Successful Real Estate Investing: Vetting a Multifamily Sponsor
Physicians who invest know that commercial real estate is a profitable venture. This same group, however, may not be aware that the process delineating an investor’s need with a syndicator’s strategy (syndicator aka sponsor) comes at the expense of extreme vetting. Multifamily expert, Veena Jetti, Founding Partner at Enzo Multifamily, basically wrote the ultimate guide to multifamily investing. Her role at Enzo means she knows the ins and outs of raising capital for profitable investments, as well as vetting a multifamily sponsor.
Vetting a multifamily sponsor follows the guidelines of these four pillars:
Pillar 1: The importance of company background and team experience
Pillar 2: Due diligence
Pillar 3: Current portfolio and fee structure
Pillar 4: Investor relations
Why should investors pay attention to these pillars to invest in real estate? Multifamily real estate?
Vetting A Multifamily Sponsor Pillar 1: Company Background And Team Experience
It’s important to know a team’s background and understand how they are structured when vetting a multifamily sponsor.
For the passive investor, who has the title of Limited Partner (LP) and doesn’t have any experience in vetting a multifamily sponsor, it is important to understand these components.
The team is the General Partner (GP), who might also be called the syndicator, deal sponsor or operator. Some questions the LP needs to ask the GP:
- How much experience do you have?
- How much time do the partners spend in their roles?
- How many team members are involved in multifamily investing full-time?
- Have your team members been through a market cycle?
These questions will help you to understand the GP’s amount of experience and level of dedication.
As an example, Veena describes her company’s background and experience.
Veena’s team at Enzo Multifamily has four partners.
All partners at Enzo have their independent roles, but they also overlap in their positions to have a second or even third pair of eyes evaluating the deals.
Veena does investor relations, manages the investors, and she is the point of contact for investors.
Veena’s partner, Sapan Talati, who was on a prior podcast with her discussing the ultimate guide to multifamily investing, is involved in asset management, acquisitions, debt structure, and underwriting and business development.
Veena, who understands underwriting, is Sapan’s second set of eyes during the underwriting process. She may walk through a deal with Sapan to discuss the assumptions involved in the deal.
The third partner is Neal Dandona an anesthesiologist involved in capital raising and operations. He interfaces with property management to be sure business plans are implemented in the correct way. He is also a point of contact for investors.
The fourth partner is Puja Talati who was the brand manager at the Hershey group.
She is married to an ophthalmologist and develops the brand strategy and marketing at Enzo. She also helps with investor relations, asset management, and marketing the asset to residents or tenants.
We can see that she and her team members bring multiple years of experience and an incredible amount of expertise and dedication to their roles. They also have a built-in oversight process for evaluating a deal to build wealth. The team at Enzo Multifamily also excel at the next pillar: Due Diligence!
Vetting A Multifamily Sponsor Pillar 2: Due Diligence
What is due diligence and why is it important when vetting a multifamily sponsor?
How does a sponsor conduct due diligence?
Due diligence is an investigation of the assets, liabilities, team and the business plan. It is knowing what the business plan consists of and the steps to the result.
The sponsor has already completed an exhaustive assessment of a property long before an investor enters the picture. Veena indicates that at Enzo Multifamily, out of every 200 properties investigated, 199 of them are rejected.
Prior to underwriting, the location and age of the building are noted. If the property is an older building, any proposed changes are investigated.
A contractor will evaluate the property, so the liabilities are known before any offers are made.
The sponsor will also gather market data.
They may send someone to pose as a renter to find out how many units are empty, why people are moving out—they want an explanation for the turnover. They ask how familiar the management is with the area and what they like about the neighborhood.
Veena states that Enzo Multifamily focuses on three or four markets. By focusing on a limited amount of markets, they can know them intimately.
When looking at an area they like to see job growth, large hospitals expanding or any large companies building in the area.
She gave Costco as an example of a large company moving into the area. She said Costco is well researched prior to building a center. The actual construction time is 18-24 months and they plan five years out.
