Category: Article

Exit Strategy Is Key in Real Estate Investing

Think back to the Saturday morning cartoons when Bugs Bunny would get stuck in a tight spot. Whether it was a rabbit hole or quicksand, there was always an “eject” button to catapult him safely out of danger. There’s certainly a valuable lesson to learn here—you should always have a reliable exit strategy.

Having an exit strategy in place for a real estate investment before it’s needed can save you the panic of feeling trapped down a rabbit hole when you want—or need—to get out.

When and How to Plan Your Exit Strategy

Your potential real estate exit strategy is best planned before you buy the property in the first place. It is wise to have a sense of how, when, and at what price you will ultimately be able to sell the property as you negotiate your purchase agreement. This helps you know that the economics make sense from the onset.

The strategy then must be tested and modified as conditions change. For example, many investors have found that the comparatively higher interest rates over the past year have impacted their plans to sell or refinance. Ideally, you will also have a realistic fallback position to guide you if your original plan doesn’t work out.

Some investors buy real estate with the intent to hold it indefinitely so they can pass it on to heirs with a stepped-up tax basis. While this may be a good plan if the property generates net income, what if it becomes a cash drain or requires an additional investment of capital or sweat equity to remain profitable? Or, what if the next generation is unwilling or unable to manage and maintain the property? Or perhaps the neighborhood around the property changes, making the original use less viable or desirable.

For an investment you intend to hold shorter term, changes in interest rates and economic conditions locally or even globally can interfere with sale plans, as many people saw during the COVID-19 pandemic. Additionally, a value-add strategy may be disrupted by labor or material shortages, changes in tenant preferences, or unanticipated structural issues with the property.

That’s why a real estate exit strategy is important, no matter how long you plan to hold on to the asset.

8 Considerations for a Personal Real Estate Exit Strategy

What constitutes a favorable and realistic real estate exit strategy depends upon your goals and risk tolerance. Consider the relevant factors below.

Return Expectations

Are you looking for modest or aggressive cash flow, or is your primary goal to achieve significant appreciation and profit? Consider how much flexibility and cushion you have in your range of successful outcomes.  Running a cap rate sensitivity can help you understand the likely range of sale proceeds based on your projected NOI (net operating income) at the time you hope to sell.

Time Horizon

How long do you intend to hold the property? Is your strategy to hold long-term, to improve and flip quickly, or something in between?  Are you willing to sell your property at a loss in order to exit at a specific time?  Your pre-acquisition underwriting should model the economics of a sale both earlier and later than your goal. This will help you understand the impact of timing on your potential returns.

Need for Liquidity

Is there an upcoming obligation, such as school tuition, that may require you to have a large amount of cash on hand? Do you have other funds readily available to cover unanticipated events? Or may you need to exit the investment earlier than planned to free up liquid assets?  One potential solution may be a line of credit secured by your property.

Changes in Tenancy

Whether your property is an apartment building where frequent turnover is expected or an office, retail or industrial building with longer lease terms, when a tenant exits, the property must be prepared for a new tenant. This means capital improvement expenses and some downtime. You also need to account for the possibility that there may be a lag between tenants. Some good market research before and during your ownership can give you a head start on finding replacement tenants.

Relationships Among Owners

There is a saying that doing business together is a great way to break up a family or friendship. If you own a property with others, have a strategy for moving forward. What if there are disagreements about the property, management or investment goals? Suppose one owner wants to leave, refinance or sell. What if someone dies or becomes incapacitated? A formalized written agreement must be in place at the time of acquisition to address potential exit scenarios.

Financing 

If you purchased the property with a mortgage loan, when does the debt mature? Can you extend the maturity date, and under what terms? Is your loan assignable to a subsequent purchaser of the property? Find out if there are penalties or restrictions for paying off your mortgage early and whether you can bring in financing from other sources. Mortgage interest rates can fluctuate unfavorably.  You may find that lenders are constrained by considerations unrelated to you when you want to refinance.

Market Conditions

Are you open to an early sale if you receive a favorable purchase offer? Can you hold on to the property longer than originally anticipated if market conditions are unfavorable?  Look into your options if your existing use of a property ceases to be the highest and best use for the asset.

Alternative Sale Formats

Depending on the type and size of asset you acquire, your exit strategy could involve a sale in stages rather than a single disposition. You may also be able to sell all or a portion of your ownership interests without transferring the property itself. Options include having a buyer acquire the entity that owns the property and contributing the real estate to a larger fund.

