The Conservative Investor's Guide to Picking Real Estate Investments: Part 2 - The Sponsor
The sponsor quality checks: analyzing experience, track record, skin in the game and running them through the "death by Google" test.
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This is a 4 part article series on how I pick conservative real estate investments for my portfolio. There are many ways to do due diligence, and I've come up with a process that I like for myself. My process is ruthless and starts with thousands of deals in my inbox each year. In the end, maybe 2 to 4 per year survive that I invest in. This series details exactly what I look at and why. I welcome the feedback of other conservative investors, and will add ideas I like to the articles. And aggressive investors should also find this helps them better appreciate and gauge the bigger risks they end up taking. (If you're a non-accredited investor, a lot of this info doesn't apply to you. Check out this non-accredited investor guide instead).
Quick Series Overview
Here's the quick recap of the series:
Part 1: Portfolio Matching (takes a few seconds per deal)
Part 2: Sponsor Quality Check (takes 15-45 minutes per deal)
Part 3: Basic Property level due diligence (takes minutes to weeks or months per deal): is about "pro-forma popping," sensitivity analysis, and "stall and see".
Part 4: Advanced property analysis (takes minutes to weeks or months per deal): is about recession stress testing, legal document analysis, etc.
At the end, I have an investment (and a sponsor) that I've put through the ringer, and am very happy to put in my portfolio.
Okay, let's talk about the sponsor quality check.
Getting Deal Flow
After identifying my portfolio matching strategy in part 1, I need to get deals, and a lot of them. So I sign up on all the top ranked crowdfunding sites (and non-accredited investor offerings). Unfortunately, the vast majority of deals on the crowdfunding platforms won't meet my strict due diligence criteria, so I can't rely on them alone. So I'm also constantly networking with people and asking them what they're investing in and recommend. And if I keep an eye on real estate news, and reach out to companies I discover that look like they might fit my criteria. If you don't want to do this, or don't have the time, you can also join an investment club, so you can hitch-hike off of other people who are doing this already.
So now instead of a trickle of deals, I have hundreds coming into my inbox every month. Then, before I start drinking from the fire-hose, I use the filtering strategy in part 1 to weed out 75%+ of them (after looking at them just a few seconds). And after this, I implement my second filtering round on the sponsor.
Start with the Sponsor First
Again, this might surprise you, but even at this point I still ignore 99.9% of the deal itself. Instead, I put the sponsor under a microscope and want to see relevant track record and skin in the game.
Why start with the sponsor instead of the deal? Studies have shown that as long as the cycle stays up, most moderately-talented, inexperienced sponsors perform well. But at some point the cycle always turns. And if we have a bad downturn, the mediocre and inexperienced sponsors will be fighting to avoid drowning, while experienced sponsors with staying power will be best positioned to weather the storm. As a conservative investor, I'm happy to go with a high-quality sponsor with an average projected yield, over a mediocre/inexperienced sponsor with a fantastic/sexy looking deal with high projected returns.
Experience, Experience, Experience
So the first thing I look at is how much experience the sponsor has in the specific strategy of the deal. Almost always, the sponsor (and the crowdfunding site if it's on one) exaggerates/over-inflates their experience.
They'll say something like "we have 20 years of experience!" That sounds like the ideal situation: a sponsor that has gone through multiple downturns and survived. But then when you dig in, you'll see that it is 4 people with five years of experience, that they are adding up together. These kind of sponsors have no downturn experience at all.
Or another common thing is that 1 person really does have 20 years of experience in real estate, but they were doing something completely different. Two decades worth of experience underwriting hotel deals for a bank isn't that useful or impressive when their new job is running a fund to purchase and fix up mobile home parks. So I always dig deeply into this, especially if there is even a smidgen of ambiguity.
Once I figure out how much experience in the specific strategy, then I have to figure out if it's enough or not. On mainstream asset classes and strategies, like multifamily, office and retail, there are hundreds of competing deals each month, and I use that to my advantage. I won't take a sponsor unless they have at least 1 full cycle experience, and did not lose any money. (Like the 3 most experienced fund manager All-Stars) I prefer the track record to be audited, however there are some perfectly legitimate old-school single property funds that were not typically run this way (in which case you can attempt to verify by talking to lenders, getting investor references, etc.).
On other asset classes, I can't be as picky. For example, mobile home parks are such a newly "discovered" investment, that there aren't a lot of deals, and it's almost impossible to find someone with full cycle experience. So I take things like that into account.
Track Record
Most deals won't pass the previous filter. But if they do, then I take a look at the entire track record.
Again, most sponsors (and crowdfunding sites) will exaggerate/plump this up, so you really have to dig in. For example, many will say "we have a fantastic x% historic IRR over 50 deals"! But when you drill in, you discover that there only showing their completed deals. Bad deals usually linger on the books for many years because they can't be closed without losing money. So it's important to understand what kind of track record you're looking at, and force them to reveal additional information if they haven't shown it.
It's important to get a list of all the deals and not just look at an average. That's because another trick is to simply report their "incredible" historic IRR, but when you drill in to individual deals, you find that some of them were real dogs and show questionable judgment.
Again, in a mainstream asset class and strategy, I want to see at least one full cycle experience and no loss of investor money. Anyone can make money during good times. I want to see that they have been tested by bad times, and to see what happened there.