Another great question to ask a sponsor is:
- “Are any of the GPs putting their own money in the deal?”
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Vetting A Multifamily Sponsor Pillar 3: Current Portfolio and Fee Structure
I really want to dive into the fee structure.
Veena states that although the fees might vary, these are the three major fees for the one out of 200 deals that are completed.I believe that when you are vetting a multifamily sponsor, it’s important that they can talk through all the fee structures.
SUGGESTED FEE STRUCTURE
Asset Acquisition Fee (2-4%)
- Fee for finding the deal, getting it under contract, sourcing the financing, moving into operational phase post-close
- The asset acquisition fee is the major way the sponsor is paid and covers due diligence costs.
Asset Management Fee (1-3%)
- Managing managers, day to day operations, newsletters, business plans, Prep K1
Disposition Fee (1%)
- During the sale of the asset, who is managing the sale, financials, squaring away insurance
Since a sponsor needs to make money, they will charge the fee on deals that do well for them. If the fee isn’t within the typical range, it is important to question the reasons. Veena indicates if they aren’t charging the fee, it could mean there is not enough money in the deal.
If the asset management fee is in the lower range, this doesn’t indicate a reason to be concerned because the fee is a minute amount compared to the total deal size and it doesn’t change the incentive for the sponsor.
Some operators might not charge a disposition fee due to lack of experience or a large check writer who refused the addition of the fee.
I believe that past performance doesn’t guarantee future results. I still want to know what assets you have and how are they performing.
An investor who is just starting to do due diligence should care about what a sponsor has done in the past.
You want to know what assumptions and business plans this team has put into place in the past that has worked, even though it is not the same business plan or projections.
Look to see if they are hitting or exceeding their performance projections. This will tell you if they are being conservative or consistent with what the market can deliver.
You also should be concerned with the sponsor’s thought process, rather than the numbers.
A sponsor should be able to explain their business plan, why they like an area, or an asset. There should be an explanation of “why choose this asset instead of the one down the street.”
At Enzo Multifamily, the goal for their investments is investing in properties with 100 units or above.
Veena said their smallest is 160 units; their portfolio indicates their properties are currently averaging 200 units and above. The smaller properties are harder to fund; however, they are the same amount of work.
Veena suggested a way that a sponsor can talk to their operator about being conservative in a hot market. Most assets are called debt service coverage constrained, which means that for every dollar of debt on the property, Fanny May and Freddie Mac require you to have $1.25 in income.
This is called the debt service coverage ratio.
Assets that have a higher DSCR (an example is 1.5 or 1.6 are great assets because they have so much income coming in) allows them to more than cover their debt service. The constraint of debt service in today’s market a lot of assets being leveraged at 60-65% instead of 80%, like they were in the past. A strong sponsor can bring equity to the deal because they see value in putting 35% (or more). This is a hedge against a dip in the market.
Enzo hasn’t taken out any short-term bridge loans. She explains that people take bridge loans because of the debt service constraints. They will go to $1.05 on the DSCR. They will give you more leverage and may go up to 80%. The problem is you will have to refinance the short-term debt in a year or 18 months. We are currently in a rising interest environment—in a year the interest could go up.
Enzo may also increase their expenses, stress test the vacancy, leave income based off the seller’s trailing 12 months of financials (if they have a million dollars of income on the financials, they use the same amount). They test out different scenarios and do a sensitivity analysis.
For vetting a multifamily sponsor for your deal, ask them how they are boosting their income. If they are trying to boost their return by adding everything into the proforma, they may be getting too specific.
If they thought they could get $15 for parking and $35 for washer and dryer, they might underwrite $25 total for both things. This makes underwriting more conservative.
Vetting A Multifamily Sponsor Pillar 4: Investor Relations
How well does the company communicate what they are trying to do?
When vetting a multifamily sponsor, communication style is vital. Does that same level of communication continue once the funding has come through? Why is continued communication important? Does all this matter when considering how to build wealth and an ideal life with real estate?
