Investing in real estate involves risk. To mitigate that risk, many investors are choosing to invest with real estate syndication sponsor teams. Partnering with an investment group gives investors an added layer of protection because they can rely on the experience and expertise of the seasoned sponsors.
Does that mean you should simply hand over your capital and blindly trust your chosen sponsor team? Not at all. Even when you’ve chosen an investment group with a proven track record, you should still do your due diligence – research and vet any investment deal yourself.
When vetting a deal, you should have a firm grasp on who the lender is and more specifically, how they do business. While there are many reputable lenders out there, I’ve unfortunately seen many lenders and lending practices fail investors time and time again.
In this article, we’re taking a deep dive into what information you should have about the lender and their typical practices before moving forward in any real estate syndication deal.
Who Is The Lender?
As a passive investor, if the details of the deal are being handled by the sponsor team, why should it matter to you who the lender is? In my experience, the lending industry is fraught with people who, for one reason or another, can’t get the deal done. I’ve seen time and time again investors ready to close and then the lender, for various reasons, backs out of the deal at the last minute.
The most important question to ask your sponsor is do they have history with the lender? More specifically have they used the lender in previous deals and how many? Look for projects where the lender has a solid reputation and positive working relationship with the sponsor.
Evaluate The Financing Details
In commercial real estate, there are three main ways a deal is financed. As you can guess, the local bank branch is not where we go to get financing for multi-million dollar commercial real estate investment properties. When financing the portion of an asset purchase not covered by investors’ capital, the general partners and sponsors of any real estate syndication typically use one of these three options – Fannie Mae Loans, Freddie Mac Loans, or Bridge Loans.
As the investor, ask your sponsor team for the financing details. Find out what type of loan will be used to purchase the property. Ask about the debt terms. Is it 40 year non-recourse debt or 30 year non-recourse debt? Ask about the interest rate – is it a fixed rate or variable? If the interest rate is variable, find out if the lender is including a rate lock. A rate lock is like an insurance policy that ensures the rate will never go over a certain number during an inflationary period.
A rate cap or purchase interest rate cap is your protection when interest rates start rising. You pay a fee to have a rate cap that serves as a sort of insurance policy by locking in a maximum loan rate.
Options To Consider
When underwriting a real estate syndication deal, there are other options the lender may want added in. As the investor, you need to have a working knowledge of the elements that could possibly be used to finance the project.
For instance, bridge debt is used to finance some properties and is a great solution when used properly. Understand that bridge debt is a riskier product, in that it allows some lenders to underwrite as post-renovation revenues. Essentially, this gives you a higher purchase price and it comes with a higher interest rate.
The commitment on bridge debt is shorter, typically three years or less. In some cases the speed in getting the money is worth more than the cost of the money. When using bridge debt, find out if there are extension options available. In other words, can you get a one year extension? If yes, how many times are you able to extend the loan? When using bridge debt, you need to know the lender’s history.
Be wary of loan-to-own lenders. This questionable practice is when lenders loan large amounts of money knowing that in the end it’s unlikely the borrower will be able to pay it back. Their strategy involves acquiring the asset through foreclosure and taking it back over. Before moving forward with bridge debt, be sure to confirm your sponsor has a solid relationship with the lender.
Prepayment penalties is another element commonly faced when financing commercial real estate loans. From the standpoint of the lender, when a loan is paid off early, it costs them a substantial amount of income, in the way of unearned interest. Adding stipulations such as prepayment penalties, protects the lender against the potential loss of that expected cash flow.
Prepayment penalties are designed to be prohibitive, but when it fits within the business plan, you can certainly choose to pay the fees.
At Bricken Investment Group, we ensure that prepayment doesn’t drastically impact cash flow or leave room for error. While there are loans available to finance commercial real estate purchases without prepayment penalties, those loans in general are more costly, have higher interest rates, and may require shorter loan terms.
Flexibility Of The Lending
In any commercial real estate deal, be sure to evaluate the flexibility of the lending. Overall, you need to determine the possibility of how the loan and all its terms might positively or negatively impact the deal. Can the syndication deal still hit its success markers if (fill in the blank: we pay prepayment penalties, extend the loan, don’t get the desired refinance etc.)?
While you should do your due diligence, your sponsor team has the responsibility of shopping and negotiating the type of funding, the loan interest rate, the timeline to fund, minimum prepayment penalty, the type of prepayment penalty charged, prepayment period, and other details that will affect the financing and largely impact the outcome of the investment deal.
When vetting the lender in a real estate syndication deal, the real question is, how well does your sponsor know the lender and how many successful deals have they completed together? Ultimately, you’re evaluating how much risk the sponsor is assuming in their choice of lender when financing the investment property.
To learn more about how we mitigate risk on the syndication investment opportunities we offer, check out any or all of these other “Vetting A Deal” blog posts:
If you still have questions about risk or how to properly vet an investment opportunity, let’s talk!
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