Most Important Step in Real Estate Syndication Investments: Performing Due Diligence and Vetting Real Estate Sponsor – An Advice From a Physician Investor.
“Finding good partners is the key to success in anything: in business, in marriage and, especially, in investing.” – Robert Kiyosaki
How to Vet Your Real Estate Sponsor? An Advice From a Physician Investor. This is probably the most important article of the entire series of blog posts I wrote on Real Estate Syndication investments. This blog post dives into the intricate working details of Real Estate Syndication investments. I strongly recommend that the readers not familiar with syndication process first read the basics of Real Estate Syndication investments before reading this article—Real Estate Syndication definition, Real Estate Syndication structure, pros and cons of Real Estate Syndication, real estate returns, and steps of the real estate process – syndication investments. In this article you will learn how physician investors are vetting their real estate sponsor.
- As a physician investor, the most important step in the whole investment process is making sure you select the right real estate sponsor. You should master the process of vetting real estate sponsors in a Real Estate Syndication investment.
- Real estate sponsor underwrites the whole project, and you want to be sure you work with an experienced and expert real estate sponsor.
- Your real estate sponsor is the one selecting a property, renovating it, managing it, and eventually selling it. Your real estate sponsor will be the one making decisions on your behalf.
- When you are considering to invest in a particular Real Estate Syndication investment offered by a certain real estate sponsor, you should start performing your due diligence and vetting real estate sponsors in a syndication investment.
- An investor should spend at least a few weeks to a few months doing this, and there is no specific structure to it. Below, I will mention 20 topics that an investor must cover to make sure they are successful and thorough in vetting their real estate sponsor and the property.
Vetting Real Estate Sponsor and Performing Due Diligence
- Experience and Prior Projects: Make sure your real estate sponsor has experience working on syndication investments. Ask to look at the previous projects, their locations, their structure, and the financials. If you can, take a field trip to look at the real estate sponsors prior projects. How long have they been investing in real estate? Have they done similar deals before? How are their previous deals performing currently? Ask them to elaborate on their best and worst performing deals.
- Ask for Referrals: Ask the real estate sponsor to give referrals. Referrals of his business associates, prior investors. Make efforts to speak with the referrals, to understand their prior working relationship with the real estate sponsor and the work ethics of the sponsor. You will be pleasantly surprised at how honest people are.
- Location: Where are their prior properties located? Are the prior properties close to the current property? Are the properties in gentrifying areas with positive population influx, with potential for future appreciation? Are their properties located in close vicinity to each other to accommodate ease of operations?
- Transparency: Keep an eye out for any responses from real estate sponsors that sound wavery–any topics real estate sponsors are trying to skip. Stress on those topics, and ask more questions on those topics. Some times, real estate sponsors do not want to know about things that may blow back on their face. You need to be skeptic, and assume the role of a detective to get to the bottom of all details. Optimally, real estate sponsors must be transparent about risks and real estate profits from the project.
- Get to Know Your Real Estate Sponsor’s Team: Ask the real estate sponsor about the details of their:
- Accounting Firm
- Legal Team
- Construction Team
- Property Management Team
- Make sure these entities are all legitimate and have a good reputation.
- Projections: All the numbers mentioned in your Private Placement Memorandum (PPM) about how much money is required to renovate the property and how much profits the property generates–these are all made on assumptions and projections of the real estate sponsor. So, it is important for the real estate sponsor to have vast experience in order to make accurate predictions, allot adequate capital for buffer/contingencies, and understand market dynamics to predict the cash flow and sale profits many years down the lane. Even a small error of judgement at this stage can lead to very unfortunate financial outcomes. Do not proceed further with the project until you thoroughly understand all the numbers. Ask the real estate sponsor how they came up with the numbers–what is the basis of their assumptions?
- Does Your Real Estate Sponsor have Skin in the Game? It is important to make sure that your real estate sponsor’s interests align with your interests. You know that the real estate sponsor has skin in the game when:
- The real estate sponsor invests their own capital into the project–know how much they invested;
- The bank loan for the syndication investment is personally secured by the sponsors assets; and
- The distributions from the cash flow are distributed as preferred returns to investors, meaning, the real estate sponsor will make money only after the investor makes a certain percentage on their investment.
- These points will make sure that the real estate sponsor has adequate motivation to make the project a financial success.
- Google Search: It is not a bad idea to perform a quick Google search to learn more about your real estate sponsor. Google can sometimes surprise you with more information than you anticipated. Google reviews, comments on forums, and prior legal troubles—pretty much everything can surface on Google if you know where to look.
- Asking Open-Ended Questions: This will put the owness back on the real estate sponsor to try to come up with legitimate answers and give you their perspective. Focused questions will often lead to scripted and rehearsed answers.
- Be Cautious of False Promises: Few real estate sponsors use phrases like “guaranteed returns”, which is not often possible. Real estate sponsors often do this to attract investors. Beware of this. Ask what they mean by ‘guaranteed’ and how they plan on keeping their promise. Ask what happens to the property in the event of a market downturn.
