How to Vet an Operator of a Fund or Syndication
What to expect:
Vetting an operator: clarify investment criteria, ask structural & business plan questions.
The structure of a deal, focusing on returns for investors.
An operator's underwriting process includes analyzing fees, aligning with investing criteria, and ensuring the company's longevity.
The different deal structures in real estate investing, including fees and timelines.
Investors should ask operators about expected returns, risk management, and timelines for investment opportunities.
The importance of evaluating investment deals based on metrics like cumulative cash on cash returns, rather than relying solely on IRR.
Asking operators about their business plans, exit strategies, and location-specific risks to make informed investment decisions.
Questions to ask an operator
Hey friend! Today we're gonna talk about how to vet an operator of a fund or a syndication. We need to find someone we can trust when we're investing our money, especially when we're going to be completely passive about it. And the first thing you actually need to do is to be clear on your own investment criteria, expected returns and risk tolerance. Once you have that, you can divide the questions to ask an operator into about three categories.
The operator, their experience, history, strategy, and how much you can trust them.
The structure of the deal- does it match your investment goals?
The business plan- asset class, market contingencies, and risk calculations.
So operator questions, how does the operator make decisions when things do not go as expected? How do they communicate when things don't go as expected? Do they even communicate with you at all when things go wrong? How often do they communicate with you when things are not going wrong? Are you ever just getting silence from them or are they giving you monthly or quarterly updates? Or is it just a K one at the end of every year and that's all you get? How are they communicating with you and what kind of information are they giving you? Also, what is the team's track record, their reputation and their experience in dealing with what you're investing in? What are their accreditation requirements meaning, who is in this deal with you? And how are they vetting people who are coming into the deal? How do they answer your questions as a limited partner and as an investor? How do you get access to the team? And how can you ask more questions about what's going on? These are all important things to speak to the operator about. One of the most important things I judge an operator by is how they respond to questions regarding the structure of the deal and the business plan. The structure of the deal is how an operator is converting returns from the asset to returns for the investor. This is what the structure of the deal is; this is where the heart of any investment lies. And this is where you will have the most questions.
How operators analyze deals
As an operator, there are so many deals that work out on the asset level that just don't give a return to investors the way we want them to so we pass on the deals that don't serve our investors. All good operators will have a three step underwriting system meaning how they analyze the deals.
Step one- does the asset provide a good return?
Step two- are those returns enough to satisfy my investors?
Step three- can my company continue to exist, find more deals, execute current deals and provide good customer service to my investors if I take this deal?
The second step in the underwriting process is where the operator makes sure a good deal also makes sense for the investors. This is where the structure of the deal that you're buying into comes in. The deal structure is how and when investors can expect returns. Though there's always risk here- nothing is guaranteed. You want to make sure step two of their underwriting process aligns very, very closely with your personal investing criteria. You want to make sure it aligns, otherwise no matter how good the deal itself is, it will not be a good deal for you if it doesn't match the returns that you want the risk that you're comfortable with. So look into that very carefully. The third step in the underwriting is also really important. You need to understand what fees the operator is receiving. Here's a little secret- If they are not taking any fees or taking a larger percentage of the cash flow, there is a problem. If the operator is not charging anything for setting this up, they are setting up their company for failure and their company will not exist long enough to execute whatever business plan they have created by taking fees that company is allowing itself to exist so that it can serve you. A lot of times what happens is there will be two to 3% acquisition fees. Sometimes there's a development fee, so there's a lot of one-time fees that will happen when a deal closes. And then sometimes there is a recurring asset management fee as well, very nominal, usually like 2%, we can definitely go into another episode about fees and what they mean. But with this small upfront situation in terms of fees, it allows them to give you a bigger split. So vet the deal very carefully. Make sure that the operator is making enough money to be alive long enough to execute the business plan and give you your returns.
Goals & timelines
So every investment offering has a different deal structure based on a different balance of cash flow, equity and depreciation. That is where you compare what the offering has to your personal investment goals. If they don't match, don't invest. That doesn't mean you can't continue to connect with the operator and learn more about why they built their offering the way they did and what the benefits and drawbacks are. Every offering also has different timelines. Timelines can be as short as three years or as long as 15. Typically, the first year is collecting the investments and finding the best deals. Years one through five is usually when the capital is deployed, meaning the operator buys the property and implements a business plan to make money on the asset, sometimes cash flows quick, and the operator opts to have distributions during that time. And other times it takes time to stabilize the property. It depends on the type of strategy and fund that you're investing in. Things like a cash flow fund would have little construction, maybe just you know, some maybe just a facelift on the property, and some basic alterations to operations or upping the tenancy, so there's less vacancy, and they're able to stabilize the asset that way. If it's more of a value add situation, usually the returns are higher than if you have a cash flow situation, but you're usually waiting about three years before you start making some consistent income from that. So usually between years five and 10, is when the investment pays the investor back in full plus returns. A good operator will have a business plan for every asset they buy, and they will often have different expected timelines. There are many things that can affect the timeline, so make sure you ask the operator how they plan to deal with these risks.
Important follow up
It's really important to ask where the returns are coming from in the investment opportunity and how the real estate syndication is turning a profit. Sometimes the investment funds will raise more money than they need so they can give dividends during the phase of the project where they are making improvements to the property. That means they're just giving you your own money back instead of getting money from the asset to pay you. Many investors actually prefer this because they aren't comfortable waiting for the asset to stabilize itself before producing returns. Some investors only invest in stable assets because they want to have immediate cash flow. It depends on you, as the individual investor, what you want, but just make sure you ask the operator and know where the returns are coming from.
Measuring deal success
Deal structures have different metrics for measuring success. Most investments use IRR or internal rate of return. This is good because it takes time into account when measuring return on investment. But I personally feel it is too easily manipulated to desired outcomes. The IRR is based on an expected exit or sale of the property, which is based on market conditions at the sale. That is very hard to predict. It is much more reliable to predict NOI or net operating income because you have control over that as an operator. Your business plan is built to increase the net operating income and the value of the asset but you can never predict market conditions. Therefore I prefer metrics like cumulative cash on cash returns that directly correlate between the amount of money I put into a deal and how I get my money back out.
Business plan questions
And finally, business plan questions. These questions are all based on the underlying asset, the market, understanding the risk portfolios of the execution of the plan and the location where this is all happening. The business plan itself is only good if it has multiple exit strategies. So make sure you ask what the exit strategies are, and if there's only one, that's a huge risk. Not saying it's not a good investment or that it won't pan out, but it's a lower risk investment when there are multiple exit strategies. Also, knowing the location and the risk parameters around the location such as population size, employment, wage growth, business growth, that will give you a better idea of the business plan and the risks involved in it. The best thing to do here is to ask the operator what the business plan is, the different exit strategies and why they're choosing that specific asset type, location, and execution strategy. Finally, just trust your gut. Oftentimes, that will have the most solid answer if they can answer everything perfectly, and your gut just tells you, “this is sketch”, probably listen to it.