Not all investors are created equal, and that’s not a bad thing. Sometimes equality isn’t all it’s cracked up to be, especially when it comes to investments. This is particularly true in real estate syndications. Risk vs. reward should be proportionate to the risk you take. More importantly, in the context of this article, the reward should be proportionate to the role you take.
I learned this the hard way. I got turned down for investment in one of my earlier projects because I didn’t understand, or more importantly, didn’t respect the role each investor wanted to play. I didn’t even know these roles existed. In my mind, and many others, there were two roles: those “with the money” and those “with the energy.” I thought that there was always money chasing people who had the energy to operate the deals, and similarly, people with deals chasing those with money for an investment. It was like a game of cat and mouse, and I was often not very good at it. That was until I began to understand the game was much more complex and received advice on how to understand investors.
What I was doing to no avail was trying to offer the same opportunity to everyone I knew who had money.
One day, I went to my mentor with a problem. I had a deal, but I couldn’t raise the funds for it. In fact, I knew this deal was going to fall through, costing me tens of thousands of dollars in due diligence fees. I didn’t go to him for money to save my deal; I went to figure out where I went wrong. I lived by the saying, “A good deal will find money.” My deal was good, it was great, yet I still couldn’t find the money.
As I entered Tony’s office, he was on the phone and motioned for me to sit down in my usual leather tufted armchair. I sat there waiting, thinking of what I would say to him. He got up, wearing a surprising outfit of a PFG fishing button-down shirt, khaki shorts, and sandals. Oh, the life of a wealthy real estate investor in Florida.
He noticed me looking at his off-brand outfit and said, “What, this? I’m heading to the coast to go fishing, getting the boat ready now. Gonna spend a few days out there. In fact, I’m getting ready to head out. What’s on your mind, kid?”
To be respectful of his time, I got straight to the point. I said, “Tony, I have this deal, I’m almost out of time to raise the funds, and I cannot get the money raised. It is a great deal. I have it all written out, I did all the due diligence, the pro forma; the deal is a no-brainer. It provides cash flow from day one that will only get better as we implement the business plan. It even has a good rate of appreciation before we refinance in year five. Yet, I cannot get anyone to commit to it.”
He looked at me and asked, “So what is your question?”
I responded, “What am I doing wrong? I thought if you had a good deal, money was supposed to find you?”
Immediately he chuckled. “Money rarely finds you with your door shut; you always have to look for it. You only find what you seek, and money goes to those who seek it. Although money is abundant and out there waiting for the right operator to be placed with, in fact, Blackstone said private investment capital is estimated to be $80 trillion globally. That’s a lot of money looking to be put to work.”
He continued, “However, you have to make yourself known and present it to the right people in the right way. You remember Goldilocks?”
“…and the Three Little Bears?” I responded.
“Yes,” he said, “She didn’t just like every bed or every bowl of porridge; they all looked the same, but to her, they were different. She had to find the one that was just right. Not every investor likes the same investment strategy. Many try different ones out early on, but then settle into what fits them. To you, it may seem all the same, but for the investor, they feel different. You have to respect that.”
“Oh,” I responded, “So what does that mean, though? They don’t like the deal I presented them?”
“No, it could be they like your deal; they just don’t like what their position in the deal would be. Do you remember how I explained the four different types of operators?”
“Yes.”
“Well, there can be four different types of investors in any deal. Four ways an investor can enter a real estate transaction. What you most likely did was present the right deal in the wrong way, or the right deal in the right way but to the wrong investor. You need the right deal, presented with the right investment strategy, to the right investor who fits that profile. Tie that in with making it known what you do long before you are trying to raise money for any specific deal. You do that, you will get more commitments than rejections.”
| Investor Type | Participation | Rewards |
| Operators (GPs) | Active management, acquisition, financing, operations | Acquisition fees, asset management fees, equity share, disposition fees |
| Limited Partners (LPs) | Provide capital, passive involvement | Preferred return, equity share, capital appreciation, cash distributions |
| Loan Sponsors (KPs) | Secure financing, provide loan guarantees | Equity share, loan guarantor fee, potentially preferred returns |
| Direct Debt Lenders | Provide mortgage or loans, no management role | Interest payments, principal repayment, secured position |
Limited Partners (LPs): Passive Equity Investors
Passive investors in the equity of a deal can invest in many formats, most notably real estate syndications. Passive investors are seeking to place their capital into a deal with an experienced operator and participate in the cash flow and upside of the deal. They provide the bulk of the capital needed for the purchase of the property, but they are not involved in day-to-day management. Like their title describes, they take on a “passive” and silent role in the investment. Their main responsibility is to contribute the capital required for the investment and, if needed, vote on any major decisions affecting the overall operating entity.
