Mastering LP Due Diligence for Apartment Syndications: A Step-by-Step Guide

We work with a group of repeat investors in our syndications, and they came to us one by one with varying levels of sophistication and knowledge. Most were or are financial or legal professionals, but some have less investment knowledge, such as one of our partners who is a retired teacher. I am hopeful that this post will provide an introduction to due diligence for the investors who are not yet familiar with this concept. I am also hopeful that this detailed description will be informative for those who are already familiar with the importance of due diligence.

For those who are not familiar with due diligence, it is a crucial first step toward making an investment. Due diligence helps inform decisions and to reduce risk, and it involves a comprehensive analysis of the property’s physical condition, the financials, the sponsor, and the investment terms. Careful, thorough due diligence can also uncover red flags that make an investment unsuitable. In this post, we will guide you through the due diligence process for investing in apartment syndications and provide tips on how to conduct due diligence effectively.

Understanding the Due Diligence Process

What is Due Diligence?

Due diligence is the process of thoroughly investigating the sponsor, the property and the investment terms to ensure that the investment is sound and worthy of your time & money. This includes examining the property’s financials, understanding property’s physical condition, the viability of the business plan, the investment terms, and the local market conditions.

Why is Due Diligence Important?

Due diligence is crucial because it allows you to identify potential risks and opportunities associated with the property, to make certain the sponsor has a realistic business plan, and to make sure the investment terms are fair. By conducting a thorough investigation, you can make informed decisions about whether to proceed with the investment.

First, it is crucial to have a checklist of items to review to make sure you don’t overlook anything important. This will help you stay organized and ensure that you have all the information you need to make a fully informed investment decision.

The Due Diligence Process

The due diligence process typically involves several components, including:

Financial Due Diligence: This involves reviewing the property’s financial statements, rent rolls, leases, and other financial documents to understand the property’s income and expenses. The sponsor should summarize this information for you.
Physical Due Diligence: This involves inspecting the property’s physical condition, including the building’s structure, systems, and amenities. Here, the sponsor should be willing to provide you with a third party inspection report.
Legal Due Diligence: This involves reviewing the governing document of the partnership, known as the Operating Agreement, as well as the Offering Memorandum and Subscription Agreement. Unless you have years of practice reviewing these documents, you may want to consult a financial and/or legal advisor for guidance. In particular, review the Offering Memorandum in its entirety. This is where you will find sponsor disclosures, and these disclosures will be very comprehensive. You must read them all. You may be very surprised by what is disclosed here.
Market Due Diligence: This involves researching the local real estate market to understand supply and demand fundamentals, demographics, rental rates, and other market conditions that may impact the property’s performance. You can do this by obtaining third party market research from the sponsor.

Step #1: Is the Sponsor Compensation Structure Fair & What is the Sponsor Co-Invest?

This first step is very important, because it’s really about character and competence. Do you want to invest with a sponsor who is banking on multiple cash fees at closing and not willing to eat their own cooking, or would you rather invest with a sponsor who is not charging cash fees at closing, and instead willing to invest in their own deal alongside you in a meaningful way for the long term? We like the latter, and you should too.

It takes an experienced team to execute real estate investment strategies, and experienced teams are not cheap. The team and the sponsor also need to be rewarded for executing the business plan and generating attractive limited partner returns. Accordingly, the sponsor absolutely needs to charge some fees and receive a split of the profits from the waterfall. However, if the sponsor fees are excessive, the waterfall is unfair and the co-invest is insignificant, we quickly take a pass and move on the next deal.

In terms of the sponsor’s compensation, it comes in two flavors: either through fees, some of which are one-time fees and some of which are ongoing fees, and it comes through the waterfall. Customary one-time fees include an acquisition fee, and on-going fees may include an asset management fee. If the sponsor is vertically integrated, the sponsor will also earn a property management fee.

Fees: How Much is Too Much?

