Whenever you are investing in real estate with anyone, you will want to make certain that the interests of whoever is managing your investments are aligned with your own. In the broadest sense, this means that their financial interests are tied to your own within the context of the deal. If you make money, so will they, and if you lose money, they will too.
An alignment of interest with a real estate sponsor is a minimum standard that investors should be looking for and what makes StarPoint stand out is that not only do the ‘traditional’ alignments of interest exist, as we will discuss in this article, but that ours go far deeper.
At StarPoint our team members, the insiders who actively work on projects, underwrite them, manage them, and know everything there is to know about them, they also invest in our deals.
There are typically at least several people involved in a real estate investment deal: limited partners (or passive investors), attorneys, contractors, lenders, appraisers and more. But the most significant of all of these are the sponsor team because it is they who know the most about a project, about the sponsor, and it is they whose efforts determine the ultimate success or otherwise of the project.
Before we delve deeper into the concept of alignment of interest and share some insider insights into why StarPoint team members invest alongside our passive investor partners, let us examine what a sponsor is exactly, and what the benefits are of investing your money with one.
The Role of a Sponsor In Real Estate Investments
Sponsors are also known as the general partner (GP) of a commercial real estate deal, and can be thought of as the deal’s main, organizing member. The sponsor is the person who initially sources the property for investment. After finding a potential investment, they will hire all the third parties they need to in order to vet the property and be assured of its potential as an investable asset and negotiate an acquisition.
They will then prepare materials and methods to present the investment to their investment committee and then, once it passes the IC, to individual investors who may like to participate in the deal prior to closing the deal, buying the asset, and executing on the business plan.
As you can imagine, this is an involved process that requires a lot of time and work on the sponsor’s part. To compensate them for this preliminary work, a cost to any deal will included fees to cover the sponsors expenses – not only of deals that close, but also to cover the overhead of analyzing and rejecting dozens if not hundreds of other deals that do not satisfy the investment standards of the sponsor. These expenses are known as ‘dead deal’ costs and are an inevitable expenditure in finding assets worthy of investment. We will discuss this in more detail shortly, along with the other fees typically that form part of the line item expenses on any project.
Benefits Of Investing With A Sponsor
Now we have identified what a sponsor is and what they do, let us look at why you would want to invest with one sponsor rather than another or, indeed, rather than going it alone and investing in real estate directly yourself. Investing alongside a sponsor is known as ‘passive investing,’ and there are multiple advantages to this strategy:
- Just as the name implies, being a passive investor allows you to share in the financial benefits of investing in real estate while someone else handles the day-to-day affairs of the project and manages the investment for you.
- Investing alongside a sponsor lowers your risk because you benefit from the upside of the investment while your exposure to a potential loss is limited only to the capital you invest (i.e. you are not also liable for any debt taken on the property, or for any misdeeds conducted by the sponsor).
- You can diversify across a range of investments by putting a relatively small amount into each project rather than concentrating all your capital into just one deal. Diversification is highly desirable and a good defensive move in investing. It prevents you from being overexposed not only to one particular asset class, like stocks or bonds, but within real estate itself by investing in different locations and asset classes.
- As long as you select your sponsor wisely, you can have the peace of mind that comes with knowing you have invested alongside someone who is a professional, full-time investor with a team of experts handling all aspects of the investment for you.
Alignment of Interest: Why It Matters & How to Assess It
Once you have determined a sponsor has the experience, background, and track record that indicates they are a capable steward for your capital, the next most critical thing you should assess is the sponsor’s motivation for inviting you to join them as a limited partner. Is there an alignment of interest between what drives them to put a deal together and yours in investing with them?
Banks understand just how critical this question is. That is why when a sponsor goes to a bank to apply for a loan for the deal, the bank will never put up 100% of the money. If they did, the sponsor would then have nothing to lose, and their incentives to act to preserve their duty to the repaying the bank its loan would have dropped to zero.
