Investors are seeking good risk-adjusted yields for taking the risk in trusting their hard-earned money with a sponsor. Sponsors are often executing a value-add business plan and the risk implicit in these projects depends on a number of factors. The geographical location of the opportunity is a key factor as are things like the product type, interest rate fluctuation risk, supply chain issues, and many other factors too numerous to explore in a simple blog post.
After speaking with many seasoned sponsors and having navigated two rather heinous market cycles in my career, what is clear to me is that the quality of the sponsor is the most important factor to consider when limited partners select a private investment opportunity. A highly-skilled project sponsor can endure market cycles, has the liquidity and risk protection strategies to withstand unfavorable conditions, and generally has a higher quality plan. One of the reasons passive investors are seeking a partner is because these individuals have a longer and stronger track record than they have on their own and generally have the time and team built to execute on the plan they outline at the point of investment. What is harder for passive investors to discern is whether or not the assumptions baked into the plan outlined are defensible and have strong margins of safety baked in.
Part of the challenge here is knowing where to look. The bulk of the returns in many shorter-term projects are baked into the exit pricing assumptions with some cap rate compression or dispersion of exit pricing. It is often the case that 50% or more of the overall profit a project will deliver is derived from the exit pricing assumptions. Thus this is really a good place for limited partners to look for clues about the risk of the plan and the character of the sponsor. It is also a reason for investors to limit their investment in early projects with a given sponsor and to spread their risk capital around while working to grow a relationship over time. Investment relationships like intimate relationships take time and nurturing to grow. People’s true intentions generally prove out over time and the easiest way for investors to protect themselves is to limit their investment, ask for the sponsor to prove themselves, and increase what they invest in later projects.
When vetting a sponsor you should probe on their experience in various market cycles. It’s hard to account for risk when you haven’t lived through the truly tough times. It’s also fairly easy for sponsors to limit contingency funds, leverage their balance sheets to the hilt, spread themselves rather thin so your project isn’t getting sufficient management time, tax their small team, or generally take on risk that is hard to uncover without asking some probing questions. During engagements with investors I welcome dialogue and generally favor conversations that take place over a period of time so we can get to know one another prior to investing together. Truly seasoned sponsors are often not chasing investors and look at the relationship as something to grow over a period of time instead of a quick fix that is needed to fund their current investment that won’t last long. Take the time needed to do things right and get to know who you’ll be hitching your train to for years to come. Your sleep patterns and your wallet will be better for having done so.
Technology continues to disrupt the real estate sector, transforming how transactions are conducted and properties are marketed.