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.

MAYBE YOU WANT to start investing in real estate, but you do not have enough capital to purchase a quality commercial property.

Alternatively, perhaps you are concerned about placing a large sum of capital into a single piece of real estate.  Maybe you do not want to personally guaranty a mortgage loan—or take on the management and maintenance responsibilities of property ownership.

Investing in a real estate syndication enables you to acquire a diversified portfolio of properties with the same amount of capital, and without having to undertake managerial or financial burdens.

What is a real estate syndication?

A real estate syndication is an aggregation of capital from multiple participants to invest together in particular real estate opportunities.

A sponsor structures each syndicated investment raises the capital, secures any necessary financing and manages the assets.

Think of syndications like a group of friends and family pooling their funds together to make an investment—however, sponsors of commercial syndications are generally real estate professionals, and the investors are typically unrelated to one another.

What can a real estate syndication invest in?

A syndication may be formed to acquire an individual property or a portfolio of several assets with common attributes (i.e., similar location or tenant).

Syndications often provide an opportunity to invest in larger or more exclusive properties with better credit and higher yields.

These investment properties may be extremely tough for you to acquire independently.

Syndications also offer a way to diversify your real estate holdings—you provide only a portion of the total equity in exchange for a corresponding fractional ownership interest in the property. So, instead of investing all of your capital in a single asset, you can spread your funds among multiple properties.

As noted above, investors in syndications will not have property management responsibilities, and they will typically have no personal liability for any mortgage on the property (other than their invested capital).

The sponsor provides operational and financial reporting. The sponsor also makes periodic distributions of cash flow and/or proceeds.

How to evaluate a real estate syndication

The most important considerations when assessing a syndication are the experience, credibility and sophistication of the sponsor.

You will want to be comfortable that the sponsor has a track record of acquiring, managing and successfully completing similar investments.

The individuals responsible for the syndication must have an excellent reputation within the real estate community.

If any of the sponsor’s past investments did not work out as planned, you will want to find out how the sponsor conducted itself to communicate with, and maximize value for, investors. This is particularly important now that real estate syndications may be offered through crowdfunding over the Internet, where you do not interact with the sponsor face to face.

Investors obviously should evaluate the real estate deal itself, and assess whether it is in line with their personal risk tolerance.

Investors should consider the following:

Answer these important questions before electing to invest in a real estate syndication.

How likely is the projected cash flow?

Income from an investment with a single tenant under a triple-net lease will be more certain than a multi-tenant property, or where the tenant is not responsible for all of the operating expenses. While a long-term lease with one tenant provides a degree of stability—assuming the tenant performs—a property with more tenants and shorter lease terms, such as apartments, allows flexibility to adjust rents frequently based on the market and lessens the impact of a vacancy.

How much leverage is used, and what are the terms?

While leverage can help increase your cash flow, loans often have lender-friendly covenants triggered by changes in cash flow. At some point, the loan will mature.  The greater the loan amount in relation to the purchase price—and the greater the outstanding projected loan balance on the maturity date—the higher the risk.

What is the exit strategy?

You should understand how long the sponsor intends to hold the property and the expectations for return of principal at the end of the investment period. You should also determine whether you can liquidate your investment if you want to exit early. Find out what will happen if the property cannot be sold profitably at the end of the intended investment period.

Use trusted advisors to help find the best investment for you

Investors must receive a private placement memorandum describing the investment, the sponsor, the deal structure (including the relationship among investors and between each investor and the sponsor), projected cash flow and returns, and the associated risks.

Ideally, the offering materials will include an opinion from a reputable legal or financial advisor.

It is possible to lose your entire equity investment if the project does not perform as expected, and there may be obligations to contribute additional capital under certain circumstances.

It is, therefore, important for investors to review the offering materials carefully, and to consult with their own financial, legal, or tax advisors before investing in a syndication.