Just as it is important for banks to understand this when dealing with sponsors, so it is for passive real estate investors. A sponsor with no skin in the game (i.e., none of their own money), is less likely to be motivated to work harder in the event challenges emerge that prevent a business plan from being executed as planned.
One way to measure a sponsor’s commitment and to determine if there is an alignment of interest is to look at the amount of capital they have invested in the deal personally. This is known as the ‘co-invest’ and, in general, a sponsor should be contributing between 5% and 10% of the total equity in the deal. It is difficult to expect a sponsor to invest much more than this because otherwise they would run out of their own capital quickly and be limited on how many deals they can offer to investors, but this range is standard in the industry and is a good sign that they believe in the deal enough to expose their own investment portfolio to it to a meaningful degree.
Also, be sure that fees the sponsor earns going into a deal do not outstrip the co-invest they are placing. The alignment of interest can evaporate if a $500,000 co-investment is matched with a $500,000 acquisition fee, for example. You do not want a sponsor to be motivated by the fees they earn, rather than the carried interest they will be rewarded with at the end of the project if they perform to or exceed projections. More on fees below.
The more money your sponsor has put into the deal, the more they stand to gain alongside you, and the more they stand to lose alongside you. If the decisions they make on any given project throughout its lifecycle are tied to their own at-risk capital, they are going to be more closely aligned with your interests because they will be subject to similar consequences of those decisions.
But even if your sponsor has demonstrated their alignment of interest by putting their own money into the deal, there are several other important factors to be aware of before choosing to invest your money with them.
Fees Collected by Sponsors In A Real Estate Deal
Here is a quick breakdown of the primary fees typically paid to a sponsor, why they are a charge to a deal, and how often they are paid throughout the course of a commercial real estate deal:
Acquisition Fee: The acquisition fee varies at 1-2% of the total size of the deal and is collected to compensate for all the pre-purchase work the sponsor put into the property, such as sourcing it, negotiating for it, underwriting it, marketing the deal to acquire capital, and to cover dead deal costs as previously mentioned.
Management Fee: The management fee varies between 3-6% of the property’s total gross annual income and is usually paid monthly. The management fee is collected to compensate the sponsor for the day-to-day responsibilities of managing an asset, ensuring occupancies stay high, rents increase, and turnover is minimized.
Asset Management Fee: The asset management fee can be between 1-2% of the total equity you have put into the deal. This fee is charged to compensate the sponsor for the time and effort of managing your money within the context of the deal, as well as keeping you updated in the form of quarterly letters, investor memos, legal, accounting, and other administrative expenses.
Disposition Fee: The disposition fee is typically between 1-2% of the total sale price of the property and is only paid once when the property is sold. This fee is to compensate the sponsor for the time and effort they put into selling the property on behalf of the deal’s passive investors.
Now let us take a look at sponsor returns, which are where a sponsor receives the bulk of their compensation for managing your capital.
Sponsor returns are the predetermined percentage of money that the sponsor is entitled to on any profits associated with a project. In the corporate world these returns are known as the carried interest and pertain to results-based compensation the principal receives for meeting or exceeding projected return hurdles.
When you are analyzing the compensation structure of a real estate deal, it is not uncommon to see a tiered approach to returns. These are essentially a sliding scale where the more returns the sponsor generates, the larger their percentage of those incremental returns becomes.
For example, if you were reading the paperwork for a deal, you might see a compensation structure in what is called a ‘waterfall.’ A waterfall is the way cash available for distribution cascades from the deal to the partners, both general and limited.
- The first tranche of payments made to partners goes to the limited partners in the form of a return of capital and some preferred return. These are prioritized for limited partners and act to ensure that their returns meet a certain threshold before the sponsor gets any compensation other than their fees.
- Above the preferred returns, any excess cash is distributed in a pre-agreed format known as the ‘promote’, where the remaining profits are split between the general and limited partners, with the bulk of those profits still usually going to the limited partners.
There are many variations of this kind of structure that can vary by sponsor, by project, and over time, but the principle is that limited partners, the passive investors in a deal, receive prioritized returns in the form of preferred payments before the sponsor receives any profits, and then an outsized share of all remaining profits generated by the deal.