Piping Rock is vertically integrated, and we typically charge a 1% acquisition fee (calculated as a percentage of acquisition cost), an asset management fee of 1-2% of the property’s gross revenues, and a property management fee of between 3% and 5% of property’s gross revenues. Some sponsors charge higher acquisition fees (2% to 3% of acquisition cost), but acquisition fees of this magnitude are off market. If your sponsor does not have a good explanation for why they are charging a 3% acquisition fee, you should pass on that deal. Other sponsors add in garbage fees such as investor on-boarding fees, due diligence fees, and accreditation verification fees. In general, more fees should generate more skepticism of that deal. Sponsors should be compensated through their promote after they’ve achieved their business plan, not upfront for simply closing the deal.

You should carefully check the fee disclosures in the PPM and the Sources and Uses table in the PPM. Here is a sample “Sources & Uses” table from a recent acquisition. In retrospect, we should have broken out the “Legal & Organizational Costs” line item, since $250,000 is a big number. If you see big line items like this, ask for more detail:

Excessive fees are things like 3% acquisition fees, with debt placement fees and disposition fees dumped on top, along with a dollop of construction management fees spread in between for executing a simple value add plan, plus some on-boarding fees for good measure. Excessive fees should trigger a red flag because they are an indication that the sponsor is not in it for the long term. These sponsors simply want to close the deal, deposit their 3% acquisition fee, and then fly to Tahiti the following day. Then, they’re able to pay their hotel bills with the on-boarding fees, the asset management fees and the construction management fees.

The reason for caution about higher fees is that all fees reduce investor returns on a one-for-one basis, so the higher the sponsor fees, the lower your returns will be. This is known as “Fee Drag” and we have written a post on why fee drag matters here. We have also written a detailed post on the various types of real estate fees here.

Assessing The Waterfall and the Co-Invest

The waterfall structure is just as important as the fee structure, because it also helps identify character and competence. The waterfall structure should clearly align the interests of the sponsor with its limited partners and it should also help de-risk the investment for the LPs.

The first step in most waterfalls is a Preferred Return which allows limited partners to collect 100% of cash flow before the sponsor receives any profit. This is how the waterfall de-risks the deal for the LPs. Not until after the limited partners have received 100% of their Preferred Return does the sponsor share in any cash flows.

After the Preferred Return is a split of all cash flows, usually something like 70% to the limited partners and 30% to the sponsor. Preferred Returns typically range from 6-8%, but in tougher market environments you may see 8-10%. Some sponsors also like to structure different Preferred Returns for different share classes, with 8% going to smaller investors and 10% going to larger investors. You can read a more detailed description of waterfall structures here, but the point here is that the waterfall should prioritize the limited partners over the sponsors. This makes sense, because the limited partners usually invest the majority of the equity, while the sponsor’s co-investment amount is usually a much smaller percentage.

So how much should the sponsor co-invest in the transaction? The short answer is that the co-investment should be a meaningful portion of the sponsors resources, such that consequences of failure will also be meaningful. Most institutional investment partners have a rule of thumb of 10% of the equity for a co-investment amount. The problem with this general rule of thumb is that 10% may not be that meaningful for larger sponsors, while 10% could be out of reach for smaller sponsors. For smaller sponsors, 5% or even 2% may still be sufficient, so long as it’s a consequential number.

The Importance of Alignment of Interests

Step #1 is all about making sure the sponsor’s interests are aligned with the interests of the limited partners. It’s obviously not a good sign if the sponsor is charging all kinds of up-front cash fees, investing a token amount, and also taking a disproportionate share of the profits. We have written more about why alignment of interests is so important here, and we have written about how we align our interests with our investors here. Do not take alignment of interests for granted.

Step #2: Understand the Sponsor’s Due Diligence Process

The syndication sponsor has its own due diligence process, and this process kicks of right after the Purchase and Sale Agreement is signed. Sponsors typically negotiate a fixed period for the due diligence process, during which the purchase contract is contingent on due diligence results acceptable to the sponsor in all respects. The sponsor’s due diligence period is typically 30 days at least, and it includes due diligence on financials, leases, title, insurance, zoning, ordinances, permits and physical due diligence including roofing, HVAC, electrical plumbing, electrical, concrete, asphalt and potential environmental contamination.

