One listener reached out to me and talked about how he’s an LP investor in a few syndicates, and he’s always watching deals come across the table. Lately, the underwriting he sees often has plans for exit in three or five years at a 4 or 4.25 cap rate, which seems optimistic and ambitious given the uncertainty of rates in this economy.
The thing is, it’s not necessarily a sponsor’s job to make a plan that projects drastic changes or a significant downside case. As an investor, you need to ask yourself if now is the time for you to be investing in real estate and ask your sponsor all of the “what if?” questions. What if we exit at a 5.5-cap, or can’t exit for the next 10 years? What if rates rise? That’s how you’ll learn about the risk involved in a deal.
A sponsor’s job isn’t to prejudice the future, it’s to protect the downside. If interest rates go up, if you can’t exit, the sponsor needs to make sure they can still function and operate. Can the company afford to pay its people if they’re not doing deals?
Conservative underwriters are not winning deals right now, and neither are groups who are modeling a 6-cap exit. As a sponsor, I need to model in interest rate hikes, long hold times, and a high-cap exit, but it’s not my job to show an LP a doomsday scenario. My job is to take on less leverage, maybe 50% instead of 70%, and find markets where we can flex our operational muscles to increase the odds of these deals working out.
As an LP you need to ask yourself, is real estate right for your right now? Do you think interest rates will stay where they are? Do you think demand will keep roaring? Do you think cap rates on exit will be where they are now? If the answer to these questions is no, it’s not a good time to invest unless your sponsor has a proven value-add strategy.
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