Exit by Selling a Property Outright

The most common real estate exit strategy is a traditional sale. In this case, the property is sold to an unrelated third party through an arms’ length transaction. The primary issues become when the sale should occur and the appropriate pricing.

For single-tenant properties, the lease terms may suggest some logical sale dates, such as the date a new lease or renewal term takes effect or a date after certain lease contingencies.

Traditional Exit Points for an Outright Sale

Depending on the type of property and how many tenants occupy it, some plausible times for an outright sale include “natural” end dates related to the property or the tenants, such as:

  • Loan maturity
  • After key leases roll
  • After significant capital improvements or structural repairs
  • A date that coincides with the expiration of relevant operating leases
  • A viable purchase offer that allows you to use your capital elsewhere

Value-Add Real Estate

If your property has a value-add component, you can sell once the improvements are complete in order to immediately monetize your upside. Or you may choose to operate the improved property for cash flow for a period of time to enjoy the fruits of your labor.  For larger properties, a value-add strategy may involve improving only a portion of the property and then selling. This leaves some “meat on the bones” for a prospective purchaser who wants to initiate its own value-add program.

Risks of Outright Sale as a Real Estate Exit Strategy

Relying on these traditional exit points can be dangerous because not all things go according to plan, especially when it comes to investments.

Demand Changes with a Changing Market

The market does not always cooperate with your plans. Cap rates, interest rates, tax laws, lending regulations, or the local or national economy may be unfavorable for a sale at the time you originally planned to exit the investment.

As many office and hospitality investors saw post-pandemic, properties in high demand at the time you acquired them may be significantly less desirable if market conditions change. In contrast, the aggressive real estate pricing in 2022 provided huge upside opportunities for investors who were willing to sell early.

Vacancy Woes

In addition, if the property’s tenancy changes significantly, you will likely need to adjust your exit expectations until you find replacement tenants or guarantors. In a multifamily property, changes in occupancy and/or rental rates can impact prospective pricing, especially if those changes position you unfavorably with your nearby competitors.

Partnership Troubles

Additionally, if you own the property with one or more partners, your timing for a sale can change. It may be hastened (or delayed) by a disagreement among the parties, a transfer of a partner’s interests, or a partner’s need for liquidity.

Finance to Get More Capital or More Time

While a loan will not enable you to immediately exit an investment, financing may provide a way to unlock capital invested in a property or buy yourself more time to sell. This can be helpful if you want to:

  • Delay the timing of a sale until market conditions improve
  • Make improvements to the property to create more value and upside
  • Use equity invested in the property for some unrelated purpose

Pros and Cons of Refinancing 

Adding leverage may increase cash flow (assuming your yield is greater than the interest rate). However, it also increases overall risk since the loan will have to be repaid before you can pocket the proceeds from any disposition of the property.

Refinancing an existing loan may allow you to take some of the equity invested and use it for other purposes. It also helps that proceeds from a refinance are not immediately taxable.

Commercial loans can be extended for periods of time. It depends on the lender, the terms of the loan, the credit of the tenant(s), the duration of their leases, and the then-current interest rates.

Financing Options and Considerations

These options assume that you can actually get a loan for the property in question with terms that make economic sense for you and that your existing lender (or a replacement lender) is willing to cooperate with you.

As some investors learned in recent years, credit is more difficult to come by post-pandemic.  There are mezzanine and bridge lenders who can help cover the gap between what your senior lender will provide and your available equity. However, this type of financing typically comes with a steep price tag.  You will have to make an honest assessment about whether your project will leave you sufficient equity if it has to support two layers of debt.

Note that some types of loans may be assignable to a subsequent purchaser of the property, which can be attractive if you can lock in a low interest rate for the long term.  Loans may also have defeasance charges, swap breakup fees, and lockout periods, making an early exit more challenging. You will need to find a buyer who will assume your loan or pay the penalty amount from the sale proceeds.

A borrower cannot receive proceeds from the sale of a property until all mortgage liens are satisfied or the loans are assumed. Therefore, financing should only be used with careful planning, taking investment goals into account.

Repositioning a Real Estate Investment

If the market is not favorable for a sale or refinancing when you want to exit an investment, repositioning or repurposing the property may unlock value.

Converting or Repurposing a Property

For example, if you own an apartment building, consider converting the property to a condominium and selling the units individually instead of trying to sell the entire building at once. You could also make capital improvements to increase the building’s longevity. Depending on the property’s location, size, and zoning, you may lease the roof to generate income from solar energy, cell towers, or recreational use.

Changing the use of a property (or a portion of it) will require additional capital and may require zoning changes as well. However, repurposing a property can potentially better position it for sale.

