Five Winning Traits of a Successful Real Estate GP
Private real estate investment via syndication is a fantastic opportunity for investors. For the deal sponsor (the general partner or “GP”), a syndication structure allows them to leverage their network to obtain equity investments from others. They can pursue much larger commercial real estate (CRE) projects than they’d be able to buy independently while providing an invaluable service for their equity partners.
For the limited partners (LPs) providing the capital, a syndication structure allows for passive investment in real estate deals without an active operation role. As passive investors, they receive the cash flow, tax benefits, and appreciation upside potential without the headaches of active management.
Evaluating the GP
While most Tactica content caters to the GP investor and tools that could aid them, I’ve noticed an uptick in LP lurkers. Some have reached out to me asking if I have any GP referrals.
It got me thinking about LP investing and what stands out when evaluating passive investment opportunities. I believe there are five essential traits an LP should look for in a GP-LP partnership when conducting due diligence on investment opportunities.
This article will be helpful for LPs as a framework for evaluating a GP and their investment. I also believe GPs will value reading about the LP decision-making process and how they’re potentially perceived.
My LP Experience
As the founder of Tactica RES, one of the biggest perks is constantly being around deals and having opportunities to invest alongside the visionaries. With my sole focus on the innovation of the Tactica platform, LP investments (passive) are my only option as a real estate investor. I don’t have the time to consider being an active participant.
Choosing the best and most sound operators behooves me, and I have put much thought into what I look for in an investment and deal sponsor.
Disclaimer: Please take my opinions with a grain of salt. While I have invested with various GPs over the years, there are LPs with far more investment experience, and I admittedly could have holes in my evaluation process. I plan to update this article as my evaluation process shifts and becomes more robust over time. Always consult with professionals and do your diligence when evaluating investment opportunities.
A Bad Deal
My first-ever LP investment was a total flop. Highlights included:
Capital-intensive business plan
Absent property management
Bad local press
Capital call
Sale for a loss
I was so excited to invest in the first syndication that the blatant risk factors blinded me. The feeling of hopelessness I had during the investment tenure was dreadful. I felt like I couldn’t say anything because I was a little fish in a large pond, and the sponsor was a prominent player in the local real estate ownership scene.
Fun Fact: The property’s name was misspelled on the apartment listing website, and management never corrected it during our entire ownership tenure!
As someone who is now entirely dependent on co-investment, I consider myself lucky to have had such an awful experience early on in my investing career. In this current economic cycle, what I experienced was not the norm. Many LPs that have begun investing in the last ten years have no idea how sour these deals can turn and how it feels to get capital called and take a big fat “L.”
I’ve learned that these private investments are not bulletproof, and things can go wrong. This mindset has stuck with me and pushed me to crank up my vetting process to avoid feeling the pain of owning another abysmal real estate asset.
5 Winning Traits of a Successful GP
(1) Ethical
Repeat after me: “As the LP investor, you are investing in a person, not a property.”
A sponsor’s character is easily the #1 attribute a passive investor should look for in their GP. Without a moral compass, nothing else matters. Promises of preferred returns and lofty IRRs are moot if the GP lacks basic ethical standards.
Thankfully, I have never dealt with an unethical GP, but make no mistake, they are out there. During my ownership tenure of Tactica, I have “worked” with shady characters who have taken advantage of me, stolen from me, and deceived me. I know these same people were raising money for their projects (or at least were intending to before I cut ties).
The good news is that there are usually clues about cloudy pasts.
A simple Google search of the sponsors’ names and business entities could give you much detail about their history with crimes, lawsuits, or newsworthy behavior. Finding pertinent information sometimes takes going beyond the first page of Google results. It’s such a simple step but is commonly missed.
I often forgot to do this with past clients and often saw subtle warning signs after the fact when I started to investigate. Pretty much everybody that I deemed as deceitful had Google baggage. Thankfully for me, a lot less was at stake than a $50,000 or even $100,000 LP equity minimum requirement.
Criminal History
It’s also worth looking up the GP’s criminal history. Most states allow you to search both criminal and civil cases online. Remember to search relevant LLCs, too.
