Understanding the Role of the Real Estate Sponsor
Anyone interested in investing in commercial real estate should understand that they are one of several players involved in bringing a project to fruition. A single deal can involve several parties: the general partner (GP), limited partners (LP), contractors, lenders, appraisers, attorneys and more. The most critical player, though, is the deal’s “sponsor”.
In commercial real estate, the term “sponsor” is used to reference to the individual or company that effectively quarterbacks the project from conception through completion. They are the owners of the property, responsible for all aspects of the transaction and on-going operations. They’re also the one aggregating capital and signing their name on all related loan documents.
In this article, we talk about the role of the sponsor in real estate transactions. Before investing in a deal, you’ll want to be sure the sponsor has the appropriate experience and track record to justify investing your hard-earned money. We’ll provide several tips on how to evaluate a sponsor’s qualifications. So, without further ado…
The Role of the Sponsor
A sponsor is the person or team that champions all aspects of a commercial real estate project on behalf of the equity investors. The sponsor is often referred to as the General Partner (GP), whereas the rest of the investors are Limited Partners (LPs). LPs take on a more passive role in the project, which is why they’re often called “silent” or “passive” partners. As a result, LP investors also have limited liability – meaning their potential loss in a downside scenario is limited to the amount of their investment.
The LPs put a lot of trust in the sponsor, and it’s easy to see why. The sponsor has significant roles and responsibilities throughout a project’s lifecycle.
A sponsor’s role starts early on – usually a month or two before investors even know a potential deal exists. The sponsor often finds the deal, whether on or off-market. The sponsor then negotiates the terms of the purchase and sale agreement. They’ll prepare investor marketing materials and assemble the equity capital and debt financing needed to acquire (and later, renovate) the property. The sponsor also oversees all pre-acquisition activities, including all due diligence (such as engaging specialists to provide third party reports and reviewing existing financial information, among other things).
Because of all the work that goes into evaluating, underwriting and preparing a deal for acquisition, sponsors will take an acquisition fee to cover related costs (and compensate them for this work, which they do even when a deal falls through).
Following acquisition, the sponsor then oversees operations and management of the property, including any planned renovations, leasing and maintenance. Depending on the size of a project, the sponsor may hire a third-party property manager to handle day-to-day management, but the sponsor will still oversee the entire process to ensure the deal’s objectives are being met. At the end of the day, the sponsor is solely responsible for all aspects of the project.
Throughout the project, the sponsor is responsible for all financial reporting, which is usually shared with investors in the form of a quarterly letter. They’ll submit draw down requests to the lender, make payments to investors in accordance with the operating agreement, and engage accountants to prepare and distribute K-1s during tax season.
Lastly, the sponsor will arrange for the refinance or disposition of the property at the end of the investment period.
How Sponsors Make Money
Sponsors make money in a few different ways.
First, and as noted above, they’ll often take an acquisition fee for lining up and conducting all due diligence on a transaction.
Most sponsors will also directly invest in a deal, just like the LPs, though not to the same extent. Sponsors generally put about 5-10% (sometimes as much as 20%) of the equity into the deal. It’s important that the sponsor have at least 5% of the equity to ensure they have adequate “skin in the game” – this helps to align interests and indicates the sponsor’s confidence in its own work product. The remainder of the equity capital comes from the LP investors. A project’s entire capitalization is the sum of GP equity, LP equity and bank debt.
Another way to better align sponsor and investor incentives is to use a promote structure with a preferred return. In other words, an investor is entitled to a full return of their investment capital plus an additional return above a certain threshold (known as the “preferred return”). Above the preferred return, the sponsor will be entitled to a percentage of total returns – think of this as their performance fee as they are only entitled to this fee if the project performs above a certain threshold.
Many sponsors will also take some sort of annual asset management fee in connection with the project. The investment documents should clearly disclose what fees will be paid to the sponsor, how those fees will be distributed and when.
How to Evaluate a Sponsor
Given the important role of a sponsor in a real estate development project, it’s imperative that the sponsor be highly qualified. The sponsor generally brings specific expertise to the project – whether about the local market or about the asset class (ideally, both). Investors should feel confident that the sponsor has a solid reputation, strong track record, the right debt and equity relationships and all other requisite skills and expertise needed to manage the project through its entire lifecycle.
Not all sponsors are created equally. Some are much more qualified than others. How can you tell? Here are some key questions to ask when evaluating the capacity of a sponsor:
- How much experience does the sponsor have in the local market and with that asset class? For instance, someone who’s primarily worked with retail or office properties likely isn’t qualified to sponsor the acquisition of a 100+ unit apartment building. A sponsor likely has more insight into, or resources in, markets in which it already has offices, employees or investments.
- Have any of the sponsor’s prior development projects failed to meet expectations? Ask the sponsors to elaborate. This isn’t always a red flag. A sponsor that has been in business through multiple real estate cycles will likely have some blemishes on their record—it’s just important to understand what happened and how they course-correct. You’ll want to know that even when a project hits a snag, the sponsor is committed to providing timely and accurate information to investors.
- How capable is the sponsor in terms of evaluating risks? Every project carries some degree of risk. You’ll want the sponsor to be honest about the project risks, and then explain how they plan to mitigate those risks during the project’s life cycle. More experienced sponsors will be transparent about these risks (e.g., a looming recession), how they may impact the property and what steps they’ll take (or have already taken) to minimize the downside scenario.
- How does the company identify other equity investors and arrange debt? You’ll want to know whether the sponsor lines up equity investment through a fund, through personal relationships, via crowdfunding or other avenues. In terms of debt, does the sponsor use a debt broker or does the sponsor have particularly strong relationships with certain banks? (A sponsor who has longstanding relationships with their debt partners is in a much better position to navigate through a recession.) Also ask about what sort of rates they expect to get on this project. Are they completely subject to the debt capital markets or are they able to source “better than market” debt by leveraging existing bank relationships?
- What systems does the sponsor have in place to ensure proper management of the project? Evaluate their processes end-to-end, from financing to renovation all the way through leasing and stabilization. You’ll want to be sure the sponsor is very deliberate in how it manages the project – an ad hoc approach creates too much execution risk.
In short, the sponsor is the most critical factor in a commercial real estate project’s success, so it’s important to work with someone that’s highly-qualified and has a proven track record. When investing in commercial real estate deals, be sure to understand who you’re working with, what they’re responsible for and how they plan to execute on the project’s business plan. As a passive LP investor, your decision-making authority is very limited after you make your decision to invest. For this reason, put the time in up front to learn about your new investment partners as you’ll be spending the next 3 to5+ years in this relationship.