11 Questions You Should Ask Every Sponsor
Passive investing is a great way to grow your holdings, income and wealth without taking up too much of your time. But being a prudent passive investor does not mean you don’t have work to do. As a passive investor, you should spend a lot of time vetting multiple sponsors in the field you want to invest in. While this list is not all inclusive, these are questions I recommend you ask simply to understand the risks and aligning the interests of the sponsor with yours as the investor. Check out links at the bottom for more posts regarding how to vet sponsor.
How are you adding value or hedging against valuation reductions and rent reductions?
In January 2020 things were looking great, but by mid-March, most of the country was under stay-at-home orders due to Coronavirus. Business operations were dramatically changed, if not shut down all together. While this is situation is hopefully short lived and a one-off occurrence, planning for such uncertainty should be a part of each deal.
When the sponsor is talking through these hedges, the business plan should make sense to you. As Warren Buffet has said, he only invests in companies he understands. Does the business plan intuitively make sense to you?
Can I run a background check on your key people?
The answer to this should always be yes, without hesitation. You are placing a fairly large amount of your hard-earned money with this group. Confirming there are no red flags in the sponsor’s past should be the first step.
How frequently are you communicating with investors?
Like any relationship, open communication is key. Communication is the key to building trust. Ideally, you receive email updates each month and a less than 24 hour turnaround on any questions.
What is your financial review process?
Does the sponsor have a formal process to review all financials? This does not need to be a 3rd party audit, but having multiple people within the company review financials, and checks and balances for handling funds is the duty of any fiduciary.
What is the “worst case” scenario and how do you try to mitigate that?
Is the sponsor clear with you that you could lose money? If property value drops below the loan balance or cash flow goes negative, is there any additional liability the investors take on? Is the sponsor allowed to require follow-on capital calls and have they ever made any?
Capital preservation should always be the first goal of any sponsor. The upside of making money does not outweigh the downside of losing money. And while every investment has its own risks, the sponsor should be glossing over potential risks.
Can you send me investor references, current and on deals that have sold?
Much like the background check, this should always be answered with a resounding yes, followed by asking how many you would like.
In your return projections, are the numbers presented project level or net to LP?
Most apartment syndications have a handful of standard ways the sponsor gets paid. These include fees at closing, ongoing fees, and a share of the profit. If the sponsor is reporting project-level numbers, the sponsor’s share isn’t taken out and the projected returns will look much better. However, as an investor your primary concern is how much YOU anticipate making. As such, it is important you seek out Net to LP returns for both past deals and proforma for reviewing upcoming deals.
How much liquidity do you keep as reserves in each deal?
Liquidity can take several forms: equity in the deal/loan to value, cash in an operating account, and cash flow from operations. Ultimately, the more cash reserves the easier it is to ride out any downturns. Generally, the lower the LTV, the higher the DSCR, and the larger the operating account or cash reserves, the lower risk the deal is.
How much do the principals or company invest in each deal and at what level?
In order to align interests, you want the sponsor to have skin in the game at the same terms you do. I would not be set on a fixed percentage, as the sponsor’s ongoing fees and profit share help align interests. But should the deal go south, you want to make sure the sponsor is out some of their own cash, not just potential earnings.
Who will be managing the property and how long have you been working with them?
Even in a good economy where valuations are improving through natural appreciation, the single biggest mistake a sponsor can make is installing the wrong management company on the asset. This effect is compounded during down economies. Whether it be lack of focus, inability to execute on the plan, aggressive lease rates that inhibit lease-up, the reasons are infinite that a property manager is not executing effectively.
One way you can mitigate these risks is to understand who that management company is, and how long the sponsor has worked with them. Has the management company been proven over the years? Do they understand and have a record of executing on similar business plans? Ultimately it is the property level operations that will dictate your returns.
How many deals have gone south or sideways, and how did those effect your strategies?
Every sponsor with any track record has a deal or two that have gone sideways, if not fully south. This should be expected. As an investor, you are trying to figure out how they handled the situation and almost more importantly, what they learned and applied from those hard-taught lessons.
There can be countless other questions that come up. Understanding track record of the company, age of the company, and background of the key principals are all important as well. But as the economy has turned, asking these questions should help you understand the integrity of the sponsor and how they are limiting your downside as an investor.
Here are additional resources to fully understand your investments in real estate:
- The Five Tax Factors When Passively Investing in Apartment Syndications
- Internal Rate of Return (IRR) vs. Cash on Cash (CoC) Return: What Is the Difference?
- The 51 Responsibilities of the General Partnership in Apartment Syndications
- The Pros and Cons of Class A and Class B Passive Apartment Investment Tiers
- How a Passive Investor Qualifies an Apartment Syndicator’s Team
- How a Passive Investor Qualifies an Apartment Syndicator
About the author:
Evan is the Investor Relations Consultant for Ashcroft Capital. As such, he spends his days working with investors to better understand their investment goals and background. With over 13 years in real estate, he has seen all sides of real estate from acquisitions, to capital raising on the equity and debt side, to operations, and actively invests himself. Please feel free to connect with Evan here.