Referrals
Don’t be afraid to ask for referrals. Anybody worth their weight in this industry should have a Rolodex of people willing to vouch for them. Even if you’re vetting a new syndicator with limited real estate experience, you should still talk to people involved in their other entrepreneurial endeavors and can speak about their character.
Before I delve into the real estate specifics, I am investigating character. Without it, it’s a non-starter.
(2) Strong Communicators
Communication and responsiveness are paramount. It cannot be underestimated. You need to pick a GP to keep you apprised of the investment. Some of my current GPs give monthly updates, while others provide quarterly, both acceptable timeframes.
If I could choose a GP that:
Achieves a modest rate of return but constantly updates me on the investment state.
Vs.
Achieves a stellar rate of returns but disappears and is unresponsive.
I choose the former every single time. I am willing to sacrifice some yield for peace of mind vs. stressing over the investment performance for most of the hold and then learning at the finish line that it did exceptionally well.
If you're reading this as a GP, you can use effective communication to plug holes in your business plan. A sensible LP understands that real estate investment is risky and factors outside your control can affect investment performance. Communicating setbacks and adversity may not be fun, but trust me, it is appreciated.
One GP I invest with faces issues at the property (no fault of his own). The LPs know it from his quarterly updates, but he also makes it a point to schedule multiple face-to-face lunches yearly.
Every time I leave those lunch meetings, I am confident and thankful for the GP team, and I am reaffirmed by their commitment and dedication to the project. It reminds me that I invested in the “right person” who will do everything in their power to turn a challenging task into a success story.
Note for GPs: In the era of Covid and digital meetings, don’t underestimate the value of live face time.
Responsiveness is also essential. I don’t care if you invest $10,000 or $1,000,000 as an LP. If you have questions and the GP isn’t willing to answer or give you time to express concerns, take your investment elsewhere. LP investing is risky and complex.
There is no excuse not to take every investor seriously and quell any doubts as they arise. That’s what GPs get paid to do in fees and carried interest. If you’re not taken seriously, look elsewhere for someone who values you.
(3) GP Trajectory
GPs, by definition, are ambitious. It takes many guts to raise money and operate real estate. It involves many different entrepreneurial hats. As an LP, I understand that growth (more units) is the common goal of most deal sponsors.
However, as an LP who has invested in you, I also want to be confident that you have processes to handle your current affairs as you move on to bigger aspirations.
Example: I invest with you on the small 20-unit value-add project you’re self-managing. I later learned you are under contract on a 300-unit property in a superior asset class. You will partner with a prominent private equity firm as a joint venture investment structure.
I’m left wondering:
Will you still care about the 20-units?
Do you have the capacity and resources to work on both projects?
Where are your priorities?
The GP Trajectory was the #1 reason my first LP investment failed. The GP was working on larger, more prestigious projects, and ultimately, the building I invested in fell through the cracks.
It’s vital that a GP with an ambition to grow their door count also has processes in place that they can scale. The problem isn’t them pursuing more prominent projects. The trouble lies when they do that before they’ve learned how to implement the proper procedures. As an LP, you don’t want to invest in a project where the GP is experiencing growing pains for the first time and is unequipped to handle them.
Before committing to an investment, it’s worth talking to the GP about their growth trajectory, goals, and processes.
(4) Compensation & Alignment
The most critical component in a GP-LP investment vehicle is alignment. For me, “alignment” means:
A GP does everything to ensure they successfully grow their LP’s investment capital as long as possible. Once achieved, they will be incentivized by an increased profit share or “promote” as compensation for a job well done.
In other words, if the LP investor(s) wins, so does the deal sponsor (in that order).
And what about fees?
GPs are deserving of fees. Syndication is their business and how they support themselves and their families. Fees are also crucial to support daily business functions.
What I try to watch out for are the exorbitant fees. Fees can be in the form of:
Acquisition Fees
Sale Fees
Refinance Fees
Asset Management Fees
Construction Management Fees
Development Fees
Again, fees are standard as they are necessary and help the GP team operate daily. However, the fee structure should not be the overwhelming profit center.
