The past year has seen news reports detailing the challenges facing various commercial real estate sectors. Office, Retail, Hotels, and other asset classes, including multifamily, have been affected. This includes reports that have detailed the struggles facing some multifamily sponsors. While industry insiders can quickly identify the missteps these firms made that led to foreclosure, those reasons might not be readily apparent to passive investors that trust a sponsor to protect their capital and deliver solid returns.

It is not an exaggeration to say your most important real estate investment decision will be selecting the right sponsor. But, if you are new to multifamily investing, it can be challenging to identify a sponsor that you can trust. What questions should you ask? Equally as important, how should you interpret their answers?

With most multifamily investments, your money will be with the sponsor for several years. These are long-term investment relationships. You want to be comfortable with how they plan to protect your capital and achieve the projected returns. And, when evaluating experienced sponsors with lengthy track records, your decision should not be driven by just competence and historical track records, but also by fit. Does the sponsor have the same investment approach as you? Are they too aggressive for your comfort? Conversely, is their hold period too long? Will you be comfortable with your capital sitting in an illiquid investment with that sponsor for 5 to 10 years?

Below are ten important questions you should ask any deal sponsor when deciding to invest with them. As you will see, there often is no purely “right” or “wrong” answer. But, the mix of answers will help shape who a “best match” sponsor is for you and your investment goals.

1. What is your investment strategy?

The first thing an investor should understand is a sponsor’s investment strategy. How do they select assets? Do they fix and flip? Or, do they hold assets for a longer period and rely on appreciation? What is their approach to capital improvements? There are several approaches, each with their own risk/reward profile. Finding a sponsor with a strategy that matches your risk tolerance is vital.

2. What is your performance record and return expectation?

An established sponsor will have a documented and published track record you can review. Be wary of any sponsor that doesn’t… When reviewing the sponsor’s returns, it is important to look for consistency, and to see if their historical performance matches their stated investment approach. Some other things to look for: Are their historical deals in their target markets? Are they multifamily deals or a different asset class? Does the hold period of their deals match their stated investment strategy? This information will give you a good idea of how likely the sponsor will follow their stated approach with your capital.

3. Where do you invest and why?

Market Selection is a key component of a sponsor’s investment strategy. A sponsor should be able to tell you which markets they will invest in and why, and also tell you which markets they avoid. We recently discussed the important state and local considerations an investor should keep in mind when evaluating a market. But, even when you are potentially investing in a pro-business market, the sponsor’s market strategy should be a logical fit. For instance, if your sponsor is projecting aggressive rent growth in their proforma, they should be working in markets with above average income growth. If they plan to buy and hold, they should not be in a market with a declining population, as they will be working with a declining pool of residents year over year.

4. Do you only sponsor multifamily investments?

Some sponsors offer investments in multiple asset classes, even within the same investment Fund. This type of diversity can be beneficial to an investor, or it can mean the sponsor is not a specialist in any particular asset class, and your risk is higher as a result. Commercial real estate investments need to be operated well to deliver strong returns, and it can be difficult to be an expert in the operations of multiple asset classes. If you decide to work with a sponsor that offers investments in multiple asset classes, you should ensure they have solid operational experience in all of the asset classes in that investment vehicle.

5. How long do you hold your assets?

It is important to understand a sponsor’s typical hold period. Shorter hold times can sometimes lead to higher IRRs, but can also reflect a more aggressive investment approach that is susceptible to short-term market fluctuations. Longer hold times require patience, but can often lead to better overall results because the sponsor has timed the disposition to maximize returns.

6. What type of financing do you use for your deals?

Sponsors have multiple financing options, and the options they choose can tell you about their investment approach. One key piece of information is the underwriter of the loan. Fannie Mae and Freddie Mac (often called “agency debt” or “GSE/Government-Sponsored Enterprises debt”) are considered the industry standard for multifamily underwriting. As of this writing, only 0.4% of Fannie/Freddie loans were delinquent, which is well below industry averages. If a sponsor sources the majority of their loans through Fannie or Freddie, it is a strong indicator that they are selecting investments in attractive markets and making conservative assumptions on their own underwrites. Life insurance companies are also major players in the multifamily lending process and have similar, conservative lending standards.

