Ultimate Guide to Evaluating the Sponsor & the Deal

Ultimate Guide to Evaluating the Sponsor, Market & Deal

As a multifamily operator, we look forward to getting past these volatile times and into a more predictable lending environment but unfortunately there will likely be some casualties in the syndication business. Trouble will come from inexperienced operators who were ill equipped to handle unexpected and prolonged adversity or did not conduct proper risk management. Evaluating the sponsor, the market and the deal is a critical skill for any investor to possess before committing to any investment. In this guide we will break down the major factors that an investor should consider to make a confident decision.

how to evaluate the sponsor

The next most important consideration when deciding on a syndication deal is to evaluate a market where the asset is located.

Track Record

There will be some good deals to be had for savvy and patient investors that act on the old adage “buy low and sell high” but just how do you pick the right sponsor team to partner with or the jockey as they say? There is just no replacement for track record and is the single best predictor in the long term success of your investment. You will want to work with an operator with a sufficient size portfolio, assets under management (AUM), operational history, and niche expertise. Ask how many deals have gone full cycle and what were the actual results versus projections, and how much of the results were attributed to market conditions vs. operational expertise. It is preferable that the operator has market cycle experience either in multifamily or running a major business, particularly through the 2008 Great Financial Crisis, as well as a history of successfully navigating through operational challenges. Additionally, ask if the sponsor has ever declared bankruptcy, lost a property or investor’s money, issued a capital call, paused distributions, or performed below expectations.

Experience

The investor should also assess the financial stability of the operator and whether it is profitable and have ample liquidity and balance sheet to not only qualify for loans but also to backstop unexpected adversities. You should also review the background of each team member to assess their qualifications and experience and whether those skills transfer to their current roles. Ideally, you will want to see dedicated members in key roles like asset / acquisitions management, investor relations, and strong back office support. Some operators tout having in house property management but there are pros and cons to both in-house vs. third party. You may have more control with an in-house staff, but you also give up the independent assessment and vendor relationships that a reputable long-time third party manager specializing in your asset class / submarket can provide in addition to the sponsor’s own underwriting.

Communication

Most investors cite communication as one of the most critical determinants whether they will invest with the sponsor again, regardless of performance and we fully agree as transparency and communication are two of our core values. We believe that proactively reporting good and bad news (and what the sponsor is doing about it) in a timely manner is the only way to ensure investors that we are good stewards of their precious capital. You will want to see monthly or quarterly updates highlighting execution of business plan, wins and challenges, as well as actual vs. projected Key Performance Indicators (KPI’s) and financials to evaluate the sponsor’s operational expertise. Ask to see past samples. A serious sponsor should also have an investor portal that stores all of the important documents like the PPM, OA, SA, K1s, etc. And you should expect reasonable response time to inquiries prior to investing (can you imagine if the communication was poor prior to investing, how about after they have your money!)

Verify

Don’t just blindly trust the information presented by the sponsor. Verify their online presence such as the company’s website, Linkedin profile(s), podcast (either as host or guest) and various social media sites. Look for evidence of honesty, integrity, and humility in how they interact with others. You can join various passive investor groups and ask around or ask the sponsor to provide you with a few investor and professional references. You can also do background checks and look for any history of criminal, regulatory violations, bankruptcies, liens, and poor credit. Meet in person if possible to get a gut feel!. Break of Day Capital created a free evaluation tool with a comprehensive list of questions that you can use when evaluating the sponsor team.

Evaluate the Sponsor Tool

how to evaluate the market

The next most important consideration when deciding on a syndication deal is to evaluate a market where the asset is located.

Market Size

The market should be of sufficient size to ensure that it has the proper infrastructure to attract additional businesses and population in-migration. The Metropolitan Statistical Area (MSA) should be of adequate size and the smallest that we prefer is at least 1 million in population. Ideally, the asset is located in an emerging market or in the path of progress with above average job / population / and wage growth which should ultimately lead to rent growth and potential to force appreciation. It is more common for growth markets to be located in business and landlord friendly states.