Some types of changes may or may not be feasible, depending on your plans, the building’s infrastructure, and the local government’s cooperation.  However, you may find that there are government incentives available to convert your property to a different use.

Increasing the Appeal of Your Real Estate

In other instances, interior remodeling, modernizing a façade, or improving landscaping may increase the property’s curb appeal.

Undertaking capital improvements to building structures and systems adds appeal to purchasers who can’t or may not want to do that work themselves in the future, as well as tenants who would potentially lease the entire building on a triple-net basis.

Alternative Exit Strategies

Partial Sale

Depending on the nature of the property, it may also be possible to sell a portion of the physical asset while retaining the rest. This can be done in a variety of ways, such as selling some buildings if the option is available or selling a portion of vacant land. Another option is potentially dividing the property into individual condominium units. There are a number of variables that can affect how much land you can end up selling if you choose to go this route.

Bring in New Equity Investors

If only some of the property’s owners wish to exit, or if a sole owner wants to reduce their ownership percentage without selling outright, you may be able to bring in new equity investors through the sale of ownership interests.

One significant challenge of changing investors is how to value the property interests. You will need to establish how the property will be managed and how the proceeds will be distributed. Note that if you have a mortgage that will be kept in place, the lender must consent.  Alternatively, you may sell outright to a buyer that would permit some or all of the owners to retain an equity interest in the new ownership of the building in exchange for a reduction of the purchase price (a “721 exchange”).

The Right Exit Strategy Is The One That Works For You

Hopefully, your real estate investment won’t trap you in a rabbit hole. With careful and creative advance planning, you can ensure several viable exit strategies to transition profitably out of property ownership.

Experienced financial advisors point out to clients that real estate investment portfolio diversity will help reduce risk in their overall portfolio. You can achieve this in the stock market by purchasing several different stocks, or by investing in a fund that holds multiple stocks.

Diversification in real estate works much the same way.

  • Investors can build a diversified portfolio by buying a variety of individual properties outright.
  • Or, you can invest in one fund that owns many properties.
  • It is also possible to diversify your holdings by investing in fractional interests in individual properties through what is called a syndication.

Real Estate Investment Portfolio Diversity: Sole Ownership
One of the most common reasons why people purchase rental real estate on their own is to maintain full control over the investment. Decisions about leasing, operations, capital improvements, financing and disposition are solely up to the owner. This presents benefits and disadvantages.

As a sole owner, you can pick your own tenants and set their rental rates. You can also discuss any of their requests for concessions, such as rent abatement or improvements to their premises. Property management will be among your most important operational choices. Taking a look at the creditworthiness of prospective tenants will also be key. You have the option to profit from your own sweat equity by handling maintenance and management issues yourself, or you can hire contractors or professional property managers.

Sole Ownership = Sole Responsibility
You will have to do your own due diligence to assess what type of work, if any, will be needed during your intended holding period. You can also decide to what extent you will make capital improvements to the property —improvements that will raise the value of the property. You’ll decide when to do them and how to pay for those improvements.

If you want to use leverage, you can adjust the amount and terms of the loan, including the maturity date, amortization schedule and any interest-only period to accommodate your needs. However, you will typically have to provide a personal guarantee for the debt, which can range from non-recourse “bad boy” carve-outs, or exceptions, to full personal recourse. This will depend on the borrower’s experience, credit and relationship with the lender.

Perhaps the most significant trade-off for the freedom of sole ownership is that it ties up your capital in one project. While this lack of diversification can be minimized by buying a mixed-use asset (e.g.. a storefront with offices or residential spaces on the upper floors) or a multi-tenant property, you will only have exposure to one location in one market. If that market declines due to economic, environmental or other reasons, you probably won’t have as much of a return on your investment as you had hoped.

Real Estate Investment Portfolio Diversity: Real Estate Funds
One alternative to avoid having all of your proverbial eggs in one basket is to invest in a professionally managed real estate fund. Funds can take many forms, including public or private REITs or private placements. An REIT is a real estate investment trust — a business entity that owns and operates a portfolio of real estate.

Investors buy shares in the REIT and receive periodic distributions of income, as well as their share of tax attributes relating to the real estate. This includes both income tax obligations and depreciation deductions. In this way, rather than buying real estate directly, you will acquire shares of a fund that owns the real estate.

REITs: Public vs. Private
REIT holdings can include both real estate and mortgage loans. These trusts are required to distribute 90% of their taxable income to their investors as dividends. Publicly traded REITs are traded on stock exchanges, so they provide easy liquidity. Like mutual funds, they make disclosures and public filings as required by the SEC.