Questions To Ask a Sponsor Before You Invest
Even if the sponsor you are considering investing with has put their own money into the deal, it is still vital to look at the other aspects of their competency for the role they have taken on.
Perhaps most importantly, look for the sponsor to commit to a clearly articulated business plan. In other words, a precisely laid out strategy on how their proposed investment will generate a positive return.
Here are some other questions you should make sure to ask any sponsor before committing any of your own money to their deal or fund:
- Does this investment fall within their area of core competence as a real estate professional?
- Do they have a track record of achieving positive returns in asset classes that are functionally comparable to their proposed investment?
- How many years of experience do they have in this local market and with this particular type of investment?
- Have any of their past projects fallen through, or failed to perform as expected or promised? (Note: this shouldn’t be an automatic disqualifier in your search for a sponsor, but it is important to be aware of.)
- How capable are they of evaluating the risks associated with this particular asset class?
- If you know of any macroeconomic forces that are trending in a negative direction for this asset class how does the sponsor plan to deal with those in their management of the asset?
- What systems or plans do they have in place to make sure the project runs smoothly? This includes their strategies for financing the project and renovating the property, all the way up to strategies for finding tenants, stabilizing the asset and ultimately selling it.
Another thing to look for is whether the sponsor is a loan guarantor in the deal. If the sponsor is a loan guarantor, the lender can pursue recovery of the balance on the loan from the sponsor’s personal funds. Most real estate deals fall into the non-recourse variety, which means the sponsor’s personal wealth and accounts are not at risk, but when they are also a loan guarantor they have more than even their own investment to lose and so are motivated by this factor alone to ensure the project proceeds as planned.
One thing to keep an eye out for is the distinction between project or deal level returns, and investor returns. Project returns are the total returns expected to be generated by the deal itself, before the sponsor has taken their percentage out. Investor returns are the part of the expected total returns that will go to the passive investors, minus the sponsor’s portion.
The key takeaway is simply this: when you are carrying out your due diligence on a real estate deal, make sure the sponsor has put an adequate amount of their own money into the deal.
Also, when reading paperwork about the deal, carefully analyze the fee and compensation structures to ensure that the sponsor is properly incentivized to maximize profits and act as an effective steward of investment capital and is not driven solely by the fees they will earn.
Join The Insiders At Starpoint
At Starpoint, we have a proven track record of success in sourcing and carrying out profitable deals. We’ve learned a lot over the years, but one of the most significant lessons has been the importance of alignment of interest with investors.
What makes StarPoint stand out is that while, of course, at the corporate level we invest in every project we offer to our investors, our team also invest on their own account, their own capital, with their own savings.
Our own team members are so convinced of the quality of the deals we source and our ability to generate returns, that they invest their own money with us. That is a level of trust that you will not find in many other private equity real estate investment companies or funds.
Here are some quotes from our team explaining what ‘inside information’ they see that others do not that gives them the confidence to invest their own savings alongside the company’s capital and that of our investors:
Through an investment committee, we review what the acquisitions team has put together. They have a proprietary model that they’ve used for years and that has produced a long standing track record of success for StarPoint.Greg Jones, CFO
The great part is the risk adjusted returns that we get on our deals compared to anything else, be it other real estate plays that other people have or be it public markets, have proven over time to be the best. Not only do we underwrite them to be the best, but over time we’ve proven them to be the best.Evan Farahnik, Principal
The number one reason is because these are great deals.Sandy Schmid, Senior VP, Acquisitions & Development
This commitment to the deal assures our limited partners that there is an alignment of interest between not only StarPoint as a company, but directly with the team also. Investors do not have the benefit of working inside the company and seeing the deepest details of every deal as our team members do so knowing that the team is investing in each deal too is a reinforcement that there is an alignment of interest that sets StarPoint apart in the industry.
To learn more about what the ‘insider traders’ at Starpoint can do for you and your investment portfolio, click here.