This is a lot to accomplish in 30 days, so it is important to know if the sponsor has agreed to less than 30 days, or if the sponsor’s offer is all cash, which usually means no due diligence contingency at all. Sponsors sometimes elect to accelerate or abbreviate the due diligence process if they’ve negotiated a good deal or they have an off market deal or the property is newer and well known to the sponsor. These are perfectly good reasons to adjust the length of time available for due diligence, but abbreviating the due diligence period increases investor risk, so this is important to know

Step #3: Ask for a Copy of the Property Condition Assessment Report

It’s often impossible for individual investors to conduct detailed physical due diligence on a property across the country. And almost no passive investor has any interest or capability to inspect 200 condensing units in Ohio in July. Still, this must be done, and we have a hack for you: the Property Condition Assessment Report.

During the sponsor due diligence process, lenders require general partners to obtain an inspection and formal report on the condition of the property and any deferred maintenance. These reports are essential, and they are called Property Condition Assessments (“PCAs”) or Property Condition and Needs Assessments (“PCNAs”). The inspections are performed by professional consulting firms who specialize in physical due diligence of real estate. The consulting company will inspect the physical condition of the property, including the building’s structure, systems, and amenities. The sponsor will not rely as heavily on the PCA reports, because they will have in-house expertise and these experts will make multiple on-site inspections and assessments, but the lender will rely heavily on these reports because they are remote just like you are.

Final PCA and/or PCNA reports are often not available until just before closing, but draft reports should be available during the syndication process. You should ask for a copy of the draft report, and the sponsor should have no hesitation in providing this information to you. The reports are often quite technical, but most prospective limited partners will be able to learn more about what professional consultants deem important in terms of physical due diligence, and you will probably glean valuable information about the property and location. If the sponsor does not have a PCA, run away.

A Brief Word About the Appraisal Report

Appraisal reports are addressed to the lender, which means they are not usually shared with the sponsor. The appraisal is an important report, because it helps provide support for the purchase price, but the appraisal does not in any way determine the purchase price. Instead, the purchase price is determined by the sponsor and the appraisal merely backs it up. It is rare for a commercial appraisal to deviate from the purchase price, so you should make sure the sponsor is intimately familiar with the local market and has strong support for the purchase price. The purchase price is the one thing that cannot be fixed after closing.

Step #3: Evaluate the Property’s Location

The Role of Investors in Due D

During the due diligence process, the sponsor or general partner may provide updates on the progress of the deal or any issues that arise. As investors, we should be responsive and provide any requested information in a timely manner. We should also be prepared to make a commitment to the deal if we decide to invest.

In conclusion, as passive investors in an apartment syndication deal, we play an important role in the due diligence process. We have a responsibility to conduct our own due diligence and maintain positive investor relations. By doing so, we can make an informed investment decision and contribute to the success of the deal.

The Role of Sponsors in Due Diligence

As sponsors, we play a crucial role in conducting due diligence for apartment syndications. Our responsibilities include overseeing the entire process, ensuring that all necessary steps are taken, and making sure that all parties involved comply with legal and ethical requirements. Our qualifications and experience are essential in ensuring that the syndication is successful.

Sponsor Responsibilities

Our primary responsibility is to ensure that the due diligence process is thorough and comprehensive. We oversee the entire process, from the initial assessment of the property to the final closing. We work with our team of experts, including real estate brokers, project sponsors, and commercial real estate brokers, to ensure that all relevant aspects of the property are assessed.

We are responsible for ensuring that all parties involved in the syndication comply with legal and ethical requirements. We ensure that all documents are in order, all disclosures are made, and all necessary permits and licenses are obtained. We also ensure that all parties involved are properly vetted and qualified to participate in the syndication.

Sponsor Qualifications

Our qualifications are essential in ensuring that the syndication is successful. We have extensive experience in real estate syndication and investment, and we have a deep understanding of the market and the legal and regulatory requirements. We have a team of experts who work with us, including real estate brokers, project sponsors, and commercial real estate brokers, who bring their expertise to the table.

We have a proven track record of success in syndicating apartment buildings, and we have a reputation for being ethical, transparent, and professional. We are committed to ensuring that our investors receive the best possible returns on their investments, and we work tirelessly to ensure that the syndication is successful.

In conclusion, sponsors play a critical role in conducting due diligence for apartment syndications. We oversee the entire process, ensure that all parties involved comply with legal and ethical requirements, and bring our qualifications and experience to the table. With our expertise and commitment to success, we ensure that the syndication is successful and our investors receive the best possible returns on their investments.