There are also private REITs whose shares are not traded; those investments are illiquid. REITs are professionally managed. The properties they buy are vetted by people with experience in the real estate industry. Those people also undertake and review due diligence for the properties and their tenants. REITs often get funding from institutional investors, so the credit and quality of the underlying assets tends to be high. Reporting is provided on a prescribed basis, and financial results are usually audited by a reputable national accounting firm.

Before investing, you will receive an offering memorandum that states the following:

  • The REIT’s investment criteria,
  • The experience of its management,
  • A description of the actual or anticipated financing and underlying real estate.
  • The benefits and risks of the investment.

If the REIT is publicly held, you will be able to liquidate your investment by trading your stock at any time.

Investment Funds: Less Responsibility = Less Control, Less Say, More Fees
Besides REITS, there are also privately held real estate investment funds, where professional managers acquire, operate and dispose of properties on behalf of their investors. Such funds work in the same way as a private REIT, but do not have a legal obligation to distribute a specific percentage of income to investors.

Among the negatives of using fund investments for real estate investment portfolio diversity are the lack of any voice or control on the part of individual investors for any part of the investment, and the fees charged in comparison to those earned through sole ownership. Depending on the size and nature of the fund, assets may be bought or sold after you invest, making it harder to know exactly what properties are part of the portfolio at any point in time.

Fees will include the administrative expenses of the fund itself and compensation for fund management, as well as the cost of outside professionals involved in the acquisition, debt financing, and management of the properties. These types of funds are likely to engage professionals in larger firms with national reputations.

Real Estate Investment Portfolio Diversity: Syndication Shares the Strategy
Another alternative to diversify your real estate holdings is to invest in a private real estate syndication. Syndications are a type of investment where many unrelated parties put their funds together to acquire a property or a group of properties sharing such characteristics such as a similar location or tenant. Syndications are put together by professional sponsors who enter into contracts to do the following:

  • Acquire the property
  • Raise the capital
  • Obtain financing
  • Operate and manage the property
  • Make distributions of cash flow and capital event proceeds to investors

Most syndications will spell out exactly which properties they own or will acquire ahead of accepting investor funds. Syndicated investments are commonly structured as limited liability companies, or LLCs. Investors acquire membership interests in the entity that owns the property, rather than holding title in their own names.

Unlike REITS, interests in syndications are not traded on public exchanges, and are typically illiquid. Recently, some crowdfunding sites have cropped up to provide another market for fractional interests in syndications. In these cases, the investments may have restrictions on transfers, such as prior sponsor or lender approval.

Syndication has higher returns, but you won’t see them quickly
Syndications also are not legally bound to give out a certain percentage of their income. While this may seem like a disadvantage from a cash flow standpoint, the rule allows the sponsor flexibility to form reserves or to pay for unanticipated expenses out of cash flow instead of making a capital call.
Typical returns for syndications are higher than yields on a REIT investment. Depending on the size and sophistication of the sponsor and the structure of the investment, as well your percentage interest in relation to the total equity, individual investors may have direct communication with the sponsor to talk about property operations. Additionally, sponsors may have more flexibility regarding the timing and nature of the investment’s disposition strategy than a REIT or fund, as these are not tied to a fixed fund liquidation date.

It’s Your Money, and Your Call
There are a number of alternatives to help with real estate investment portfolio diversity. All real estate investments involve risk, beginning with the level of experience and integrity of the individuals acquiring, managing and selling the assets. The party could be you or outside professionals. In any case, it is important for you to do your own due diligence to understand the risks, costs and potential rewards of your investment.

And the Best Real Estate Investment is…
One question I am often asked about with regards to real estate is: What is the “best” type of property to invest in?

Obviously, there is no right or wrong answer. Your ability to risk the money you invest, the returns you might expect, time horizons, and your overall investment goals all impact what investment might be right for you.

The following factors impact the success of all real estate investments:

1) Location

2) Financing

3) Tenancy

4) Necessity for capital improvements

Additionally, the terms of any existing leases will affect a property’s performance. There are, however, some benefits and challenges inherent in various asset classes. Understanding these details can help you assess what type of investment is best to help you meet your goals.

This column addresses the risks and rewards generally associated with residential, retail, office, industrial, and operational real estate investments.

Residential Investment Properties
Residential investment properties are attractive because there are a broad range of choices in a wide variety of price points. You can invest in a single-family home, a condominium unit, or a multi-tenant building.

Furthermore, there is a comparatively strong supply of possible residential tenants compared to other asset types. Everyone needs to live somewhere.

