#119 Create Alignment Of Interest With The Right Sponsor

Welcome to the Passive Income MD Podcast, where we talk about creating your ideal life through multiple streams of income. I'm your host, Peter Kim. If you enjoy hearing about this stuff, make sure to hit subscribe so I can bring it to you every week. Now let's get on with the show. Hi everyone. Hope you've had another great week. I'm recording this when I've been coming off a few vacations seem to have happened back to back. I don't know about you, but sometimes when I come back from vacation, I'm exhausted. I need to take time off. I need to take just relax. I think it's because when I'm on vacation, I try to make the most of it. I'm actually typically not one of those people that like to just go lay on the beach. I like to do things, create memories, create experiences, be active. And I always feel like I can relax when I come back. It's funny. And so I come back and I've been a little bit tired, but at the same time, I've been able to reconnect to the community. I've been connecting to all the cool things that are happening right now, especially in the Passive Income MD world. Again, thanks to those who are listening to this right now. There are so many people that I've talked to who said that they listened to this podcast in different areas, in the car, running with whatever it might be. And again, I just really appreciate you. And I want to know that we try to bring as much value to your life as we can on a weekly basis in a short period of time. And so today we're going to be talking about a topic that I think is really important when it comes to investments, and that is the idea of trust. I'm sure you've thought that in the past you're going to be going into some sort of investment or you're going to be working with somebody in the financial sector and you're like, how can I trust them? I think inherently as physicians, oftentimes we feel like we're targets. I don't know if you felt like that. Especially in residency, there were tabletops of people trying to sell you things. And so inherently or kind of like instinctively, you kind of become defensive. You also hear about physicians and doctors getting themselves into poor situations or sometimes getting preyed upon. And so that feeling of trust, it doesn't come easily when it comes to certain investments. I know that in my life, I know that in some of my relatives lives, they've gone into some investments which didn't serve them well. And the question is, like, how do they know? And how does you know whenever you look into investment, that you can trust that person? Now, I'm going to be talking about these things in the context of looking at private real estate deals, because that's probably what I look at the most. Now, this can apply to so many other things, other types of investments, but today I'm going to be talking about syndications and funds. Now, the term that we use oftentimes when doing due diligence for these things, it's not trust. The term that we often use is something called alignment of interest. Now, I'm going to use that a lot. You're going to hear about it a lot. You've probably already heard about it a lot on this podcast, if you've been listening a while. But alignment of interest, what seems like a simple word, is probably the most important thing or one of the most important things to look at when you're looking at a deal. It's an arrangement. And what it means is that all parties really stand to benefit from the same outcome. Now, I've heard it said before. How do you know that you can trust someone? It doesn't matter if there's someone you know, someone you barely know, maybe it's even your enemy. How can you trust that person? Well, it means that if you have the same interest, meaning that you ultimately have the same goal and you're incentivized for the same goal, you then you can trust them, meaning that you are all going for the same thing. The problem happens when interests are misaligned, meaning that somebody gains when somebody loses. For example, you want to find a situation where everybody wins and that there are benefits to everyone. Maybe there are some downsides, as always, but you want to maximize that alignment, and that's when you want to make sure you invest. So when it comes to private real estate, again, you can apply a lot of these things generally. But there are a few ways to make sure your sponsor, the person who's running the deal, their interests are in line with yours. Number one, you've got to look at the business plan and the exit strategy. Like before you consider investing in syndication, it's really important to understand your sponsor's business plan and exit strategy because they're the ones that are actively managing this property, this deal. They're going to be making all the critical decisions. They're the general partners, you're the limited partner, meaning that you're pretty much along for the ride. You make a decision to invest and then you have to basically just wait and trust and rely on the sponsors to make good decisions. So before getting into any sort of deal, please don't be afraid to ask questions to evaluate if the investment, if it's a good fit for you. So here's some questions you can ask, but especially in this topic. What is the expected cash flow? Is that going to happen earlier on? Is that going to happen later? You know, what kind of strategy are they employing here? Is this a situation where it's like a development deal, where there's a higher risk deal, you know, and a higher return? Or is it perhaps a lower risk deal, lower return? Where are they investing? Why are they investing in that place? How long do they expect this investment to last? All of these questions are ones that you absolutely need to know which