“Don’t bet on the horse, bet on the jockey.”
When you choose to invest in a deal as a limited partner (LP), you are taking a risk more on the deal sponsor (GP) and their underwriting, just as much, if not more, than the deal itself.
I’m not saying you should invest in a crummy deal just because it has a sponsor with a great track record attached to it. What I am saying is that you need to vet the deal and the sponsor’s assumption in the financials you are being presented, likely in some Offering Memorandum (OM).
An excel spreadsheet can overwhelm many investors, largely because many investors aren’t geeks who love to crunch numbers (Sorry excel lovers). Some are doctors, lawyers, engineers etc.
That’s why I want to break down the big items you want to look for in a financial model to assure your sponsor is underwriting conservatively to avoid any potential setbacks while executing their business plan.
- Sponsor Track Record
Before investing in a deal, you want to make sure the sponsorship team has a track record. This can be previous real estate experience or maybe experience running a company and successfully executing on that businesses main objectives.
Let’s take both sides of the coin:
You are approached by a random guy offering you supposedly insane returns on a real estate deal, but he hasn’t done a deal in his life
You are approached by a sponsorship group who has done numerous deals in one city, and they are now doing another deal one block from two other assets they own. The returns are fair, stable and not Insane, but again, they have proven they can do this.
Are you investing your hard earned money with the insane return newbie or the consistent, conservative return sponsorship group?
I think the answer is obvious here.
- Rent Growth
When a sponsor underwrites a deal, you may see an area where they plug in a percent increase in rent growth over the life of the deal. You may see something like 3% increase in rent growth. Depending on the market, this could be very achievable. What this means essentially is that if a tenant is paying $900 in rent during year one, the sponsor assumes he/she can achieve a rent bump of $27 per month next year when the lease is renewed.
However, if your sponsor is underwriting at a consistent rent growth rate of 6%-7% when the market normally has a rent growth rate of 4%, then your sponsor is showing you inflated numbers they may not be able to achieve. If they can’t hit these metrics, then your income is less than anticipated, hurting the return projections you were anticipating.
Solution: Make sure your sponsor can thoroughly explain his justification for the rent growth rates he/she is underwriting.
- Exit Cap Rate
Assume you buy a property for $4,000,000. This property has an NOI (Net operating income) of $315,000, this means you bought the property at a cap rate of 7.8%
NOI ➗ Purchase Price = Cap Rate
Cap Rate assumes you bought the property all cash. In this case, if you bought this property for $4 million cash, you can expect a 7.8% return year one. Over time, the property will likely increase in value through rent increases and capital appreciation, as generally real estate goes up in value over time.
Let’s say after ten years, the NOI has gone from $315,000 to $425,000. This means if you use the same 7.8% cap rate when you bought the property, your new value is:
NOI ➗ Cap Rate = Value
$425,000 ➗ .078 = $5,448,717
This means your property has gained an additional $1,448,717 of value over 10 years, not bad!
However, over those ten years, the cap rates likely won’t be the same. A general rule many syndicators like to use is increasing the “Exit Cap” (the cap rate assumption when you exit the deal) by .50-.75 of the entry cap. In our case, this means taking our 7.8% Cap and assuming an exit cap rate of 8.3%
Let’s use this new exit cap rate to get our new assumed value:
$425,000 NOI ➗ .083 Cap Rate = $5,120,481
Just on the cap rate increasing 50 basis points (.5%), the value at the exit decreased by $328,236.
If you’re investing in this deal, that’s going to impact your final returns. Make sure your sponsor if conservative in their exit cap rate. If they have an exit cap lower than their entry cap, you want to be very careful to understand why.
As I mentioned earlier, the greatest deal in the world can quickly go down in flames with an overly aggressive sponsor. Make sure to do your due diligence on the sponsor’s assumptions and question everything.
Trust but Verify.
If you have more questions, please feel free to email me at Jason@3pillarsrei.com