As we move further into the digital era and as the broader real estate crowdfunding market has grown, it has become considerably easier for sponsors to find investors and for investors to find possible sponsors. Various platforms and networks enable both parties to make valuable connections that can help them move closer to achieving their real estate objectives. However, while finding a potential sponsor is not difficult, finding the right sponsor requires more work. This is a key part of our role at Alpha Investing. We engage in considerable sponsor-level due diligence, evaluating dozens of possible sponsors and narrowing the field down to just a few we find to be the best of class.
When comparing possible sponsors, the first thing we’ll want to look for is how they were able to perform when conducting similar projects in the past. Developing or improving real estate is a complicated process for which the best lessons are generally learned through experience. A sponsor who has only been in the industry for a few years, and certainly one who has not endured and survived a meaningful downtown, though potentially highly capable, may not be the right fit because they cannot demonstrate, yet, how they would handle the inevitability of a cyclical downturn.
While looking at previous projects, there are countless components we need to pay attention to. Things such as the type of properties they have bought, their pace of execution, and their use of and access to debt will all indicate the type of experience they have acquired, their ability to successfully execute business plans, and their ability to manage projects when things aren’t going according to plan.
What kind of lenders and agencies do they typically work with? Debt funds? Fannie and Freddie? Do they prefer to work with local or national banks? Where is their expertise the strongest? The weakest? The history a prospective sponsor has within the industry will also directly affect the ways they will be able to navigate the market. Asking—and getting answers to—these questions and many others will make it much easier to find a sponsor that will be a strong fit.
Maintaining Positive Relationships with Lenders
Beyond demonstrating success in past projects, the sponsor will also need to demonstrate a capacity to successfully establish strong relationships with reliable lenders. When raising significant amounts of capital, as many syndication projects require, having a pre-existing network of lenders and agency relationships will be exceptionally important.
Sponsors may have lender relationships within their own geographical region who have deep knowledge of the local market, with more distant but deeper pocketed institutional connections, and with various combinations thereof. Suppose a situation were to arise where a project needs to be refinanced. Without strong existing relationships with the parties needed to make this refinancing possible, the project could be financially paralyzed – especially if overall economic conditions have deteriorated.
Again, experience speaks volumes with lender relationships and as changes to the capital stack and the need to restructure a project occur frequently, investors will want to work with a sponsor who has weathered a downturn and/or who is known to lenders as being able to perform irrespective of the circumstances.
Having a Pulse on the Market
Over the long term, the real estate market typically produces a greater rate of return than can be generated via investing in the stock market (as measured by the DJIA, S&P 500, etc.), but the market itself—despite being tied to finite, physical assets—is not without volatility. While it can be tempting for sponsors to promise high projected returns by tweaking key assumptions, in order to attract potential investors in a crowded field, they also need to understand how to create realistic expectations that will allow them to deliver consistently over the long term.
A qualified sponsor will have a pulse on the market and will also be able to help investors understand what might happen in a variety of different situations. Having a pulse on the market means understanding not only where things stand in the status quo, but how they can potentially change in the future. It means recognizing that multiple sources of volatility can affect the real estate market, which includes the market’s connection to the broader economy, the ways demand for certain properties can suddenly fluctuate, and various other factors.
The outbreak of COVID-19 is a perfect example of why having a reactive sponsor is important. Though seemingly nobody was able to see this outbreak coming and few were able to forecast just how intense its economic impact would be, sponsors that already had a built-in ability to adapt will likely be more resilient and have a higher chance of coming out ahead. Stress testing should not only include the most likely scenario or the average scenario, but unforeseen downside scenarios as well.
Working with a Small, Intimate Group of Sponsors
For investors who plan on investing in commercial real estate as an important part of their overall investment portfolio, diversification across a range of highly qualified sponsors can help mitigate risk while enhancing returns. Developing close relationships with a small network of proven sponsors can benefit both you and them; for them, because together with other investors you can provide a steady flow of capital they can use to transact decisively on opportunistic deals, and for you because it can provide greater negotiating clout when looking at deal structure and returns splits. At Alpha Investing, we seek to foster recurring capital relationships with a small group of high caliber, institutional-quality sponsors.
Building Sufficient Infrastructure
Examining the infrastructure of each sponsor’s firm is also an important component of the selection process. Some firms prefer to hire large teams which, though beneficial during boom times in executing on business plans effectively, can prove to be a weighty overhead burden to carry when the cycle undergoes its inevitable downturns.
Other firms prefer to keep their overhead lean, hire very few staff internally, and outsource many of their major functions. The advantage of this structure is that there tends to be a lot more agility to handle deal flow without feeling the need to keep staff busy and do deals for the sake of doing deals. During down times, similarly there is flexibility, but in both cases, there are seldom economies of scale and costs can be a higher burden on the project level than a firm that delivers services in-house.
Furthermore, there are key-man issues with very small teams that outsource the bulk of their work. If something dramatic were to happen to the lead principal, it is important to see that there is an effective continuation plan in place so that their projects can still be appropriately managed.
Some of the most successful sponsors we’ve encountered often have a core team of ten people or fewer. With digital advancements allowing the subcontracting process to be easier than ever before, this core team can swiftly subcontract all supplementary work, allowing them to scale up and down for any project that is needed and as the market cycle dictates.
Having an ability to adapt to changing circumstances is one of the most desirable traits a sponsor can have. When adaptability, quality, and efficiency can intersect, you will have almost certainly discovered a sponsor that can effectively meet your needs.
Steadying the Course
As suggested, developing a healthy relationship between the sponsor and the investors is critical for any project to succeed. While sponsors need to know investors’ specific needs and expectations, they will also need to have the awareness to plan for all contingencies and investors need to have the confidence to defer to sponsors to make the right decisions.
All investors want to maximize their returns to the greatest extent possible—this is especially true during periods of great uncertainty and volatility, as 2020 has already proven itself to be. However, when short-term gains come at the expense of medium and long-term objectives, the sponsor is not making decisions that are in the investors’ best interest. In an effective relationship, the sponsor will be able to push for higher ground without aggressively tarnishing future earning potential.
Preserving Capital, Protecting from Downsides
An effective sponsor, ultimately, will be involved for the long-haul and will have the discipline and wherewithal to develop smart strategies that are clearly supported by the available data. But they will also be able to deliver desirable outcomes today. Their strategy—in terms of generating capital and making intelligent decisions—will require a careful balancing act.
Ultimately, the traits that are desirable in a sponsor will be essentially the same traits that are desirable in any business partner. They will have the capacity to act without being inefficient; they will be able to preserve capital while also protecting from potential downsides (such as sudden economic shocks); they will be able to focus on the finer details of a project while also having a fifty-thousand foot view of the market as a whole.