Financial Due Diligence

When doing due diligence for an apartment syndication, financial due diligence is a crucial step. It involves understanding the financing, analyzing the business plan, reviewing the pro forma, and examining financial reports.

Understanding Financing

Securing financing is a critical aspect of apartment syndication. We need to understand the financing options available and choose the best one that aligns with our investment goals. We should evaluate the terms and conditions of the loan, including interest rates, fees, and repayment terms.

The Business Plan

A well-thought-out business plan is essential for the success of an apartment syndication. We should analyze the business plan to ensure that it aligns with our investment goals. The business plan should outline the investment strategy, target market, and expected returns.

Pro Forma and Financial Reports

Pro forma and financial reports provide valuable insight into the income and expenses of the property. We should review the pro forma to understand the projected income and expenses and ensure that they align with our investment goals. We should also examine the financial reports to verify the accuracy of the pro forma.

To analyze the financial reports, we can use a spreadsheet to calculate key metrics such as the net operating income (NOI), cap rate, and cash-on-cash return. We should also examine the rent roll and lease agreements to ensure that the projected income is accurate.

In summary, financial due diligence is a critical step when doing due diligence for an apartment syndication. We should understand the financing options, analyze the business plan, review the pro forma and financial reports, and use a spreadsheet to calculate key metrics.

Physical Due Diligence

When it comes to apartment syndication, physical due diligence is a crucial step that helps us identify potential issues and make informed decisions about property acquisitions. Physical due diligence involves inspecting the property’s physical condition, which includes the building’s systems, structure, and grounds. In this section, we will discuss the three sub-sections of physical due diligence: the property management team, renovations and asset management, and physical inspections.

The Property Management Team

The property management team is responsible for overseeing the day-to-day operations of the property. During the due diligence process, we analyze the property management team to ensure they have the necessary experience, skills, and resources to manage the property effectively. We also review their financial statements to ensure they are financially stable and have a proven track record of managing similar properties.

Renovations and Asset Management

Renovations and asset management are critical components of the due diligence process. We review the property’s historical financial performance to identify areas where improvements can be made. We also analyze the property’s renovation plan to ensure it aligns with our investment objectives. Additionally, we review the property’s asset management plan to ensure it is aligned with our overall investment strategy.

Physical Inspections

Physical inspections are an essential part of the due diligence process. We conduct both an internal property condition assessment and a property condition assessment to identify any potential issues with the property’s systems, structure, and grounds. We also conduct a unit walk to assess the condition of each unit and identify any necessary repairs or upgrades.

In conclusion, physical due diligence is a critical step in apartment syndication that helps us identify potential issues and make informed decisions about property acquisitions. By analyzing the property management team, renovations and asset management, and conducting physical inspections, we can ensure we make sound investments that align with our investment objectives.

Legal Due Diligence

When it comes to apartment syndications, legal due diligence is a crucial part of the process. It involves reviewing all legal documents and contracts related to the property to ensure that there are no legal issues that could cause problems down the line. Here are some key aspects of legal due diligence that we focus on:

The Role of Attorneys

Attorneys play a critical role in the legal due diligence process. They review all legal documents, including purchase agreements, leases, and any other contracts related to the property. Their job is to identify any potential legal issues or liabilities and to ensure that the syndication is structured in a way that is legally sound. We work closely with our attorneys to ensure that all legal aspects of the syndication are thoroughly reviewed and addressed.

The Private Placement Memorandum

The Private Placement Memorandum (PPM) is a legal document that outlines the terms of the syndication. It includes information about the property, the investment structure, and the risks associated with the investment. It is important to review the PPM carefully to ensure that all terms are clearly defined and that there are no surprises down the line. We work with our attorneys to ensure that the PPM is accurate and complete.

Reviewing Documents

During the legal due diligence process, we review all legal documents related to the property, including leases, contracts, and financial statements. We pay close attention to any potential legal issues or liabilities and work with our attorneys to ensure that they are addressed. We also review the property’s compliance with SEC regulations and ensure that all necessary filings have been made.