Skin in the Game
Next, I look at the amount of skin the sponsor has in the game. (The amount of cash that they are co-investing alongside investors). Why is this important? Paul Kaseburg has sat on both sides of the table on over $1.7 billion of real estate deals. He explains that the dirty secret of the industry is that every sponsor claims their performance-based compensation aligns them with you... but it really doesn't. (See Black-Belt Real-Estate Strategies from Investment Author Paul Kaseburg: Part 1 ) They benefit disproportionately if the fund does well, but you take all the risk if it doesn't. This incentivizes risk-taking, which is what no conservative investor wants to hear.
In a few cases, the sponsor may offset this risk by putting a substantial amount of their own cash into the investment, just like an investor. Then they are sharing the downside risk along with investors, and it serves as a check on the incentive to push risk higher.
However, as usual, many sponsors/sites will exaggerate the skin in the game. Real skin in the game is cash, invested on the same terms as investors. But many times if you drill in, you'll find that they didn't put in any cash, but rather put in a "fee" that they are taking from investors in the fund. While better than nothing, it's not much of a disincentive against excessive risk-taking.
For example, some sponsors will offer up dozens of funds onto the marketplace this way, and put no real cash into any of them. If even a small percentage of them do very well, they will profit handsomely, even if every other fund goes bust. But if you are invested in one of those busted funds, it's a completely different story. I want to see cold hard cash, not a fee.
Another trick is that they will put in cash, but it is on different terms than normal investors. For example, they may get a better preferred return than yours, or participate in some better way than you can. In cases like this I have to ask, "if you're not willing to invest in your own fund on the same terms as me, then why should I invest"? For me, those are red flags. Regardless of your own opinion, it's important to at least ask and know if the skin in the game is in cash in on the same terms as investors or not.
Open to Scrutiny (Or do they "lawyer up")?
No investor knows everything...including myself. So if I'm serious about an investment, I will always bounce it off of other investors in a high quality investment club. Many times someone's noticed a small detail or fact I'd missed, and saved me from making expensive mistakes.
Sponsors will always require me to sign a nondisclosure agreement (NDA) to see the terms of the investment. However, I've found that most reputable sponsors allow an exception for people advising me on my investment (including not just licensed professionals but also my spouse, business partners and an investment club). This is especially true in an investment club where all the members are bound to secrecy by an NDA themselves.
Despite this, I always tell the sponsor I'm going to share the information with club members. I do this as a courtesy, and also as a test. The vast majority have no problem with it and pass the test. (And many of the sponsors of the more compelling deals will get excited by the idea of the potential referrals.).
However, about 2% will instead "lawyer up" and say that the information can't be shared with anyone else. In the past, I've given these firms the benefit of the doubt, and assumed that they were just being very legally defensive. But when I've dug into them further, I've always found something either bad or horribly bad (in the terms, the deal itself or the sponsor). After 9 or 10 times, I've stopped bothering with sponsors like that. If they won't agree to being scrutinized by my peers, then for me it's a red flag and I move on.
"Death by Google"
This is something I usually do quickly at this stage, and then in more detail later if the deal survives that long. I google every single thing I can think of regarding the sponsor, to see what dirt I can dredge up. This might sound simple, but it takes time to do well.
I usually start with the easy ones like "<sponsor name> fraud", "<sponsor name> ripoff", "<sponsor name> lawsuit". If I see a lot of controversy, I usually pass. It's possible they could be smeared, but I usually feel I don't need to take the chance, because there's probably another sponsor with a clear name doing something similar.
I also check the names of all the principals. For example, one principal I found had been named in a local newspaper as being associated with a scandal involving evasion of property taxes. Several have had multiple sanctions from FINRA (Financial Industry Regulatory Authority) for various types of fraud involving customers. Another good source to check is the SEC for any actions.
I also check rating sites, like yelp, glassdoor, etc.. I've found out a lot of inside information about sponsors that were running shoddy operations this way.
Any claims that the sponsor makes, I verify. For example, one sponsor claimed that he had written a thesis before graduating from Harvard business school, when in actuality he had just gotten a certificate from a 4-5 week program. Some investors will overlook things like this, because they feel that all sponsors are salespeople! I feel that there are salespeople that do have integrity, and those are the only ones I do business with. I also follow what I call the "roach test": if I can find one ethical problem in plain sight, I know there are probably hundreds hiding where I can't see. This test may have caused me to miss out on some good investments. But it's also saved me from some catastrophic ones as well (like this one). So, outlandish claims that aren't corrected are red flag for me.
Putting It Together
It doesn't take too long to do the above (about 15 to 45 minutes, depending on how much probing I have to do and back and forth with the sponsor). And it usually weeds out about 90% of the deals. If an investment survives this, I finally start to get a little bit excited/interested. Maybe this will be one of the diamonds, and it's worth looking into further.
The next step takes the longest, running as short as a few hours (for the quickly discarded ones), to as long as weeks or months (for the successful ones). Ironically, the worst deals fall out very quickly, and it's the best deals that take the longest to fully understand. But in the end, I ended up with an investment that I feel very comfortable with, and that I feel matches my conservative risk profile. I'll talk about that more in Part 3.