Passive investors are typically characterized as busy professionals, such as doctors, lawyers, or executives who have disposable income. However, they do not have the time or expertise to manage real estate themselves. They are risk-averse and are looking to limit their liability, which aligns well in a syndication structure. They also look for stability and predictability as they are often focused on the income the investment will generate. Passive investors want to have control over the operator they select because they want to trust the operator is experienced and professional, as well as able to effectively execute the business plan and maximize returns on their capital investment.
Passive investors get paid via a preferred return. Typically, LPs receive a preferred return, usually 6-8% annually, before any profits are distributed to the general partner (GP), or operator. They also get an equity share in the investment. After the preferred return is paid, when a sale of the property or a refinancing of the property occurs, the excess profits or capital gains will be distributed to limited partners in proportion to their investment. Another benefit for the limited partner is their share value will grow as the property appreciates in value over time. Limited partners will also get to share in the tax benefits of depreciation on their investment since they have equity stake in the property. Limited partners will receive disbursements of cash (monthly, quarterly, or annually) from the cash flow of the property.
These traits and goals line up well with real estate syndications. What you don’t want to offer a passive investor that fits this category is an active role or a role that does not limit their liability. They will also not be as interested in the same deal if you offer them a debt holder position. The promise of only a monthly interest payment and no upside may not be appealing to this investor. Limited partners often take on the LP role in pursuit of the share in appreciation and equity, as well as the tax benefits of depreciation to offset other income they may have. Investing as a debt holder does not provide this.
Tony also mentioned, not all LPs are the same. Some want more cash flow and less appreciation of the investment, really focusing on the stability of the income. While other LPs are okay with low or slow cash flow but a higher back end of capital appreciation on sale or refinance. He told me to be sure I knew which passive investor I was dealing with before pitching a deal to them.
Loan Sponsors: Semi-Passive Debt Investors
A loan sponsor is a unique way to invest in a real estate syndication that I had never heard of previously to this conversation. Often in a transaction, a bank loan is needed to purchase the property. The general partner might need assistance in qualifying for the loan on the bank’s terms. A loan sponsor will provide the necessary creditworthiness to secure the loan.
The loan sponsor, or key principal (KP) as some banks call them, will use their strong financial background, significant net worth, and robust credit history as an asset to the general partner of the deal, allowing the syndication to qualify for the needed bank lending to acquire the investment. Banks will often require a net worth in the amount of the loan being secured and at least 10% of the loan amount in liquid assets. Sponsors can typically provide this when a GP is unable to do it on their own. The loan sponsor will typically be a part of the GP team, but their primary role is to ensure the financing is secured. The loan sponsor may be required to provide personal guarantees on the loan, which can involve a large amount of financial risk if the investment fails to perform as expected.
The loan sponsor will typically be compensated by getting a portion of equity in the deal. This can usually be a small portion, around 10%, of the GP’s share of the equity or profits. They may also be compensated with an upfront flat fee, known as a loan guarantor fee. This is typically based on loan size and is paid for their ability to secure the needed financing. Loan sponsors can also invest as a limited partner in conjunction with their equity share on the GP side, allowing them to receive preferred returns in proportion to the size of their LP investment.
Loan sponsors are often not active operators, so they do not want to be actively involved in the transaction. However, they are still not passive investors; they have a moderate involvement in the deal and capitalize on the strength of their financial profile. Presenting an investment to a loan sponsor, they will be looking for the strength of the deal, the viability of its performance, as well as the ability of the operator to steward the investment and complete the business plan. Loan sponsors like to mitigate their risk, so presenting a loan sponsor with a riskier investment that an operator does not have experience completing is not ideal.