Perhaps the biggest challenge with residential property is that it tends to be management-intensive in terms of maintaining the property and collecting rent. If you are not handy, or if the property is not near you, you will likely need to hire someone to handle operational matters for you.

In addition, units in multi-tenant buildings may be negatively affected by neighboring owners. Residential renters’ appetites for amenities change more quickly than do commercial tenants. On top of that, pricing may be competitive, as you must bid against both prospective investors and prospective residents.

The following are specific risk factors for residential properties:

  • Individuals do not typically have pockets as deep as commercial businesses. You will need to check the credit of your tenant(s) and any lease guarantors.
  • The neighborhood — or demand for rental housing in the area — may change significantly in a relatively short period of time. The proximity of the property to public transportation and neighborhood amenities (including grocers, dining and entertainment, parks and recreation, and quality schools) can also impact the desirability of apartments.
  • The demand for property-level amenities is always evolving. This is particularly important for a multi-tenant building where common areas must be maintained as well as individual units.
  • Residential leases tend to be shorter term than commercial leases, so you may need to find new tenants on an annual basis. Turnover costs might include leasing commissions or referral fees in addition to normal cleaning expenses. On the upside, changes in tenancy also provide an opportunity to increase rents more quickly if market conditions improve.
  • Government subsidies or tax incentives may be available for some types of low-income housing.
  • When reviewing the rent roll, note that rent concessions can boost occupancy. However, they will decrease revenue on a per-square-foot basis.

Retail Investment Properties and Office Investments
Retail and office investments share several similar features. Both can be single- or multi-tenant properties. The tenants may include global, national, or regional firms, as well as “mom and pop” businesses.

The number of tenants and the tenants’ credit and sophistication, as well as the extent of common areas maintained by the landlord will impact the ease of managing both types of properties.

Recent market trends for both sectors include a general reduction in square footage desired by tenants. In retail, this is largely due to internet sales and better distribution channels — resulting in less inventory stored on-site. In office buildings, the need for storage areas for paper files has been reduced significantly by electronic records. Additionally, the footprint of offices has waned as companies have become more open to telecommuting, and have shifted from fewer single-user areas in favor of collaborative common spaces.

As a by-product of telecommuting, space requirements have also been affected by hoteling. This happens when employees reserve desks or offices on a daily or hourly basis when they are physically in the office, using lockers or other designated storage space for files and personal items when they are working remotely.

One of the biggest challenges faced by the retail sector is the impact of e-commerce. While 91.6% of retail sales still arise from brick-and-mortar stores, the future of large retail spaces (such as department and big box stores) is unclear.

Some retailers have moved to a showroom model. At the store, customers can see and touch sample products, and then have the goods shipped from a distribution center. In contrast, Amazon has now opened brick-and-mortar stores to supplement its online presence. Learning how to Leverage Real Estate Investments to your advantage could really pay off depending on the timing.

E-fairness legislation is currently being deliberated by Congress to require online retailers to collect sales tax for all customers regardless of whether they have a physical presence in the state. This would eliminate price distinctions due to state and local taxes.

  • Regarding single-tenant retail and office properties, the investor should focus on the following:
    The tenant’s credit. Obviously, the success of the investment hinges on the ability of the tenant to perform its obligations under the lease. This includes both paying rent and performing maintenance and other obligations. A guarantee from a deep pocket may provide a backstop in the event of a default of a subsidiary. But enforcing that promise may be expensive and time-consuming — and perhaps impossible if the tenant ends up bankrupt.
  • The length and terms of the lease. A long-term lease provides predictable income and a basis to acquire financing. But it also means little opportunity to capture upside potential if market rents increase. The lease will designate landlord and tenant responsibilities (both for normal operations and in case something goes wrong) and may also include rental concessions or allowances for tenant improvements.
  • The location. Look at the market demand for space and the supply of tenants, as well as accessible parking, transportation and amenities. Downtown hubs and larger metropolitan areas provide a bigger tenant base to draw from if the economy falters.
  • The age of the property. What is the likelihood that significant capital repairs will be needed, and when? How long has the tenant been operating in the location?

If there are multiple tenants, you may also consider the following additional factors:

  • When reviewing the rent roll, do several leases expire at the same time? This presents both a danger of high vacancy and an opportunity to redevelop larger portions of the property at once. Rent concessions (as well as tenant improvement costs) paid over the lease term and then burned off will affect the true rental revenue stream.
  • Each tenant may have specific parking requirements, but tenants may not all have the same hours of operation. This may provide flexibility if parking space is at a premium.
  • Pay attention to what items are included and excluded from common-area maintenance charges (CAM), and how — and when — CAM charges are passed through to the tenants and reconciled.