will help you determine whether your financial alignment match, like basically aligns with that of the sponsor. Right? So that's the first thing. Find out what their plan is, really understand that, and then figure out the exit strategy. I will tell you, I made this mistake especially early on. Like I remember I invested in syndication. I kind of remember some numbers about returns and I remember a number of years, but that's basically all I remembered. And I remember thinking, hey, how come I'm not getting any cash flow from this? And I realized that, hey, this is a deal where it's going to take a little while for that cash flow to come. Now if I was in a situation where I was living off that cash flow, I wanted that cash flow. Now this wouldn't have fit with my strategy. And so it's really important for you to understand that. Number two, another thing that you can think about when it comes to alignment of interest is how much a sponsor is investing. We often call that the co investment. Now the size of that co investment, some people call it skin in the game. It's, it is a marker of alignment of interest. Now, if the sponsor invests a significant amount of capital, right, the higher risk they run that they'll lose capital themselves. You know, perhaps some people see a higher co invest as a greater mark that they have some faith in their investment. However, at the same time, let's be honest, some of these deals are really big. It's not really practical for a lot of these sponsors to invest huge amounts in every deal. They may not have the capital for that. And they also want to leave room for investors to come in themselves. So you'll often find that sponsors typically invest anywhere between 5 to 10% of the investment capital in the deal. But again, this can vary and I wouldn't say one number is better than another. But sometimes I always ask them, how much are you investing in the deal? And I like to see it fall somewhere between that range, 5 to 10%. If it's lower, I definitely ask them why. If it's higher, I also ask them why they're investing so much because there's probably a story behind it as well. The third thing, when it comes to these type of investments like syndications, we want to talk about the sponsor compensation and the fees, like how do they get paid? Especially people care about these things called fees. These are things that the sponsor receives for really running, for facilitating the deal. So it is important to look at these fees and understand what you're seeing. It's possible that certain deals are so full of fees, are so high they're front loaded, that honestly the sponsor doesn't really have as much incentive on the backside to do really well. They know that just by raising the money for the deal, they're going to make a ton of money on the front side. And maybe that backside, maybe it doesn't matter how well the deal does. That's not the type of deal that you want to see. You want to look for balance where you want to find out where sponsors are compensated because you want them to be compensated as well. Otherwise they're not going to really be incentivized to do well. But you want to find a situation where they get paid. When you get paid, meaning that you do well, then they do well. So here are some of the fees that you might see in a syndication. You might hear something called an acquisition fee. Now this fee, just so you know, it happens when the property's acquired, they get it upon closing the property, you know, they spend weeks, months, whatever it is, researching, sorting, underwriting, creating relationships with all these brokers, figuring out business plans. So they do charge a small amount of the purchase price to acquire an asset. That's those time spent upfront to do the deal. Just so you know, a lot of times these sponsors, they might have to fight and do all this stuff for multiple deals and they don't even get the deal. And so just so you know, this is why sometimes the acquisition fee is somewhere between 1 and 2%. That seems to be pretty standard. Sometimes it could be 3%. It helps to offset all that time and energy and effort in between deals to get future deals. Now there's something also called a financing or loan fee. This means that the sponsor gets compensated for financing or taking the responsibility of financing such a large investment opportunity. This can be extremely, you know, risky. This can take a lot of time to set all this stuff up. This can be labor intensive. So this usually runs between 0.5 to 1% the total loan amount. Now you might find something called an asset management fee. That means that they are managing, overseeing the asset, meaning that they are watching this deal to make sure it's running well, that it's following along with the business plan, that it's humming along and whatever changes need to happen, these things can adjust, A thing can be adjusted and they can make sure that they're meeting if not exceeding projections as well as the business plan. Just so you. This number is again somewhere between 1% and 3% of the collected rent or projected gross income. That seemed to be a pretty standard number somewhere in that range. Now, I'm not going to all the fees because you don't need to know that. But sometimes there's something called disposition fee, which is when the property also sells. The cost of marketing, selling a property, ensuring a smooth transition happens between different ownership that can come out to about 1% of the sales price. Again, when you look at a syndication, all of these things are not outlined just in that offering memorandum or that initial deck you get. You really gotta go into what's called the ppm, the private placement memorandum, to look at all those fees to see if there are any sort of hidden