Active Investors And Passive Investors
Every day he strolls into class late, rest his head on his desk then falls asleep. The only thing he takes note of is when the bell rings, because that means its time to leave. Yet somehow, seemingly effortlessly he aces every test. Most bystanders are perplexed because they don’t see all the work he does behind the scenes, outside of the spotlight and outside of the classroom. That’s the secret to his success. At some point in your educational career you may have seen this kid, or this kid might have even been you. These types also exist in the world of investing. Enter stage left: The actively passive investors – Loan Guarantors and Key Principles.
In the world of Real Estate Syndication, you have active investors such as asset managers and underwriters and passive investors such as limited partners. There are also what I like to call actively passive investors – loan guarantors and key principals. They are slightly more hands on than limited partners but nowhere near as active as asset managers. Although these loan guarantors and key principals may not work on the asset directly, the work they do behind the scenes enables the investment to be successful.
Loan Guarantors And Key Principals
You’ve probably heard of a loan guarantor before or can at-least make an educated guess as to what they do. They sign on a loan, guaranteeing that it will be repaid. The role of a key principal, however, may be more foreign to you. While they perform a similar function to that of loan guarantors there are some slight nuances.
Key principals are the people who sign on the loan and can include members of the general partners or limited partners in the syndication. To understand the nuances of the two it may help to first understand what it takes to qualify for a loan and what is expected of someone who signs on a loan.
How To Qualify For An Apartment Community Commercial Real Estate Loan
To qualify for a loan to purchase an apartment community you typically need 1) net-worth equal to or greater than the loan amount 2) liquidity/ cash reserves to pay the loan and 3)prior experience managing/owning an asset similar to the one you are seeking to finance. Banks require this as they assume someone with the experience and financial strength to meet these requirements is more likely to make a successful investment.
The ideal loan guarantor would meet all three requirements but at a minimum should meet the first two. This is what separates the loan guarantor and the key principal. A key principal can be an asset manager or underwriter who is also guaranteeing the loan but does not have the required net-worth or liquidity.
A Key principal can also be a limited partner who helps to meet one of the criteria (such as a cumulative net worth) by signing on the loan. Why are these people so important? Because without them the loan would not be approved and **Poof** there goes your chances of securing the investment.
Key Principal Compensation
Key principals typically do not receive additional compensation beyond whatever equity they already owned. In contrast, loan guarantors are handsomely compensated with a flat fee ie: 1% of the loan amount at closing or an equity stake (ie: 25% of the general partner’s equity) regardless of whether or not they put their capital at stake to invest in the deal (Side note: lenders typically prefer when loan guarantors also invest in the deal). These numbers are negotiable and increase with the risk associated with the deal.
Misconceptions About Loan Guarantors And Key Principals
Let’s make something clear, these actively passive investors are guaranteeing the loan, but they are not expected to pay it themselves. The payments for the loan should be sourced from income produced by the apartment community or cash reserves in the operating budget. Depending on the type of loan recourse vs. non-recourse they may not even be required to pay if the above payment sources fail. So how are these investors actively passive? They do work outside the spotlight that does not directly impact the asset. Lenders require that guarantors maintain liquidity/reserves for the lifespan of the loan, granted this is not frequently checked, especially if payments are up to date. Maintaining these financial requirements is the “active” work these investors must do. Work they probably would have done anyway. They are actively passive.
So, the guarantor shows up to class late, after the deal has been sourced, terms been negotiated, and due diligence has been performed. They sign on the loan, receive their compensation and to everyone else it may seem as if they are sleeping, hibernating, silent during the hold period of the investment. What bystanders are not seeing is the work these actively passive investors are doing behind the scenes, outside of the classroom, and outside of the spotlight.