How a Real Estate Sponsor Lost $650,000

Real Estate Related News:

• U.S. Banks See Weak Loan Demand Despite Fed Rate Cuts

• Core and Value-Add Multifamily Metrics Improve in Q3

• Trump Tax Changes Could Significantly Impact CRE

• Multifamily Cap Rates Rebound, Sparking Fresh Investor Interest

Treasury yields have been fluctuating wildly. The latest volatility appears to be driven by Trump’s win, along with a Republican-controlled House and Senate, which is perceived to potentially increase economic growth and inflation.

As a result, the market demands higher interest rates on treasury yields to compensate for the projected increase in inflation and longer-term risk associated with investing in something that matures in 5 to 10 years. 

I’m no economist, so take this all with a grain of salt! That said, I thought Avi Kozlowski did an excellent job of explaining this in his LinkedIn post, which can be read here: 

If someone looked at my computer history they’d probably be confused by my daily searches, like “10 year treasury yield” along with some other of my odd searches, such as “why does my fiancé not drink enough water and then complain about a headache?” 

We can dive into hydration later 🙂 

For now, let’s focus on why treasury yields matter to us, which comes down to two main reasons:

• Cap Rates

• Debt Financing Costs

Cap rates, a commercial property valuation metric, are roughly correlated to treasury yields. 

As for financing rates, they’re directly tied to treasury yields. More than anything, what individuals in real estate really want is stability in rates. When rates are stable, we can plan ahead with more certainty. 

Things get tricky when rates are volatile for many reasons. The story below highlights one of them. 

A general partner (GP) I’ve invested with in the past felt the full impact of this. If you need a refresher on what a GP/Sponsor and a Limited Partner (LP) is, check out my previous article here.

Back in 2023, rates were highly volatile, but briefly seemed to stabilize around 3.5%. The GP found what appeared to be a strong deal, made an offer, and put it under contract. 

The GP wanted a 5-year fixed-rate loan, so their interest rate was based on the 5 year treasury yield.

Let’s say the lender’s spread was 2%, which resulted in an all-in interest rate of 5.5%.

(5-Year Treasury Field + Lender Spread = Total All-In Interest Rate)

In their analysis of the deal, the GP accounted for potential rate fluctuations and built in a buffer to ensure that a small increase of .25-.5% wouldn’t kill the deal.

When a deal is under contract and the GP is planning to use fixed-rate debt, they typically do not “lock in” the interest rate until closing, or just before. This leaves a window of time from offer acceptance until closing where things can go wrong, like interest rates increasing.

The GP put up $650,000 in hard money, which the seller gets to keep if the buyer backs out of the deal. This is a strategy used to incentivize the seller to accept their offer over others. 

Sure enough, during the contract period, treasury yields began to rise slowly, but the GP had built in enough of a cushion to absorb this small increase without much concern. Everything seemed fine. 

Then—the yields didn’t just creep up—they started to spike, and fast. The GP did not plan for this, and instead of locking in their original 5.5% interest rate, they were now facing an interest rate of 6.65% or higher.

This deal did not have high cash flow to begin with, as it was in a highly competitive market. Looking at their new interest rate, the deal had lower projected returns and increased risk from lower cash flow.

By the time rates had skyrocketed, the GP had already raised the equity (down payment, closing costs, and capex) from limited partners—people like you and me. They had millions of dollars sitting in their bank account, ready to purchase this property.

It’s important to understand that raising capital is no small feat—it’s a huge effort, especially when you’re raising tens of millions of dollars from individual investors writing checks in the range of $25,000 to $500,000.

At this point, all the GP had to do was sign the documents and close the deal.

They would keep their $650,000, collect acquisition fees for their firm, and likely could have spun the narrative to many of their LPs, explaining that the increase in their interest rate was no big deal. 

But instead, they did the right thing—even though it wasn’t easy.

It was just too risky. In the end, they chose to cancel the contract and walk away from the deal.

While they’re not a small firm, they’re not a huge one either, and a 650k loss must have been a hard pill to swallow at the time.  

You might wonder if there was ever any silver lining to this situation, and thankfully, I believe there was. 

So, what did they gain from this experience?

They earned immense trust from their LPs and capital partners. 

The general partners chose to absorb the full $650k loss and refunded all of the money to the LPs.

It’s crucial for prospective investors to understand the deal they are investing in, but arguably more important, they need to understand the GP/sponsor and their ethics. LPs need to be able to trust the person they are wiring their hard-earned capital to. 

In this case, the GP lost personal money, but in doing so, gained the trust of their investors.

When evaluating a sponsor, ask yourself: Would this person be willing to risk their own capital if a deal materially changed during the contract period?

This happens more often than you might think. Just earlier this year, I witnessed a sponsor materially alter the financing structure of a deal, downplaying the importance of the shift in strategy to their LPs.

That’s a major red flag. Especially since the new structure made the deal far riskier than it was when initially presented to investors.

Invest wisely out there! And as always, I’m open to feedback, so feel free to reach out.