Some issues specific to shopping centers include:

  • Shopping center leases may have use or radius restrictions limiting the type of businesses the landlord can add to the shopping center. These “non-compete” clauses can be narrowly tailored (e.g., to exclude a specific competitor), but are frequently broadly worded (e.g., sellers of women’s shoes).
  • Some shopping center leases include provisions that allow other stores, including smaller tenants, to pay less rent or even terminate their leases if anchor tenants “go dark” or leave the center.

Industrial Property Investments
Industrial properties include warehouses, distribution centers, manufacturing facilities and flex buildings. Access to transportation is more important for industrial assets than other property types; tenants will need to be able to easily transport materials and goods to and from the facility. Features that warrant special attention when considering an industrial building include:

  • Number of dock doors and the type of dock equipment (for example, bumpers, drive-in or dock high doors);
  • Size and security of the truck court, which should be separate for each tenant (as well as separated from passenger vehicle parking areas);
  • Clear height of storage and operational (non-office) areas;
  • Drainage, sprinkler, lighting, and ventilation systems, especially for manufacturing and production areas;
  • Size of the office areas, which often require a higher degree of finishes to be provided by the landlord.

Operational Real Estate Investments
Operational properties do not get leased to specific tenants. They are instead used by paying customers on a daily, weekly, or monthly basis. Hotels, parking garages, self-storage facilities and some assisted/senior living centers are examples of this asset class.

Unlike residential, retail, office, and industrial properties, the success of an operational property is largely dependent on the underlying business at the property. Income from such assets will change due to seasonal and other variances in business.

For operational assets, therefore, it is important to have property management with specific expertise in the field who can 1) handle the business on a day-to-day basis, and 2) optimize use while controlling costs. Accordingly, these properties do not make good “armchair” investments without the help of an experienced operator to take on these efforts.

Operational assets are also more dependent on the local economy than other property types. The occupants do not need to ask for rent reductions from the landlord if business is slow; the income adjusts itself based on the market. On the other hand, a strong demand for the property’s services or reduced competition can mean quicker income for the landlord.

The Overall Picture
No asset class is necessarily “better” than any other for investment. However, some types of properties will need more time and expertise than others to keep cash flowing. Having multiple tenants may increase the operational complexity of a property, but it may also afford more flexibility to adjust rents or repurpose space if needed.

You should always obtain your own market research and conduct due diligence before investing in a property. Reviewing existing leases is a key to understanding the potential benefits and pitfalls of a given asset.

Ideally, passive investors should strive for diversity in their investment portfolios, and rely on knowledgeable property management if issues arise. Mixed-use properties, such as storefronts with apartments or offices located above them, may have both advantages and disadvantages of their component asset types. They also offer a degree of diversification within a single building.

ASSUME YOU LEARNED about an opportunity to invest in a real estate project. The property is in a great location, has quality tenants and the underlying economics appear sound. Better yet, it’s within your range of risk tolerance.

However, the company offering the deal is an unknown—you’ve never heard of it.How can you determine whether the offering is legitimate and the sponsor is trustworthy?

When considering investing in a passive real estate deal, the qualities of the sponsor are arguably more important than the underlying real estate:

  • How much relative experience does the sponsor possess?
  • Is the sponsor credible? How do you know?
  • Does the sponsor have the necessary sophistication?

If you, a passive investor, want to maximize the success of your investment, then you must rely on the expertise of the syndicator, promoter or sponsor who puts the deal together. [1]

Why the Real Estate Deal Sponsor Is So Important
The sponsor is the party who:

  • finds the property and enters into a purchase and sale agreement;
  • assembles the capital and financing to acquire the property;
  • communicates with all of the investors;
  • directs and reviews all aspects of due diligence;
  • oversees the operations and management of the property, including leasing and maintenance;
  • provides financial reporting; and
  • arranges for the disposition of the property at the end of the investment period.

If the sponsor is not honest, experienced and diligent, you could lose some (or all) of your investment.

While many industries rely heavily on user reviews to provide general feedback about quality, this practice is not prevalent in the financial services sector. So how do you get good information to evaluate a sponsor?

Certainly, anecdotal information—such as a referral by a trusted source—is helpful. Here are some other, subjective, criteria that tell you how to evaluate sponsors.

What Is the Sponsor’s Track Record?
Understanding the sponsor’s experience with the type of offering at issue, both qualitative and quantitative, is a good starting point for your due diligence.

How long has the sponsor been in business? Who are its principals, and what kind of real estate experience do they bring to the project?