Operators (General Partners, GPs): Active Equity Investors
Operators want an active role in a deal. If they have a complementary skill set, they can be great to partner with on a joint venture or co-GP style investment. Operators are more entrepreneurial and prefer to be actively involved in the management of the deal. They want to be a part of the strategic decision-making process of the project. They believe their ideas and hands-on approach are what will make the deal a success. The operator wants to have control over the deal. They are constantly using and building their expertise. Taking on a project that requires them to draw on past experiences or build upon skills they already have motivates them. Operators are always looking to become better so they can get to the next and bigger deal.
Offering a passive role too early in an operator’s career will result in a rejection. They are looking for deals they can operate and have direct involvement in. Only later on in an operator’s career will you find them open to passive investments in other operators. Be aware of what stage your operator friends are at. Even if investing passively at later stages of their career, they have a lifetime of operational experience they can share. Often, they are happy and want to provide advice and insight to the current operator on a deal. Do not have them invest if you are not willing to listen to advice from an experienced veteran.
Operators are willing to take on higher levels of risk in the pursuit of a higher reward. They typically invest little to none of their own money in a deal. Instead, they offer 100% commitment of time and effort to ensuring the business plan is executed and the investment returns are maximized. Operators are compensated with an upfront acquisition fee on the purchase of the transaction, usually 1-5% of the purchase price, as well as an asset management fee of 1-2% annually on the gross income of the property. Operators will also get an equity share of profits after the limited partners get their preferred returns. There is also a disposition fee on the sale of the property, although I personally have never been a fan of this type of fee for an operator.
Direct Debt Lenders: Passive Debt Investors
This is a category I never fully understood until after this conversation. Debt holders are very conservative. They are looking for secure and predictable returns. This investor is usually established and secure financially, looking to preserve their wealth while providing predictable income. The interest payments on the debt/loan they provide to an investment are sufficient for them. They are not enticed by the promise of equity or property appreciation.
Debt holders will often take either a 1st or 2nd lien position on a property to secure their investment. The debt holder will receive monthly interest income in an amount that is typically higher than the going market rate but can differ based on the amount being lent, the industry, and operator qualifications. I have seen lenders offer rates as low as 5% and up to 15% during different economic cycles. Many lenders will offer debt origination fees of 1 or 2 points of the loan amount. These fees can be waived depending on the size of the deal and amount of business they do with the operator. The lender will also get their principal repaid at the end of the loan term or as a prepayment when the operator sells or refinances the deal.
Like the limited partner, this investor receives a passive role in the investment, having no ownership or ability to participate in the operation of the deal. The debt holder relies on the operator to manage the property and meet the payment obligations. Passive debt investors love the predictable and steady interest income coming in every month.
As a risk-averse investor, they typically invest in asset classes they know and have experience in, looking at the operator’s experience and ability to perform and meet the loan terms. Offering a debt lender an equity stake as a limited partner will not be met with open arms. They prefer the loan security and collateral provided as part of the debt instrument. Passive debt investors need and require protection of their investment. Taking a lien position on the property in either the 1st or 2nd position is required in case of default. However, on larger deals where more capital is required, it can become difficult to structure debt when you have more than two debt providers. Offering a 3rd or 4th lien position is not ideal for debt investors.
Respecting investors’ profiles for investment and understanding that not every investor fits into the same strategy box shows the investors that you listened to them, you’re not just pitching to them. From that point on, I made sure to understand which type of investor I was talking to, what they needed to feel secure, what their tolerance was for risk and participation, and how they wanted to be compensated. Where I used to spin my wheels trying to gain traction raising capital from the wrong people on the right deal, I now can present the right deal in the right way to the right people. I play matchmaker, as any good capital-raising operator should. Taking a look at how a particular deal is structured and finding the investors whose profiles match.
Although I will openly discuss what I am working on, I will never pitch a deal to the wrong person or pitch a good deal in the wrong way to an investor looking to place capital. If we can’t match that investor’s preference on this deal, we will look to structure one down the road that fits their needs. Otherwise, I allow others to come to me if they want to try a new strategy or investment participation role. Stepping out of their box must be their idea; you cannot force conformity when it comes to capital raising. The most important thing I learned is that no matter how good a deal is, if no one knows it exists, the money won’t find you. If a tree falls in the woods, did it make a sound?
If you liked this article and wanted to discuss your investment profile, USE THIS LINK to schedule a time for us to dive deeper into the topic.
-The MHP Operator
