Real Estate Observer This newsletter will provide frameworks & analysis you can use to confidently invest your capital in private market real estate. It is written from the perspective of someone who reviews many deals in search of one that fits my personal or my investor community’s preferences. To keep up with what I’m working on, click here. |
Pay Attention to Subtle Cues
Investors and prospective limited partners should be mindful of the subtle signals the other person on the call may be sending. It's crucial to be a strong judge of both character and competence. Don’t invest simply because the vibes seem right.
What to Expect from the Sponsor
Most sponsors will typically ask about your investment goals and risk tolerance. If they don’t inquire about your background or investment preferences, that’s a red flag. They should be assessing your ability to invest wisely, both financially and from a competence standpoint.
At the same time, you should be evaluating whether you and the sponsor are a good fit, just as much as they’re determining if you’re a good match for their opportunities.
For example:
If you have a net worth of $1,000,000 and are considering placing $500,000 in a development deal, any reasonable sponsor should decline your investment and, ideally, take the opportunity to educate you on the real risks of investing in real estate.
Know Your Own Risk Tolerances
A crucial part of this process is making sure you understand your own risk tolerances and investment criteria. While we’ll dive deeper into these preferences in future articles, here are a few examples to consider:
Cash Flow vs. Equity Growth
Reward vs. Risk
Liquidity Preferences
Shorter Hold Periods vs. Longer Hold Periods
Diversification through a Fund vs. Direct Investment in a Property
Once you’ve outlined your investment goals, risk tolerances, and criteria, the conversation should shift toward evaluating the sponsor.
Key Areas to Evaluate
1. Their Experience
How long have they been involved in real estate?
What did they do before entering real estate? (For example, being a successful doctor is not the same as being a successful real estate investor or operator).
Who are the other general partners, and what is their experience? How long has the team worked together?
2. Their Investment Thesis
What asset class do they focus on, and why?
Do they specialize in a subset of that asset class (Class A, B, C, or warzone)?
What markets do they operate in?
What does a typical deal look like?
What are the biggest risks associated with their deals?
3. Their Track Record
Are they transparent about both their successes and failures? (Not every deal will be a home run, but the sponsor should always be honest).
If they haven’t exited any investments yet, how are their active deals performing relative to projections?
Specialization Matters
When working with a sponsor, it’s important to hear that they specialize in a particular area. Avoid sponsors who appear to be throwing darts at a map or constantly changing strategies with each deal.
It takes significant time to truly learn a market, build relationships, and perform at a high level. A solid sponsor should be able to provide thoughtful, well-articulated answers to your questions.
Red Flags to Watch For:
Overly defensive behavior
Cagey responses regarding experience, track record, or other critical topics
Remember, you’re trusting these individuals with your hard-earned capital.
Educating Yourself as an LP
One common issue with average LP investors is that they often lack knowledge in areas like:
Current market conditions
Financing trends
The nuances of the investment class they’re interested in
The more informed you are, the better you’ll be at assessing a sponsor’s competence. You don’t need to be an expert, but staying updated through newsletters and understanding basic deal analysis can make a huge difference.
A Personal Anecdote:
I used to be a fly-fishing guide in Wyoming during college, and my brother is currently a full-time guide. We often joke that if we made a mistake—like tying a bad knot or rowing poorly—most clients wouldn’t even notice because they didn’t know enough about fly fishing.
It’s the same principle here, except now your capital is on the line.
Example: Exit Cap Rate
An LP might evaluate two deals:
One with a 5% exit cap rate
Another with a 6% exit cap rate
To an inexperienced investor, this difference might seem minor. However, all else being equal (market, asset class, etc.), this 1% difference can have a significant impact on returns.
For example, consider how the returns change by adjusting the exit cap rate by just 1%. Deals where most of the return is expected from the sale, rather than cash flow from the hold period, are especially sensitive to changes in the exit cap rate.
5% Exit Cap:
6% Exit Cap:
Final Thoughts
While you are a passive investor once you invest, you need to be active during the due diligence phase. Evaluate the sponsor, their experience, their track record, and their alignment with your goals. Your capital depends on it.
Thanks for reading! If you’re interested in North Carolina single-family development or existing multifamily opportunities, you can follow along by clicking here. I usually only come across 1–3 deals per year that are worth investing in.