What is the nature of the sponsor’s experience with the type of asset in question, and the geographic location?

Experience with retail or office properties does not always translate to knowledge about, for example, managing a multifamily building. Similarly, a sponsor likely has more insight into, or resources in, markets in which it already has offices, employees or investments.

Relatedly, have any of the sponsor’s prior deals gone south? If so, why, and what did the sponsor do about it? A sponsor that has been in business for some time—especially during the Great Recession—should have some blemishes on its track record. Understanding how the sponsor handled difficult situations in the past, including timely and accurately communicating information to investors, provides insight into what you can expect if the new investment does not go according to plan.

While past performance does not guarantee future results, it is helpful to understand how a sponsor’s projected returns compared to what investors actually received. Beware of a sponsor that indicates that all of its prior investments outcomes were favorable!

Does the Sponsor Have Skin in the Game?
During the Great Recession, some financial institutions created investment products for other people’s money—not placing any of their own funds at risk. This structure numbed the institutions’ natural instinct to avoid assuming too much risk; economists call this a principal-agent problem.

A sponsor’s investment of its own capital (or its principals’ personal funds) indicates the sponsor’s confidence in its own work product. This is especially true if the sponsor is earning a promote—getting paid ahead of, or hand-in-hand with, investors during the course of the deal (or upon disposition).

What is in the Agreement Between Investors and the Sponsor?
When you invest in a syndication, you entrust your capital to the sponsor. You must understand what responsibilities the sponsor agrees to undertake on your behalf—and any rights and remedies you may have if the deal does not progress as originally projected.

You should also determine whether you or any of the other investors can influence major decisions (i.e., a sale or refinance), and to what extent you can liquidate or transfer your interest to someone else.

  • If additional funds are required in the future to preserve or improve the investment, can the sponsor make capital calls?
  • What will happen to your investment if you do not contribute additional money?
  • Are there any circumstances under which the sponsor can rescind your investment?
  • How are you protected from malfeasance by the sponsor or other investors?

All of these considerations should be addressed in the offering materials.

How Does Sponsor Make Money on the Deal?
Sponsors earn fees for putting investments together. The investment documents should clearly disclose what fees will be paid to the sponsor, and when. Some fees are typically assessed up front, while others may accrue over time—such as an annual asset management fee. There are also fees that may be charged upon disposition or refinance of the property.

Some sponsors make their offerings available to the public through the use of registered representatives or financial advisors.

Others enter into subscriptions with the investor directly, in person or over the Internet.

Note that if you invest through a third party:

  1. The third party should, at a minimum, have the appropriate credentials, such as securities licenses, to make the offering available to you; and
  2. The representative earns a commission for bringing you into the investment (in addition to whatever the sponsor earns). This means you should also find out whether that person may have any conflicts of interest. Sponsors who rely on outside brokers to solicit investors may have a larger up-front fee to enable them to pay commissions and still make a profit.

Some deals have a promote structure, where the sponsor receives a percentage of cash flow or proceeds ahead of or concurrently with distributions to investors. You should understand whether and to what extent the sponsor is entitled to fees if investors do not receive the projected cash flow (or worse, if they lose their invested principal).

If there are third parties involved with the investment, such as outside property managers or joint venture partners, the prospectus should reflect how their compensation is calculated—especially if they are affiliates of the sponsor, may have conflicts of interest or do not receive a market rate fee or distributions pari passu with investors.

The parties who create and offer the investment opportunity to you are entitled to compensation for their work. As an informed investor, you should be aware of what those fees are, as well as when and how they arise.

Check References
A legitimate sponsor will be able to identify legal counsel, financial or tax advisors, and lenders it has worked with to serve as references. Further, the offering documents should include opinions from a reputable, independent law or accounting firm.

Other valuable references include the sponsor’s joint venture partners or investors. Find out who the sponsor worked with and why, particularly partners who played a role in the operation of the project, and let them speak to the character and capabilities of the sponsor.

It may seem like a long list of “satisfied customers” would be a good sign of a reputable sponsor. However, that is not necessarily the case if investors are individuals or family offices rather than institutions.

A good sponsor keeps confidential its investors’ information, and a good sponsor does not reveal its clients’ identities without express permission (do you really want your colleague/neighbor/ex-spouse knowing about your finances?).

In the End, Do Not Ignore the Fundamentals of the Deal
Of course, you must always analyze the real estate aspects of any particular investment. Ensure that you are comfortable with the underlying property and deal terms.

Investments in most syndications are illiquid; you should not commit yourself to a project expected to tie up your funds for longer than you are willing to part with them.