In other words, fees should not be the sole motivator of the investment decision. The investment should have to perform well before the GP reaps material gains.
I have a little wiggle room here. I will likely pay a steeper fee structure if you are an experienced operator with decades of track record. I get it. You’ve earned that leverage, in my opinion.
However, if you are syndicating your first deal ever and pitching a 3% acquisition fee on the front end with a 3% residual sale fee and 2% annual asset management, that’s an easy pass.
I just saw a project that had a similar structure to the above. The problem with a fee structure like this is no alignment. The GP profit center primarily revolves around the following:
Closing on the asset
Selling the asset
They can still win if they accomplish those two things without operational improvement or appreciation, while the LP does not. That is not alignment, regardless of what the IRR waterfall hurdles stipulate.
(5) Business Plan & Numbers
Does the business plan make sense? This analysis is usually a pretty high-level assessment for me. I want to understand the project and see how it fits the overall macroeconomic picture and submarket.
For example, I’m not a fan of 80%+ LTC bridge debt on distressed properties in a rising rate environment. I'm not too fond of having a short-term (expensive) financing arrangement on a speculative scope. I’m a pass on these deals at the moment. It’s not a knock on the business plan; it’s more of a personal preference regarding my investment appetite.
Another example is from a few years ago. I was not too fond of a redevelopment project with a $30,000 per unit renovation budget because it targeted a proforma rent that was 2x what it cost to own a home in this submarket (assuming a 5% downpayment). It didn’t seem sustainable long-term.
I like to play the devil’s advocate, poke holes in the business plan, and talk to the GP about my concerns. There have been instances where the sponsor has eased my problems and pointed out flaws in my thought process, allowing me to gain comfort with the project. Other times, we’ve agreed to disagree and mutually decided to connect again when new opportunities presented themselves.
Numbers
Overall, I don’t get as granular as you may think trying to dissect the deal metrics and numbers. I expect the GPs have already done that. When it comes to the actual proforma, I’m most curious about how the sponsorship team is:
Underwriting overall expense ratio (and management plan in general)
I have disqualified more projects due to deficient property tax underwriting than any other line item. There have been buildings where assessments are already published online that will dictate the property taxes for next year (or Year 1 of the proforma), and the GP is still only underwriting a 3% increase annually over the current year’s tax payable when property taxes are guaranteed to increase much more than that.
Even more concerning is when the purchase price is well above the current county assessment level in a market that tends to reassess at 95% - 100% of the purchase price, and it’s not accounted for in the underwriting!
Another crucial step is understanding how the cash flow distributions flow between GP/LPs. Usually, the numbers in the slide deck aren’t sufficient to fully understand it. You need to read the actual operating agreement to understand the timing and order of payments.
Generally, if the LP isn’t paid back 100% in full before the GP is incentivized, I will pass on the opportunity (with the caveat that there are some distribution structures where this may not be the case but are still fair).
I also will verify that the return metrics are logical. An acquisition opportunity recently hit my inbox, touting a projected 17% IRR over a 10-year investment hold, but the equity multiple was not even 2x. I didn’t understand how this was possible. I thought, “There must be a mistake in the proforma.”
It didn’t pass the sniff test, and I spent no more energy pursuing the opportunity. The GP lost me (and likely others) before pitching the project.
Nothing is guaranteed in real estate investing. However, thinking critically about the business plan and looking for blatant oversight with proforma assumptions has proven fruitful in my evaluation process.
Summary
If you are an aspiring LP investor, your success will hinge much more on the GP you invest with than the physical properties you invest in (although a rockstar sponsor tends to find sound real estate). Seeing a GP that exhibits a:
Moral compass
Willingness to communicate and respond
Defined growth trajectory (that is scalable)
Compensation structure emphasizing alignment
Sound business plan with sensible projections
You are likely going to be happy in the long run. Anything can happen at the property and in the macroeconomic environment from month to month or year to year. It’s the GP you trust to be on the frontlines fighting to protect your capital and handle the threats that inevitably come along in commercial real estate investing.
The five traits above will go a long way in helping you determine if you’ve found a partner up for the challenge.
