In the February Issue
- Introduction to Syndicated Deals
- Role of the Project Sponsor
- How to Review Project Assets
- Financial Review and Structure of a Deal
If you’re a dentist, doctor, or new to the world of real estate investing, this newsletter is for you. Knowledge is key when it comes to choosing your investments wisely, so I’m going to walk you through the inner workings of real estate funds and how fund managers like myself choose partner sponsors to work with and deals to invest in.
We’ll form our discussion around three different segments of a syndicated deal: project sponsor, asset review, and project structure/ financial review.
*Listen to my latest conversation with David Phelps on this topic.
By the end, you’ll be well-equipped on how fund managers, like ourselves, choose deals and generate returns for our investors. Let’s get started.
Introduction to Syndicated Deals
Syndicated deals are often times commercial deals like storage facilities, multifamily complexes, commercial warehouses, retail deals, plazas, shopping centers, etc. These deals require a larger amount of capital up front and an experienced project sponsor to run the deal through its life cycle.
(If you’re interested in learning more about the difference between individual deals and syndicated deals, check out August’s newsletter.)
Regardless of the type of investment, there are risks involved. With syndicated deals, it’s no different, but they offer strong benefits that many other traditional investment sectors lack. Take a look:
Pros of Syndicated Deals:
- Passive Investment
- Depreciation benefits that reduce tax liabilities
- Strong returns with an experienced project sponsor
- Leverage to enhance cash flow
- Capital gains
Cons of Syndicated Deals
- Lack of control over the deal
- No liquidity
If you invest in a syndicated deal with a good management team and experienced project sponsor, your likelihood of generating strong cash flow and depreciation benefits significantly increase. With any investment opportunity, there is risk, but it can be minimized with good management.
In today’s market climate, syndicated deals offer investors an alternative to traditional investment vehicles to generate attractive returns. Let’s look at these type of deals more closely in order to better understand what is involved.
Project Sponsor Underwriting
One of the first things to look at when considering a deal is the person or organization who will run the project through its life cycle. This person is referred to as the project sponsor.
*Investor Note: If you’re a passive investor who is considering taking part in a syndication, you may not have the same level of influence or ability to review the deal as the fund managers; however, it’s still important to know how syndications work so you can set yourself up for success when choosing a fund.
When evaluating a project sponsor, the first thing to consider is their referral chain. “Who referred this person? What was their experience like working with them?” It’s helpful to have a common acquaintance with the sponsor to know how deals have performed with them in the past.
In addition to experience, it’s important to know the sponsor has integrity in the deals they pursue. “Do they do what they say? Or are they constantly changing information in the moment?” Integrity is something you cannot compromise on when finding a project sponsor.
Sponsor Participation in the Deal
Another important, yet crucial piece of information to ask about is how much the sponsor plans on participating in the deal– or in layman’s terms, what’s their ‘skin in the game.’ There are two parts to consider when looking at sponsor participation: How much of their own money are they contributing toward the deal and what is the fee structure of the syndication (how does the investor get paid).
*Note: If the only money contributed toward a deal is from investors, then all the risk falls upon them and a project sponsor could walk away unharmed if the deal goes poorly.
Perhaps the more important question to consider is how the project sponsor is paid– which can occur through a variety of different fees.
- Annual Asset Management Fee This fee is pretty common across most syndications at a reasonable level. The fees you really have to watch out for are the up-front fees that project sponsors will charge. If there are more fees on the front end, the project sponsor is more motivated to make deals rather than generate strong returns.
- Property Management Fees These fees are more common with multi-family projects; however, the project sponsor may be charging a 1% asset management fee as well.
- Back-End Performance Fees In most syndications, there is a preferred return and a performance split above the preferred return. For example, if a deal has a 8% preferred return and a 70/30 performance split above the 8%, the sponsor will receive the 30% end of the split. This type of fee structure sets a minimum bar that the project sponsor needs to meet and then will get paid some kind of performance split after.
When evaluating a fee structure, there should be a fair split between the sponsor and investor. A fair split can be anywhere from 80/20 to 50/50 on some projects. If there is a higher preferred return, then the split will be lower.
Asset Review
What makes a “good” deal actually good? During the next part of the underwriting process, we tackle this question by looking at the asset itself and knowing the in and outs of the project. You need to know why it’s a good deal before investing.
A lot of deals will come from what we call “distressed sellers.” A distressed situation might be divorce, death in the family, bankruptcy, foreclosure, etc. Often times people in these distressed situations will need to sell their house or another asset at a discounted price; therefore, these distressed areas quickly become opportunity zones for investors.