costs. Everything needs to be disclosed in there. So. And when I talk to a lot of people, they want to know like what is a good fee and what is a bad fee? Like how much is too much. Now I will tell you that it's a balance. There's no one right answer. Honestly, when I look at one deal versus the next, it's sometimes hard to compare apples to apples. You just have to look at the overall amount of fees and see if they fall within these ranges. See if they seem reasonable for the risk for the returns that you might be getting compared to another deal. And it's opportunity cost. Let's say that fees are necessary. Anything you do, where you get great service, where you get there are going to be fees involved. I promise you. It's just going to be the cost of doing business. Again, you want them to feel like they're being compensated well, but at the same time you need to make sure that they are incentivized to also really perform well for their investors. Obviously, if they don't do a great job, investors won't come back to them. But on a deal to deal basis. You want to make sure that again, all of that alignment is happening. Now, how else does the sponsor get paid? They get a split of the profit. So not only do you get a fee for running the deal, when the deal ends, when it sells all these type of things, they get a small portion of the profit. Now, how do you know if that profit is reasonable? I've seen all sorts of splits where 80% goes to the investors, 20% goes to the sponsor. I've seen 70, 30, I've seen 64, I've seen 50, 50, all of these things I've seen and there's no right or wrong. It's what an investor, what you seem reasonable based on, again, the level of risk, the level experience, what you expect. At the end of the day, I'd rather invest in someone that gave me a 50, 50 split. If I end up with a better return than someone who gives me an 80, 20, there's more risk involved, maybe a less experienced sponsor. And honestly, at the end of the day I make less. So you can't just go by that 80, 20, 70, 30 for anything in life. You got to look at what the net result will be to you and the certainty that comes along with that. The other thing to look for is something called a preferred return, as well as what's called the waterfall structure. I've talked about that in the past. But a preferred return, by the way, it's amount that you get promised first in terms of the profit before the sponsor starts to participate. There's something called a waterfall structure. It's in every single deal. So please look for that. They may not call it the waterfall structure, but they might call it the compensation structure. They might call it the profit split, whatever it is. If you can think about a waterfall of a bucket from one bucket to the next bucket, you know, the profit comes in, it fills up a bucket. When that's full, it drops to the next one. It is just looks like a waterfall. It's important to understand that structure, to look at it and make sure that you as an investor are put first so that you make sure that you're getting paid before the sponsors, meaning that you have to do well before the sponsor gets compensated. And there's something called preferred return, which means that you get a percentage or whatever that profit is before the sponsor starts to participate. These things again vary significantly, These splits vary significantly. And again, you've got to use all of these things in context, looking at all these things together. And I promise you, the more deals you look at the more these things will start to pop out, like in terms of irregularities or something that doesn't seem to make sense. But you got to put all these things together and look at it and say, all right, you know what, this deal makes sense for me because it fits my goals if it's my objectives. And I know that the sponsors are well incentivized to do well for me, the investor. And of course you have the experience to actually pull that out and make it happen. So I will tell you, when the interests of an investor and sponsor are aligned, you're going to be able to build your real estate investing portfolio. The amount of income that you get much faster and smoother. And when you find that right incentive and you find the right sponsors that are doing that, you're going to be able to sidestep maybe some of the other pitfalls and the mistakes that maybe you've seen other people make. Because I promise you, for lots of people that ran into poor investments, obviously they probably didn't do a good amount of due diligence, but they probably didn't find out whether there was good alignment of interests. All of these things, of course, are to create passive income. And it's not about the money. It's to buy back time, to really take control of your time, letting you do the things you love with the people you love. Hopefully you've been able to really enjoy that the last few months where you get a taste of it. I'm all about that. I'm hungry for more time, more experiences, more moments with family and loved ones. Real estate just happens to be a vehicle to help me get there. Hope that was helpful. Bring your questions, bring your comments on our Facebook group Passive Income Docs, and let's hear from you and hope you have an amazing week. Thank you. Enjoy the show. Let me know by dropping a review in the podcast app you're listening to us in. And if you haven't already, make sure to hit subscribe. Are you part of our community yet? Join thousands of physicians who are also on this journey to creating their ideal lives through multiple streams of income. You can join us on our Facebook group Passive Income Docs and you can always learn more at our website, passiveincomemd.com thanks again for allowing me to be a part of your journey. See you next time.