Defaults are always a possibility in real estate development projects. The risk exists regardless of how shrewd a private investor or lender is.
Before committing to real estate investment, it’s critical to understand the risks involved, including the risk for defaults, and your personal risk tolerance.
Related: 5 Things Experienced Real Estate Investors Might Not Know About Commercial Real Estate
Role of the Sponsor
A real estate sponsor has a range of roles. These start at the very beginning of the real estate development or investment process and extend all the way to the monetization or sale of the real estate asset.
A sponsor is someone who creates, or finds, the deal. He then works to negotiate the sale agreement and its terms. The sponsor uses marketing materials to acquire assets and find lenders and investors. He then arranges the financing that’ll be needed to purchase the property. Essentially, the sponsor oversees all activities that occur before the acquisition.
After the purchase, the sponsor also ensures the property’s management and operations are taken care of. This includes renovations, leasing, and maintenance.
The sponsor provides all financial reports during the investment project, which are typically communicated to investors on a quarterly basis. They’ll work with accountants to create and distribute the K-1 schedules during tax season, submit drawdown requests to the lenders, and pay investors as outlined in the investment agreement.
At the conclusion of the investment period, the sponsor will make arrangements for the sale of the property or refinancing of the project.
Sponsor Default Risks
There are many circumstances in which a sponsor may default. Some of these factors may be out of the sponsor’s control, like a bad turn in the economy or a force majeure.
However, other problems are usually within the sponsor’s control and accountability. For example, he may be incapable of getting the job done. He may have chosen or mismanaged suppliers that do not deliver on time. He may run into financial distress or over-leverage and lack the cash to operate the property properly.
In case of a sponsor default, investors need to take action to protect their rights and interests.
Here are some actions and remedies that investors can take in case of a sponsor default:
Discuss it with the Platform
In dealing with real estate through a crowdfunding platform, you’re making an investment in a note or stock arrangement with the sponsor. If everything goes as planned, you’re counting on the platform to put things right (or as close to right as they can). Thus, part of your due diligence must involve learning how the business intends to handle these circumstances, should they come.
Discussing the problem with them may be a good first step. Find out your platform’s approach to defaults and decide if it works for you. The platform might have some leverage over the sponsor that small investors do not.
Some platforms, like SecondRE, let you buy holdings directly from the sponsor and act as an intermediary. All assets are vetted to ensure reputable sponsors and investments, but in such cases, the investor needs to work directly with his sponsor or sell his holdings if liquidity is enabled.
We vet all of our sponsors and investments before they go on the SecondRE Marketplace to reduce risks. Have questions about how? Get in touch with us today.
Consult with an Attorney
When you may face a more intricate situation, it’s recommended to discuss your situation with an attorney.
An attorney can offer legal advice specific to your case. They’ll know whether federal or state laws protect you as an investor. Lawyers would examine the specific agreements relating to your investment and the real estate property in question. This can help you understand what grounds you have for any available legal remedies.
If there are grounds, the next logical steps would be sending demand letters from the lawyers, followed by a lawsuit or arbitration against the defaulting sponsor.
If discussing your situation with an attorney, make sure to choose a firm with knowledge and experience in real estate law.
Related: 4 Reasons to Consider Stabilized Assets Over Value-Add
Financial Reimbursement
In some situations, you might be able to obtain direct financial reimbursement in case of a default. For example, with REITs, the fund might handle the different defaults and work to provide you with a blended return that takes defaults into account. Details regarding such reimbursements may only appear in the fund’s returns to you as an invisible component of the investment.
In other cases, according to the agreements, you might be legally entitled to financial reimbursement. Exercising such rights would usually require you to seek reimbursement through an attorney.
How To Reduce the Risk of Investing with a Defaulting Sponsor
Sponsors vary greatly from one another. Some are less likely to default than others. When assessing a sponsor’s potential, consider the following important inquiries:
- How much market and asset class experience does the sponsor have in the area? A sponsor most likely has stronger knowledge of or access to resources in markets where they already have establishments, personnel, or investments.
- Has the sponsor ever had a development project default or fallen short of expectations? There will undoubtedly be some blemishes on the record of a sponsor who has operated through several real estate cycles. However, what matters is that you comprehend what went wrong and how the sponsor plans to move forward.
- How competent is the sponsor in assessing risks? Every undertaking involves a certain amount of risk. You want the sponsor to be open and honest about the project’s risks before outlining how they intend to reduce them over the course of the project.
- How does the sponsor finance the deal? How much debt and equity capital does he secure? You should find out if the sponsor arranges equity investment through a fund, personal connections, crowdsourcing, or other means. Additionally, inquire about the expected rates of return for this project.
- What controls has the sponsor put in place to guarantee effective project management? Evaluate each step of their procedures, from financing to remodeling, leasing, and stability. An ad hoc method adds too much execution risk. Therefore, you’ll want to ensure the sponsor controls the project with great care.
Related: Why Do Sponsors Want To Provide Liquidity?
Protect Yourself Against Defaulting Sponsors
An investment in real estate has the potential to generate good returns. However, it is still critical to recognize that default risk is a major scenario you might need to deal with. Avoid being lured into shaky deals. Follow the advice listed above to find a sponsor that is trustworthy with your investment.
In addition, understand in advance how defaults will be handled. Research the platform’s approach and the applicable law to better understand how to deal with a sponsor’s default event in the unfortunate chance it happens.
Want to get started on a Marketplace that vets all sponsors and investments in advance? Activate your SecondRE account.