Commercial Backed Mortgage Securities (CMBS) loans can offer more flexible terms than their GSE/LifeCo counterparts. These loans are usually underwritten and issued by banks at the national and regional level. They can be more aggressive in their underwriting assumptions and are willing to assume more risk. It is not uncommon to see shorter term loans with higher leverage. This can lead to high returns if the sponsor executes their business plan correctly, and the market cooperates with that plan. But these loans often offer less room for error than agency debt, as evidenced by their higher delinquency rates.

Commercial Real Estate Collateralized Loan Obligations (CLO’s) are considered even more risky than CMBS loans. They are not underwritten by banks and typically have very aggressive terms. In a hot market, CLO’s might appear tempting, but they do not have a proven track record of withstanding any level of market stress.

Another important piece of a sponsor’s lending strategy is Loan to Value (LTV) ratios. High LTV ratios (75% to 80%-plus) are considered riskier, but can reward investors with higher returns if the investment performs well. Lower LTVs will have lower debt payments, and are generally considered to be safer, but can have lower total returns because they require larger equity investments. Essentially, the lower the LTV, the lower the leverage, and the higher the safety. A sponsor should be able to explain their lending approach to you and how it is consistent with their overall investment strategy. You can then determine if it is the right fit for you.

7. Do you offer single asset investments or fund investment vehicles? What are the primary differences between your individual deals and your funds?

If you talk to a sponsor about investing, and they offer single asset investments as well as fund investments, they should be able to walk you through the potential advantages and risks of each investment type. Single asset deals offer you the flexibility to select individual properties and markets. Funds offer less flexibility, but can potentially offer more diversification. Additionally, hold times are typically longer for fund investments than single asset opportunities.

8. How do you protect my investment?

Every sponsor makes multiple assumptions when projecting returns on an acquisition. From lending to market selection to property management, a sponsor is responsible for dozens of decisions that will drive the success of the investment. You should feel comfortable asking a sponsor about the decisions they make to mitigate risk and protect your principal.

9. What happens after you liquidate an asset? Do you offer 1031 Exchanges after a sale?

1031 Exchanges are a powerful tool to defer capital gains tax and accelerate equity over the long term. However, some investors are willing to incur capital gain taxes and recapture taxes so that they can maintain capital flexibility. Again, there is no right or wrong answer here, but a sponsor that can offer you the flexibility of either solution at property sale can provide more options for you, as portfolio needs change over time.

10. How are you, the sponsor, compensated? How much of your own capital is invested in the deal or fund?

You should understand how a sponsor is compensated. Ideally, you want the majority of their compensation to be directly aligned with achieving positive investment results for you. What is their fee structure, and what events result in compensation for the sponsor? What type of profit split is the sponsor expecting? In what sequence do investors receive returns (i.e., what is the capital waterfall)? Does the sponsor get paid even if the deal is not profitable? If so, how? The answers to these questions will give you a good idea of how confident the sponsor is in their approach. If a sponsor is heavy on operational fees and low on profit split, that could be a sign that they are not sure the investment will perform the way they are selling it.

Another key consideration is how much of the sponsor’s own capital is invested in the deal. You’ll hear the term “skin in the game.” Ideally, you want the sponsor to have a significant investment in the project. Keep in mind, the best lenders will require significant personal cash reserves to be held by the investment sponsors. So they can’t invest everything. You just want to see that they are at least as committed to the deal as you are.

In summary, there is no objectively “right” or “wrong” answer to any of these questions. However, by asking some or all of these questions, either directly or to yourself, as you review their offering materials and corporate information, you can significantly increase your chances of having a profitable investment.

Sponsor selection is the single most important aspect of your investment.

Make sure you spend the time to find the right investment partner for your hard earned capital.