The current election cycle generated a high volume of articles about the virtues or vices of real estate investment. (Exactly which depends on your political leanings.) Unfortunately, the pundits’ understanding of the tax laws has proven lacking. Perhaps the most prevalent misconceptions surround the like-kind exchange rules found in § 1031 of the Internal Revenue Code. That provision allows taxpayers to defer paying certain taxes when they exchange a business or investment property for a similar property of greater or equal value rather than selling for cash. While the majority of the recent commentary focuses on real estate, especially in light of Donald Trump’s businesses, individuals and companies use § 1031 in many legitimate industries. Repealing these provisions would not only fail to generate additional tax dollars for the government but would also stifle domestic economic growth. Today’s column seeks to clarify some of the misconceptions perpetuated by these articles.

Myth: § 1031 Exchanges Allow Taxpayers to Permanently Avoid Real Estate Taxes

Section 1031 provides a mechanism to defer tax, not to evade or avoid tax liability. It doesn’t even reduce the amount to ultimately be paid. Like-kind exchanges affect only the timing of when real estate investors pay certain taxes.
To completely defer the payment of certain taxes at the time she sells a property, § 1031 requires that a taxpayer jump through a series of hoops, including

1. not taking any cash proceeds whatsoever,

2. purchasing replacement property of greater or equal value,

3. acquiring all replacement property shortly after the first property transfers,

4. ensuring the owner of the new property is the exact same taxpayer as the selling party (i.e., not creating a new company or buying out investment partners),

5. acquiring replacement property that is “like kind” to the relinquished property, and

6. holding the replacement property for investment or business use rather than personal use. If the property owner fails to follow any one of these requirements, the taxpayer pay tax on the transaction for the year the investor sells or transfers the original property.

Further, even if all of the necessary steps are followed, the deferral of taxes is only temporary; an overwhelming 88 percent of properties acquired through like-kind exchanges are later disposed of through fully taxable sales. (See The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges In Real Estate, David C. Ling & Milena Petrova, Marc & June 2015, p. 54.) And when the sale actually occurs, the tax bill will apply to a more expensive replacement property because the § 1031 rules require the new property to be of greater or equal value than the original property [see above].

Myth: § 1031 Is Bad for the U.S. Economy

While it may seem counterintuitive, § 1031 exchanges actually encourage investment, create jobs and stimulate the economy. One reason is the rule that replacement property is of greater or equal value, as discussed above. So businesses and investors are actually “trading up” and investing in more (or more expensive) property than they started with. The tax deferral also encourages people to sell instead of holding their assets and to invest in capital improvements. Each sale consequently employs a variety of people (i.e., contractors, surveyors, environmental consultants, escrow officers, and public utility workers). These transactions stimulate the economy, in part, because it diverts capital gains tax revenue to productive use.

1031 exchanges play an integral role in many industries besides real estate. These include construction, truck and air transportation, equipment/vehicle rental and leasing, and oil and gas extraction and pipelines. They encourage transportation companies to upgrade their vehicles. They also encourage businesses to improve their systems and equipment. Research shows that elimination of § 1031 exchanges in these industries would reduce America’s annual GDP by $27.5 billion, according to the 2015 “Report on the Economic Impact of Repealing Like-Kind Exchange Rules,” from Ernst & Young LLP. Repeal of § 1031 would also lead to increased cost of capital, reduced levels of investments, slower economic growth, a concentrated burden in those industries that rely heavily on like-kind exchanges, and the long-term contraction in the overall U.S. GDP of approximately $8.1 billion annually, the same report estimates. §1031 keeps money here in America, as only U.S. property qualifies for an exchange.

Myth: § 1031 Exchanges Favor Developers

Contrary to recent reports in the New York Times, developers rarely use §1031 exchanges. A developer’s real estate is their inventory, not property held for investment. Further, §1031 exchanges can only capture the value of improvements made within 180 days after the sale of the taxpayer’s relinquished property. As significant real estate developments take substantially longer than six months to complete, §1031 does not provide a useful tax shelter for such projects.

Myth: § 1031 Only Favors the Wealthy

1031 is one of the few incentives available to, and used by, taxpayers of all sizes. Exchanges help individuals, partnerships, limited liability companies and corporations. In fact, 60% of exchanges involve properties worth less than $1 million. And more than one third sell for less than $500,000, according to the May 2014 report from the Federation of Exchange Accommodators, “Impact of IRC §1031 on the Economy.”