Every industry has its own jargon, and the business of investing in real estate is no exception. Terms like real estate sponsor, promote, preferred returns, ladders, waterfalls, GP, LP, and IRR are tossed around routinely in the deal room but may sound like a foreign language to some.
In this article, we will focus on the role of the sponsor but in the process offer definitions of these commonly used terms.
What is a Real Estate Sponsor?
There is a lot that goes into being a sponsor, but the primary roles are to find, acquire, and manage real estate assets. The sponsor then provides others the opportunity to invest who may not have the time or ability to fully research and vet the opportunity themselves.
Generally, sponsors are expected to have some of their own cash invested in the opportunity, usually no less than 5% of the total cash equity raised. The sponsor’s cash investment is sometimes referred to as “co-invest” or the slang term “skin-in-the-game”.
In exchange for their efforts, the sponsor earns a fee but also a “promote”, which is a share of the future profits from the investment.
Investment Distribution Types
Profits can be divided between the sponsor and investors any number of ways. One popular way is to offer investors 100% of the first scoop of profits up to a certain level, and then share each dollar above that threshold. If the first profit scoop is 6% paid to investors, then that investment would have a “6% preferred return” or “6% pref”. The profits above that are split between the sponsor and the investors at different levels as the profits get higher.
Splits are often referred to as “waterfalls” and the profit level that determines what that waterfall split might be is often called the “ladder”. The higher up the profit ladder, the more the split of profits would typically waterfall out to the sponsor. For example, after the initial 6% pref that goes 100% to investors, profits up the ladder might be split 70% to the investor and 30% to the sponsor until the investor reaches 12% and then they ladder up again 60%/40% until the investor reaches 15% and then it ladders one final time to 50%/50% from there.
While the pref structure is most common and has a great deal of appeal, it tends to work best for shorter or medium hold periods (3 to 5 years). Development and Value-add opportunities would be a good example as those investments often create little cash flow but, if it goes well, appreciation upside is harvested upon sale. The sponsor has a lot of incentive to sell as soon as that appreciated value is achieved.
An alternative for yield-focused and longer-term holds (7 to 10 years) is to align investors and sponsor to share profits from the start. This works well as it keeps the sponsor focused on operational effectiveness to drive cash flow (yield) as a high priority throughout the life of the investment.
Most sponsors will form a Limited Liability Company (LLC) for each individual asset and it’s inside of that LLC where the sponsor takes the role of General Partner (also known as GP or Managing Member) and investors the Limited Partner (also known as LP or Limited Member). In addition to being the sponsor, the GP’s have most of the business risk of the investment whereas the LP’s risk is limited to the amount they invest. Investors seeking diversification through a sponsor might invest in several different assets but still retain full discretion as each opportunity is formed into its own LLC and then sponsored. These have become attractive features to investors and are reasons why direct investment has grown in popularity in recent years.
Measuring Investment Success
One metric investors rely on to measure the results of their investment is Internal Rate of Return (IRR), which is the rate at which each invested dollar is expected to return, adjusted for the time value of money. Apples to apples comparisons of real estate opportunities is typically done by comparing their respective IRR’s. In its simplest form, the IRR would be the sum of the cash pulled out as profits during the hold period plus the cash that spills in as profits upon sale measured against the original investment and adjusted for how those returns are paid out over the hold period.
Real Estate Sponsor Uniques
Of course, there is much more that goes into being a sponsor than just the work of finding, acquiring, and managing a real estate asset. Calling oneself a sponsor rarely brings investors to the table. Most sponsors have a proven track record that takes years to build. Some have a unique underwriting model, unique market access, or are vertically integrated as other competitive differentiators. While there are some similarities, there can be a lot of differences. As one investor once said to us, “When you’ve seen one sponsor, you’ve seen. . . only one”.