- Risk Mitigation: Discuss the real estate sponsor’s plan for unforeseen circumstances. What happens if the real estate sponsor has a health problem? What happens in case of a market downturn and the property does not make as much money and property cannot be sold for a profit? What happens in case of a natural disaster, earthquake, or lawsuit on the property?
- Contingencies and Buffers: Did the real estate sponsor account for any contingencies and buffers? Real estate sponsors usually have some capital allotment for unforeseen expenses (i.e. sudden roof leaks, and etc.) a.k.a. unexpected expenses, so that they don’t have to go back to the investors to raise more capital in the event of this unexpected expenses.
- Additional Capital Requirements: If additional capital were to be required half way through the construction, and all the buffer funds are used up, what happens next? Do the investors have to chip in more money? If the investors do not want to contribute additional capital, can they have the option to dilute their stock instead of contributing the capital?
- Financial Documents: Ask the real estate sponsor regarding who will be preparing the financials of the projections and the actuals once the property is up and running. The financials must be prepared by a trained person, preferably CFO level person, and must be shared with the investor in a transparent manner, every month or quarter. Since an average investor does not understand the fine details of the financial documents, there is a lot of wiggle room to play with the numbers, and make them work in favor of the sponsor. The trick is for the investors to ask any and all questions they might have.
- Capitalization Policy: Make sure the syndication team has created a Capitalization Policy. This policy helps you understand what was written off and what was capitalized on the balance sheet. It is a way to ensure proper planning and transparency.
- Tax Benefits: Ask the real estate sponsor regarding tax benefits for investors? What tax deductions will be transferred to the investors? When can an investor expect a K-1 form?
- Profits and Timing: Ask about the cash flow distribution percentages, ask if the investor distribution returns are preferred or not, frequency of payouts, refinance profit distributions, and etc. Ask when exactly the real estate profits will start rolling in, immediately or after a few quarters? You must know this and hold your real estate sponsor accountable for this.
- Investor Updates: How often will the investors be updated on the project progress? Usually, investor updates are held by syndications every month, sometimes every quarter. These are used to communicate updates regarding the project, financial performances, steps that will be taken to improve property performance, and etc.
- Retirement Accounts: Does the Real Estate Syndication structure allow the investors to invest with their retirement accounts (e.g. self-directed 401k)? If so, the real estate sponsor’s attorney has to make sure this is all done by the book and follows regulations.
- Time Commitment: Are the real estate sponsors working on more than one project at a time? Investors need to make sure that the syndication investment has the real estate sponsor’s undivided attention, or at-least has a dedicated team who is attending to this project.
Overall, this is a pretty exhaustive list and it was not meant to overwhelm the investors. This is to make sure investors cover all their bases, make safe and informed investment choices. There are too many people out there looking to scam the investors, and we want to make sure we do all we can to protect investor’s wealth, and facilitate their investment via legitimate channels.
How Long Does It Take to Perform Due Diligence?
- The whole process of due diligence might take at least a few weeks to a few months to be thorough. If you are not satisfied with the results from your due diligence, you must take it seriously and stay away from the syndication investment opportunity.
- Very often, investors are subject to something called “FOMO”–Fear Of Missing Out–when it comes to such investment opportunities. This FOMO makes the investors make bad choices. Just remember that if this deal or project does not work, there is always another project or opportunity tomorrow.
- Don’t just invest due to the Fear of Missing Out. Make smart choices.
How Much Does It Cost to Perform Due Diligence?
- In order to perform a thorough due diligence on your Real Estate Syndication investment as outlined above, it usually does not cost anything in money for the initial process. It will however take up a lot of your effort and time.
- Being busy in the hospital, it is not an easy task to make multiple phone calls, attend meetings, spend time looking at the numbers, following up on numerous emails related to the syndication project. That being said, if you want to invest safely, if you want to make sure you stay away from fraudulent people or teams, there is no shortcut to it. You must put in this initial time and effort to learn as much as you can about the syndication investment and the real estate sponsor.
- Once you complete the initial due diligence process, if you decide to move forward with the investment, you will need to evaluate the Private Placement Memorandum (PPM)–the legal agreement of the syndication investment.
- You will have to hire an expert real estate attorney to perform this review. This usually costs between $1000 to $2000 USD.
- If you decide to invest into the syndication via your LLC, you will have to open an LLC and have an operating agreement for the LLC. Setting up an LLC with cost around $200 USD (in addition to the state specific filing fee which varies depending on the state of entity formation) for CPA fees, and another $1000 USD for your attorney to create an operating agreement.
In conclusion, make sure you work with the right people, take your time to get to know them. This will make or break your deal. If you made it to the end of the article, it means that you are strongly considering investing your money into real estate. Now that you have learned about the due diligence process and vetting real estate sponsor in syndication investments for a physician investor, get started with evaluating the syndication investments on you desk, and reach out to us if you need any resources to help you make a decision.
You will find the rest of the topics regarding Real Estate Syndications for a physician investor here.
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