At Enzo Multifamily, investors are treated like family. Veena said they have a personal relationship with their investors—they know the children of their investors and their birthdates!
Investors are also sent an email for every asset updating them on any changes made to the properties (along with pictures), market situations affecting the value of the property, or articles about things that affect the property.
It all adds up
We’ve covered the four pillars of successfully vetting a multifamily sponsor. We also addressed the importance of knowing a sponsor’s background, their level of knowledge, if they have experienced a market cycle and how to gauge their dedication to your investments.
We understand due diligence and the role it plays in investing and the intense legwork that goes into every potential venture.
As we heard, the ratio is astounding, at Enzo Multifamily out of 200 potential investment possibilities, only one was offered to investors! Those odds are whoa.
Always important to me is the fee structure.
Veena explained the typical ranges in fees, what each fee covers, and understanding why there might be an anomaly in the charges. She also explained why thought processes are more important than numbers.
She suggested steps for being conservative when the market is hot. And finally, when vetting a multifamily sponsor, look at the relationship between the investor and them. Veena told us how Enzo Multifamily deals with their personal and professional relationships including their method for keeping investors updated on properties.
Now that you know what to look for when searching for a company to trust with your investments—go build your wealth!
Journal Club: Passive Income MD
For this episode’s Journal Club, we highlight Passive Income MD’s article titled “The Four Ways to Make Money in Owning Real Estate.”
I thought it was rather fitting as we discussed the 4 pillars of vetting a multifamily sponsor in our show and this article references the other side of investing in real estate by putting in the hard work and directly owning the property with no outside capital or partners.
While this is hard to do on a large scale, and I promise you this is not passive income or mailbox money like we discussed in the show. This is one way to do it and Passive Income MD wrote a great article summarizing these key points.
Making Money in Owning Real Estate
There are 4 ways to make money in owning real estate.
The first that Passive Income MD highlights is appreciation.
It’s not just the appreciation you think of, like a home going up in value, but he mentions forced appreciation. I quote “Forced appreciation is where an owner can help increase the value of a property by improving the property itself. For example, you might renovate the kitchen and bathrooms in a home enabling you to sell it at a higher value. If it’s an apartment building, you might be able to raise rents and lower expenses, thereby increasing the overall net operating income. This, in turn, increases the building’s value.”
The second way to make money is cash flow, my personal favorite.
Cash flow is “what’s left over from the rental income when the expenses are paid off each month. If there’s a surplus, that’s positive cash flow. If there’s a deficit, you have a negative cash flow.” Obviously, the goal isn’t to acquire properties with negative cash flow so due diligence and running the numbers are critical. Think of it this way, you make money when you buy real estate, not when you sell it. Let that sink in for a second, and I’ll repeat it, you make money when you buy real estate, not when you sell it.
The third way is a way that most don’t think about, taxes in the form of depreciation.
And I quote, “depreciation, whereby the IRS allows you to determine the value of the actual building, divide that value by 27.5 (the useful life of a property as determined by the IRS), and deduct that precise amount each year.”
For example, if your rental property (the building itself) is valued at $500,000, you would divide that by 27.5 years (which equals ~$18,000) and be able to deduct $18,000 as a depreciation expense each year for 27.5 years. This deduction allows you to report a smaller profit to the IRS, thereby reducing the amount you ultimately owe in taxes.”
The final way is by forced savings through a mortgage principal paydown, adding more capital to the minimum monthly payment which goes directly to the principal, the amount you borrowed and still owe, not prepaying interest.
While everyone’s situation is different, I can tell you mine as it relates to this. I don’t personally like holding a lot of bonds as a proxy to bonds, I like to pay down my mortgage a bit quicker by adding to the monthly payment.
While I’m diversifying and investing elsewhere, I do like to toss some extra capital to the mortgage. Not only is the renter paying my mortgage for me, but they are also slowly buying me the property little by little, just like Passive Income MD states.
I really like this article, it’s short and to the point, but it packs a big punch in high-quality content. I’ve linked to it here, so please go there and check it out.