Professional investors sometimes borrow terminology from horse racing: pick the jockey, not the horse. I know virtually nothing about horse racing, but I understand the wisdom in that line. The person driving an investment is often a far more important factor than the underlying property or company one puts money into. Let’s translate this reality to the world of real estate.
Syndication Managers Aren’t Created Equal
Many are attracted to the potential solid returns and tax favorability of real estate but don’t have enough time, skills, or capital to invest by themselves. They turn to real estate syndicate managers, who often do an excellent job finding good opportunities, gathering funds, and managing properties.
However, some managers aren’t especially competent or selective and cut corners to close as many deals as possible. Limited Partners in large deals can be pretty helpless if things don’t go as planned.
Track Record Limitations
Of course, even the best investment manager can encounter a bad market or unforeseen obstacles. Still, investors may improve their odds of success by being selective about whom they entrust their funds to.
Choosing a manager solely based on a good track record is a simplistic approach to manager due diligence. Reputed track records are often too short to be meaningful or may simply offer cherry-picked information. Short-term success stories not backed by solid data don’t mean much to savvy investors.
Streaks of Mazal
While every excellent investment manager, by definition, has strong historical performance, not everyone who provided investors with high returns is an excellent manager. “A rising tide lifts all boats,” the saying goes, and performance that managers may tout as proof of talent is often solely the credit of a strong market wave.
Market cycles take time to unfold, and those who coasted while paying little attention to deal quality, management execution, and financing stability were really just throwing the dice. They are most likely to have deals blow up, all the while blaming it on the horrible market environment.
Anecdotes Don’t Count
Again, even the most talented and careful investor can hit a rough spot and even have deals get wiped out. But investors are much less likely to get hurt under a careful and attentive manager than one who’s just grabbing deals to build his own empire, while giving little consideration to learning the business, finding solid deals, and working hard to protect the interests of his investors in good economic times and bad.
Therefore, basic hishtadlus requires looking beyond shallow anecdotal track records. Professional investors look under the hood to evaluate the quality of their general manager’s character, capabilities, and incentives before wiring funds.
People Perspectives
While mazal plays a role, we should always look to do business with ehrlich, straightforward, and talented people. Investors should inquire about the personal reputation of the key players handling their hard-earned dollars. Someone who has left a trail of dinei Torah and litigation behind them will probably not be a good partner in the long run.
Does the team responsible for finding, underwriting, and managing the deals consist of smart, experienced, and motivated people? Some think a chevrahman partner will make them money in creative ways. Perhaps. But often, the sly partner will use subterfuge against their partners, not for them.
Process Questions
Even ehrlich and savvy managers don’t always have a consistent process for finding and executing pipelines of solid opportunities. Good deals don’t grow on trees, and it’s common for even established players to pivot into new regions and property types.
Do they have the capacity for that change? Are excellent local management teams in place to execute? How much risk does a manager prepare for in the deal structures? What’s the stability of their usual capital stack? Are projected returns driven by shaky mortgage structures? Will Limited Partners (LPs) have money for cash calls in case that becomes necessary? All good questions to ask.
Focus on Fees
Fees charged by investment managers obviously matter because every dollar going into their pocket is a dollar not going into the Limited Partners’ pockets. General Partner (GP) investment managers can and generally will negotiate the best fee structure they can get investors to accept. Still, the Limited Partner (LP) silent investors should try to ensure that the payments are commensurate with the attractiveness of the deal’s potential.
Excessive fees can make the risk of a deal not worthwhile from the LP’s perspective. Net (after-fee) returns are what matters to those putting money in the deal, not the gross.
Alignment of Interest
But much more than the amounts, it’s the structure of how fees are paid that requires scrutiny. People follow incentives, and allowing managers to structure terms like “heads, we win; tails, I win, you lose” is a recipe for financial disaster. In well-designed compensation structures, interests between investors and managers are kept as tight as possible.
To ensure a true partnership between capital and those running the deals, it’s so important to require significant skin in the game and prioritize capital returns, hurdle rates, and the like. Unfortunately, many deal terms incentivize quantity over quality, to the little guy’s detriment.
Not for Everyone
As you can see, this kind of due diligence is not easy or quick. In a practical sense, it’s often not possible for smaller investors determined to access real estate syndications (and hedge fund-type managers, too). Should a $50,000 or even $500,000 investor attempt to grill an established manager like I’m describing, there’s a fair chance they will simply hang up the phone.
Not that I’m blaming the GPs. I probably would be impatient, too, if I were in a similar circumstance. They often can find investors without jumping through additional hoops and negotiations. At least when the economy is strong, and deals are flowing.
Still, most larger investors do thorough manager due diligence and/or have unbiased professionals vet their deals for them. Smaller investors in pooled deals who skip managerial research should at least recognize that they’re likely taking a shortcut that may come back to bite them. Most are, therefore, better off sticking to simpler modes of investment like mutual funds and single-family home rentals they can control.
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