So once you know know where the deal is coming from, it’s important to look at the value-add plan for the deal. You need to look at the scope of work needing to be done, the amount of capital needed for the project, the project schedule, and the projected outcomes and returns of the project.
*Investor Note: With any deal, there is risk, so it’s important to look at the mitigation plan in place to help offset those risks.
Does the Project Need to Be Appraised?
For any project, it’s a good idea to get a formal appraisal on the deal to establish the industry standard. In essence, it’s a competitive market analysis for the project.
Appraisals do have to be taken with a grain of salt because they can be manipulated to meet the goals of the people ordering the appraisal. However, they aren’t bad. You simply have to remember they are someone else’s opinion on the deal.
In addition to an appraisal, a feasibility study should be conducted by third party professionals. This type of review is especially important in downward markets when it’s more important than ever to know the environmental and competitive space in the surrounding area. For example, a feasibility study could demonstrate that a given area lacks a supply of self-storage units and building facilities.
Structure and Financials Review
The third and final section of syndication underwriting is looking at the structural and financial review of the deal. This includes looking at the equity capital needed, debt capital and terms, current financials, future projections, performance review, cash flow, IRR calculations and more.
To begin, the financial review of a deal has to be conducted from a fairness angle, meaning, the project has to be fair for everybody involved (for both investors and sponsors). Like we mentioned earlier, investors shouldn’t bear all the risk in a deal and should be paid more than sponsors (in most cases).
The next aspect of the financial review is looking at the capital stack, or in other words, how much equity and debt capital is needed. We analyze exactly what the money will be used for in the project for redevelopment, renovations, etc. All of this information helps the project sponsor know exactly how much money they need to raise.
Sponsors don’t want to raise too much capital because they have to pay a preferred return on any unused capital; They also don’t want to underaise capital and have to do capital calls throughout the project lifecycle. This is why the financial review is so necessary in order to calculate the ideal amount of capital to be raised.
Cash Flow Analysis on a Deal
Depending on the type of project, cash flow has the potential to fluctuate throughout the project life cycle, so it’s helpful to know why this is happening. Below are a few reasons why cash flow might differentiate at various points:
- Mortgage maturity
- Refinancing
- Vacancy
- Value-Add Improvements
In re-development projects (or ground- up projects), there will be very limited cash flow in the first couple of years but will be offset on the back end with appreciation. These types of projects tend to be a little more speculative because you’re assuming the price will appreciate.
With value-add projects, there is a similar situation where the cash flow is limited initially, but the difference is that the appreciation is forced and not determined by market conditions.
When it comes to the internal rate of return (IRR) on a deal, it’s important to know what percentage of the total IRR is coming from cash flow versus appreciation. Project sponsors will anticipate an expected IRR on a project by assuming an exit price with a certain CAP rate
How CAP Rates Affect Cash Flow
CAP rates are typically used in commercial type deals. Over the past couple of years, CAP rates have been historically low, but have since increased along with rising interest rates. Many project sponsors have yet to adjust their numbers to account for the hike in CAP rates.
There’s an inverse relationship between CAP rates and sales price. A lower CAP rate means a higher sale price and vice versa. So, if the underwriter says they will sell an asset at a 6% CAP rate, they are expecting a future investor to buy that property from them with the property generating 6% cash-in without any mortgage in the first place.
However, if mortgage rates increase, investors may not be willing to pay that kind of CAP rate.
In order to mitigate this speculative risk, you can perform a stress test on the project. This means you can ask the underwriter to re-write the project assuming an increase or decrease of the CAP rate by 1% in order to conduct a financial review on the deal.
Wrap-Up
Between finding project sponsors and conducting a financial review, you now have a better understanding of the underwriting process for a syndicated deal. As you can see, there is a lot of ‘behind the scenes’ work involved in investing in real estate deals which is why participating in a fund can be a passive way for you to invest in the types of syndicated deals mentioned above.
The Tempo Opportunity Fund LLC specifically focuses on value-add projects because of their strong cash flow and protected value during economic downturns.
If you would like to learn more about the Tempo Opportunity Fund, feel free to visit www.https://tempofunding.com/investors/ or contact us and we would be happy to walk through investment opportunities with you.
Thanks for reading!
Mike Zlotnik
CEO, TF Management Group LLC
This newsletter and its contents are not an attempt to sell securities, nor to sell anything at all, nor provide legal, nor tax accounting, nor any other advice. The presenter is a private lending and real estate fund management business, and the information represented herein are purely for educational purposes and represents the opinions of the presented. Prior to making any investment or legal decision you should seek professional opinions from a licensed attorney, and a financial advisor.
TF Management Group LLC (TFMG) is an investment fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.
