 50 deals with an average track record of, say, 30% net IRR. And let’s assume I am assessing a sponsor of large apartment communities. However, when I look at the track record and dig into some of the assets listed, I find that 15 of those 50 deals were single-family fix-and-flips, or another asset class altogether. These types of assets do not align with the current investment opportunity, so I don’t count them towards their experience.
When you’re looking at a track record, you should be spending a little time digging into each asset. If the detailed returns of every deal listed are tightly clustered together — for example, all ranging from 18% net to 22% net — there is no value in asking for details on each asset. But if you are seeing some deals that yielded low single-digit returns and others that yielded very high returns, you can ask for those details. Additionally, if you are seeing hold periods that seem to be all over the place, this too can be reflective of vastly different asset types.
Like the prior question, I want to see the track record of deals that generally align with the current investment offering. For instance, if I am investing in a value-add multifamily deal, and the track record is in multifamily development, those could be vastly different areas of expertise and execution. Unlike the question above, in this example, the sponsor has always been focused on large-scale multifamily properties, however, the business plan has changed within this asset type.
You could ask the sponsor how their business plan has changed over time and if the returns reflected on the track record are showing those changes.
As noted in the first question, I look for net returns exclusively, in both track record and projected returns. If the returns projected are net to LP, then a change in the waterfall and fees over time can dramatically impact the returns. For example, a 1% acquisition fee versus a 3% acquisition fee can greatly impact the overall IRR for the investors. Or an 80/20 split up to a 20% net IRR, then 65/35 will generate a much higher investor return than a 70/30 split up to a 12% net IRR, then 50/50. It could work the other way, though, too. If the fees have reduced over time or the investor’s share of the waterfall splits has increased, then the track record could look better than it actually is.
You can ask the sponsor what the waterfall and fee structure was on the deals shown and how the historical returns would be impacted under the current waterfall and fee structure.
As you are well aware, we are out of the bull run that started in 2010 and really accelerated from 2018 through 2022. For many sponsors, the end of 2022 and into 2023 was the first time they have seen any slowdown. A track record dating back to the 1990s or early 2000s is great, but not always realistic. However, if the track record starts with acquisitions made in 2018, there could be real concerns about what was driven by the rapid market appreciation and luck versus skill of the sponsor.
You can ask the sponsor about the overall experiences of the partners. If the track record of the company is not that long, but the founders have worked in the industry since 2005, this can provide some clarity on experience with market downturns.
A lot of real estate sponsors are not operators. They outsource the property management and front-line execution of the business plan. While there are great third-party property management companies out there, it is worthwhile to understand the sponsor’s relationship and history with the property management company. At the end of the day, as an investor, your returns are driven by tenants paying rent in the real estate you invested in. In my experiences talking with thousands of passive real estate investors, the deals that typically go south are caused by the sponsor putting the wrong management team on the asset.
Beyond property management, you will occasionally find sponsors showing their personal limited partner investments on their track record. Alternatively, there are a fair number of groups that got started not as the lead sponsor actually running the operations of a deal, but rather as a co-sponsor, primarily responsible for raising capital and serving an investor relations role. Occasionally, while these groups were part of the sponsorship team on a deal, they did not serve any operational role in the deal and therefore played little to no role in the actual performance of that deal.
When you are assessing the track record, you can ask who the property management company was. Who is the property manager for the property you are investing in? What is the sponsor’s track record and experience with the property manager?
Having assessed hundreds of real estate investment sponsors, I have seen a lot of ways different sponsors can manipulate their track record to paint a strong picture of their company. To be certain, many groups are very honest and transparent about their track records. They do not strategically remove deals or hide behind summarized returns. They disclose if they were primarily a capital partner, and not an operating partner in deals listed. However, you will not know if the sponsor you are assessing is honest and transparent without asking questions to understand what is in the track record they are sharing with you.
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 better understand their investment goals and backgrounds. 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.