Further, the deal should have an exit strategy—a plan to dispose of the asset after a certain period of time, and a fallback plan in case the market, tenancy or some other factor changes during the holding period.?

An investment inconsistent with your personal risk tolerance or time horizon will be a poor choice for you, regardless of the strength of the sponsor.

[1] I will refer to all of these parties generically as the “sponsor” for simplicity.

Most people know that they should do some “homework” before purchasing investment real estate. (Interested in real estate investing? Start here.)

But what does good due diligence really look like?

This article describes several forms of general due diligence that can help you make an informed decision before purchasing an investment property.

No matter the property type, some diligence items will always be on your checklist. That said, it is critical to understand that your due diligence requirements depend on the type of asset you are investing in. Here is a short list of investment property categories to consider; each comes with a unique set of inquiries necessary to fully understand its risks and opportunities:

Vacant land for development
Apartments
Retail businesses
Industrial buildings
Properties with an operating business component, such as hotels and parking garages

Why Is the Property on the Market?
Word to the wise: due diligence on investment real estate should begin here.

Why is the property on the market? This simple question can reveal much about the prospective success of your investment. It can also reveal what additional due diligence may be needed before you buy.

If you are purchasing a new building directly from the developer, your due diligence will focus more heavily on construction and warranty issues rather than the past track record of the property.

In contrast, if the property has been operating for some time, the sale may be motivated by issues relating directly to

  • the seller (i.e., partners wanting to part ways, need for liquidity)
  • the financing (i.e., imminent maturity of an existing loan)
  • the tenancy (lease terms recently renewed, or soon to expire)
  • the market (rise or decline in property values, neighborhood demographics)

Each of these reasons suggests an emphasis on different forms of real estate due diligence.

Who Are the Tenants and Can You Trust Them?
The performance of investment property depends largely on cash flow. You need to understand the likelihood that the tenants will fulfill their lease obligations—and what security you will have should they fail to do so.

If your tenants are individuals, you will want to verify the rent rolls and understand the leasing criteria of the seller’s property management.

With a commercial tenant, you can rely on credit rating companies such as Standard & Poor’s or Moody’s, public securities filings and tenant financial statements. These may help predict whether the tenant and guarantor have the financial wherewithal to honor the lease obligations.

Additionally, information about the tenant’s operations at the property—lines of business, tenant-funded capital improvements or sales volumes can indicate whether the tenant is likely to renew or extend the term of its lease.

What Are the Market Conditions?
Diligent investors consider two different aspects of the market:

  • trends related to the asset itself, and
  • those related to the location of the property.

Asset-specific due diligence includes comparable sale prices, rental data, vacancy rates and appraisals. (Read more about pricing commercial real estate.)

Locational market trends include demographics and average household incomes near the property, the number and type of employers in the area and access to amenities like public transportation.

Economic incentives, such as tax abatements and interest rates, can apply to either the property itself or the neighborhood.

What Is the Physical Condition of the Property?
In addition to what you can readily see from a property walkthrough, two types of third-party real estate due diligence are common for commercial properties.

Property condition reports (PCRs) address building and structural aspects of the property, such as the condition of the roof, heating and plumbing systems, and construction materials.

Environmental site assessments (ESAs) include a Phase I environmental study, and potentially a Phase II or deeper analysis if the original report discloses an area of potential concern.

Lenders commonly require both a PCR and an ESA before providing a mortgage loan for a commercial property.

Legal Due Diligence
There are a variety of legal items you or your attorney should review. A title search confirms whether your seller has free and clear title to the property to convey to you, as well as any potential restrictions or benefits that may run with the property (i.e., easements, restrictive covenants, condominium declarations, or zoning).

A related item is a survey, which will show the property’s legal and physical boundaries, as well as the location of utilities and any easements. Ideally, the title report and survey will be consistent with one another.

Will You Use Financial Leverage?
If you finance your investment with a mortgage, it is wise to do some due diligence on prospective lenders to ensure that you get a loan best suited to your needs.

Different banks may offer alternative terms for your project (interest rate, loan term, amortization schedule, guaranty requirements) depending on the credit of the tenant(s), the terms of the lease(s) in place and the degree of leverage you require.

Lenders also vary in required loan covenants, such as reserve requirements. A local bank where you have an existing relationship may prove easiest to work with.

Make Better Decisions Based on Facts and Circumstances
Thoughtful real estate due diligence will not guaranty that your property will perform as expected, but it should give you comfort that your investment decision is sound based on facts and circumstances at the time of closing.