In summary, legal due diligence is a critical part of the apartment syndication process. We work closely with our attorneys to ensure that all legal aspects of the syndication are thoroughly reviewed and addressed. By conducting a thorough legal due diligence review, we can help ensure that the syndication is structured in a way that is legally sound and that there are no legal issues that could cause problems down the line.

Market Due Diligence

When it comes to apartment syndication, one of the most critical aspects of due diligence is market research. Conducting thorough market research can help us make informed decisions about the potential success of an investment. In this section, we will cover the key sub-sections of market due diligence.

Understanding Markets

Before we can conduct market research, we need to have a clear understanding of what a market is. A market is a geographic area where buyers and sellers interact to trade goods and services. In the case of real estate, a market refers to the area where properties are bought and sold.

Market Condition Reports

During the due diligence process, we rely on market condition reports to help us understand the current state of the market. These reports provide us with valuable information about the supply and demand of rental properties in the area, as well as rental rates and vacancy rates.

Target Market

Once we have a clear understanding of the market conditions, we can determine our target market. Our target market is the demographic group that we believe will be most interested in renting our properties. This could include families, young professionals, or retirees, depending on the location and amenities of the property.

Investment Criteria

Finally, we need to establish our investment criteria. This includes factors such as the size and age of the property, the location, and the potential for future growth. By establishing clear investment criteria, we can ensure that we are only investing in properties that meet our specific needs and goals.

In summary, market due diligence is an essential part of the apartment syndication process. By understanding the market, conducting thorough market research, and establishing clear investment criteria, we can make informed decisions about potential investments and increase our chances of success.

Risk Management in Due Diligence

As we perform due diligence for an apartment syndication, risk management should be a crucial aspect of our process. By identifying and mitigating risks, we can ensure that we are making informed decisions and protecting the interests of our investors.

Identifying Risks

To identify risks, we may need the help of a consultant who has experience in the multifamily industry. This consultant can help us create a checklist of potential risks that we should consider during due diligence. Some of the risks we may need to consider include:

Physical risks: such as the condition of the property, potential hazards, and safety concerns.
Financial risks: such as the property’s financial performance, market trends, and potential liabilities.
Legal risks: such as zoning and building code compliance, tenant disputes, and pending litigation.
Environmental risks: such as hazardous materials, water damage, and mold.

By identifying these risks, we can create a plan to mitigate them and protect our investors.

Mitigating Risks

Once we have identified potential risks, we need to develop a plan to mitigate them. Some strategies we may use include:

Conducting thorough inspections of the property to identify any physical risks and create a plan to address them.
Reviewing financial statements, market data, and other relevant information to understand the property’s financial performance and identify any potential risks.
Reviewing legal documents and consulting with legal experts to ensure compliance with all applicable laws and regulations.
Conducting environmental assessments to identify any potential hazards and create a plan to address them.

By taking these steps, we can mitigate potential risks and ensure that we are making informed decisions during due diligence.

In summary, risk management should be a crucial aspect of our due diligence process for an apartment syndication. By identifying and mitigating risks, we can protect the interests of our investors and make informed decisions. Working with a consultant and creating a checklist of potential risks can help us identify risks, while thorough inspections, financial review, legal review, and environmental assessments can help us mitigate them.

Conclusion

In conclusion, performing proper due diligence is crucial for any real estate investment, especially when it comes to apartment syndications. We must ensure that we have thoroughly inspected the property, its financial documents, and the market conditions before making any investment decisions.

As a general partner, it is our responsibility to provide our limited partners with accurate and transparent information about the investment opportunity, including cash flow projections, preferred return, and profit splits. We must also have the necessary knowledge and experience to handle any issues that may arise during the hold time.

When pooling money for an equity investment, we must comply with private securities regulations, such as Rule 506(b), and avoid any advertising that may violate these rules. We should also review bank statements and due diligence reports from sponsors before making any investment decisions.

Real estate attorneys can also provide valuable guidance during the due diligence process, especially when it comes to tax benefits and profit splits. It is important to consider the tax implications of any investment and consult with a tax professional if necessary.

Overall, investing in apartment syndications can provide significant net worth appreciation and tax benefits, but it is crucial to perform proper due diligence and understand all responsibilities before making any investment decisions. We hope that this article, along with our podcast and blog, has provided valuable insights into the world of real estate investing and syndication.