Employment

Having a diverse employer base across several industries is also critical in that it minimizes the negative impact to the overall job market from adverse changes in any one or two industries, and even better if the various businesses are non-correlated. Ideally, the submarket should not be dominated by any one industry or make up more than 15-20% of the total employer base. The presence of large hospitals, blue chip S&P 1000 companies, and the likes of Costco or Trader Joe’s would be a great sign as these types of companies often conduct a substantial amount of research at great cost before deciding on where to set up shop.

Median Income

The ideal median income range should be at least 2.5 times the pro-forma rent levels, not too high where people can afford to buy homes or too low where they cannot support the higher projected rents for upgraded units as is often part of the value add business plan. In addition, higher median home prices would make homeownership a lot less available and more attractive for renting. A low cost of living, favorable crime statistics and school ratings are other key attributes that support an attractive submarket. Lastly, you will need to pay attention to the absorption rate to avoid a sudden increase in the supply of units that could impact occupancy. To sum up, it is critical to be in growth markets with strong fundamentals to enhance the success of executing Value Add strategy.

Employment

how to evaluate the deal

Evaluating the multifamily deal itself is probably the easiest but nevertheless important in deciding whether the investment strategy (core, value add, or development) is appropriate for your portfolio. Do not just pick the deal with the highest projected IRR, it is just a wild guess at best.

Evaluating the Business Plan

Review the business plan and make sure the capex budget is sufficient. A couple of key metrics of interest are yield on cost which is the pro forma cap rate once the property has stabilized and a related metric called development spread, which is the difference between the yield on cost and the going-in cap rate. The development spread measures the amount of “value add” or the improvements made to the operations to force appreciation. The projected rents should be well supported by true comparable properties and similar unit amenities. It is also ideal for the asset to be located with easy access to major highways, retail, grocery, restaurants, etc.

Evaluating the Debt

It is important to understand the debt structure and determine its suitability for the business plan. It does not make sense to put on long term 12 year fixed agency debt if the plan calls for selling the property in 3 to 5 years after stabilization and incur steep prepayment penalties. Is the rate fixed or floating and if floating, is there a rate cap in place for the entire maturity of the loan? In addition, a conservative operator would keep excessive reserves not only for all major components of the asset regardless of the condition at the time of purchase, but also for working capital and contingencies for unexpected issues.

Evaluating the Underwriting

When it comes to underwriting, you will want to see conservative rent growth, reasonable expense ratios, and economic vacancy assumptions to make sure the operator isn’t making aggressive assumptions to inflate the projected returns on paper. Pay close attention to the insurance cost, property taxes, and if the property is in a flood zone which will require additional coverage and added risk. Is the operator using a reversion cap rate that is realistic or inline with long term historical average? Be aware that even a small reduction in the reversion cap rate can increase the projected valuation of the property significantly. What kind of stress testing / break even occupancy and sensitivity analysis has the operator performed? It is good to see how changes in occupancy, cap rates, or rent growths impact the investor’s returns.

Evaluating the Fees & Splits

As it relates to fees and profit splits, you will want to see that the fees are reasonable and that there is alignment of interest and skin in the game from the operator. Acquisition, loan guarantee, and asset management fees are typical, but capital raising, broker dealer commissions, and disposition fees are less common. Is the operator putting in their own money in the deal net of their fees, and signing on the loan? There are infinite ways to structure the profit splits or the waterfall, but one that is favorable to investors prioritizes the return of investor capital plus a high hurdle rate (preferred rate) before the sponsor gets to participate in the profit split, and incentives the operator to outperform but allowing a higher profit split if investor returns reach a certain targeted level.

Evaluating the Legal Documents

Carefully review the Private Placement Memorandum (PPM), Operating Agreement (OA), and Subscription Agreement (SA) as they provide the governing and legal framework for your investment into the deal. Make sure that your understanding of the terms of the deal as represented in the investment deck is clearly spelled in these documents.

Evaluate the Deal Tool