Introduction:
This is the fourth four-part series on how I choose conservative real estate investments for my portfolio. There are numerous approaches to due diligence, and I’ve developed one that works well for me. My method is brutal, beginning with thousands of discounts in my inbox each year. In the end, maybe 2 to 4 of the investments I make do survive.
Stress testing during the recession, legal document analysis, and so forth.
(As is customary, I’m just an investor sharing my personal view, not a financial advisor, attorney, or accountant.) Before making any financial decisions, consult with your financial professionals. We do not accept money from any sponsor or platform in exchange for anything, including postings, reviews, referring investors, affiliate leads, or advertising. We also do not negotiate special arrangements in the club for ourselves above and beyond.)
IMPORTANT UPDATE ON COVID-19: This information was posted before anyone knew there would be a global pandemic in the spring of 2020. As a result, it may lack the critical information required to make a successful investment today. Some of the information may be outdated, inaccurate, or irrelevant. See “How will Covid-19 / Coronavirus Affect my Alternative Investment Portfolio?” for more information on examining investments in this new period.
This is the fourth four-part series on how I choose conservative real estate investments for my portfolio. There are numerous approaches to due diligence, and I’ve developed one that works well for me. My method is brutal, beginning with thousands of discounts in my inbox each year. In the end, maybe 2 to 4 of the investments I make do survive.
This series explains what I look at and why. I appreciate feedback from other conservative investors and will incorporate ideas I like into the articles. Furthermore, active investors should find that this helps them better comprehend and assess the larger risks they accept. (If you are a non-accredited investor, much of this information is irrelevant to you.) Instead, read this non-accredited investor guidance).
Here’s a basic rundown of the series:
- Part 1: Portfolio Alignment (takes a few seconds per deal)
- Part 2: Quality Control of Sponsors (takes 15-45 minutes per deal)
- Part 3: Basic Properties Due Diligence (takes minutes to weeks or months for each deal): This section is about “Pro-forma popping,” sensitivity analysis, and “delay and see.”
- Part 4: Advanced property analysis (takes minutes to weeks or months per deal): This section covers recession stress testing, legal document analysis, and other topics.
Finally, I have an investment (and a sponsor) that I’ve put through its paces and am extremely glad to include in my portfolio.
So, in part 4, I have a very attractive investment that could be a diamond. Now is the time to go even deeper to see if it is a genuine contender or just another pretender.
The “Under Pressure” Recession Stress Test
As I discussed in part one, I believe we are nearing the conclusion of the physical cycle and that a downturn will occur sooner rather than later. So I will not invest in anything unless I am confident in its ability to withstand a recession. So I perform a “recession stress test,” in which I mimic the impact of a severe recession on the investment and see what occurs. Many deals disintegrate like an ice cream cone under a dump truck; if they do, I abandon the transaction and go on. But a few stand firm, and I know I’m on to a winner when that happens.
First, I look for historical performance statistics for the deal’s area and asset type. This is frequently available on Google from brokers such as Marcus & Millichap or data providers such as Axiometrics. It may be necessary to call a local/county property appraiser’s office occasionally. Typically, this may be accomplished over the phone, but it can be useful to be a member of an investing club where someone local can drop by to get information from a difficult source.
The most important indicator for equity investments is an increase in vacancy and a decrease in rental income. To be safe, I go back to several recessions and choose the worst. (For example, commercial real estate performed poorly during the S&L crisis, whereas residential real estate performed poorly during the Great Recession.) Then, in the pro forma, I choose the most difficult year (with the lowest cash flow) and pretend the recession struck that year by running the numbers through it and monitoring what occurred.
I pay great attention to the result: the cash flow. If that falls below $0 on a leveraged equity transaction, the transaction will fail. In the event of a blowup, the fund would have defaulted on its obligations, and investors would have lost their entire investment. If I notice this, I sigh with satisfaction that I’m not the one putting myself at risk and move on to the next deal.
Some individuals may be content if it passes, but in my situation, I’m still not done. Every recession is unique, and the next one will likely be worse than the previous ones. So I’d like to have an extra cushion in case that happens. I shall overstress the investment to test for this (for example, 2x the worst vacancies, 3x the worst rental income drops). If I do this and it still does not default on its obligations, I will be overjoyed.
Debt transactions are comparable but based on specific information: past default rates. So, suppose I’m looking at a hard money loan first position debt fund in California that conducts construction loans on multifamily units. In that case, I look for the worst recession in that state (S&L crisis recession). Then I make a spreadsheet that calculates the fund’s return and run the calculations to see what occurs. If I begin to observe significant principal losses, I exit. Again, I will overstress the investment (1.5x worse default rate, 2x, etc.) to ensure a cushion in case things go wrong the next time.
(Note: These procedures rely on the auditing firm’s legitimacy. The vast majority of them are, but there is a handful that is not. So, before I begin, I Google the auditing business and look for complaints or potential difficulties. I also check to see if there have been any SEC fraud reports.)
I request as many years of results as the fund has. First, I want to ensure that the fund performed as promised in the presentation deck. Some funds, believe it or not, have failed this criterion. It’s not worth taking a chance on a fund that can’t be trusted on something basic. As a result, when I see this, I go on.
If it passes, I perform a “Ponzi scheme check” to ensure that I am not investing in the next Bernie Madoff. This does necessitate the skill of reading accounting paperwork, which I understand not everyone possesses. If you don’t, your accountant or other investors in a good club can assist you.
To perform the audit, I examined how much money the fund produced and compared it to the distributions. If the dividends exceed the earnings, there could be a serious problem. I bring it up with the sponsor and inquire if there is a definite cause. I’m out if the reason they give doesn’t make sense to me.
I’ve also witnessed the inverse, where the dividends are far smaller than the fund’s earnings. The sponsor may be reserving funds for something legitimate. However, if I notice this, I will enquire more to find out why and ensure that I am comfortable with it.
Every transaction has a massive legal document at least 50-100 pages long. The Private Placement Memorandum is referred to as such in 506B and 506C offerings (PPM). It’s referred to as a 10K in some publicly traded offers. Others refer to it as a Prospectus.
And while I only mentioned it in this final post, by the time I got here, I’d been compelled to read quite a bit to finish previous phases. For example, the fees are frequently not written out in the pitch deck, so I must dive through the legal paperwork to ensure I get everything. But now is the time for me to bite the bullet and read it cover to cover.
This is not a fun stage and is easily the worst part of the due diligence procedure. But I do it because I’ve uncovered hidden terms in contracts that were so stupid that I had to pull out of the deal multiple times. And because they can be found in any part, there’s no way to find them without reading everything.
A crowdfunding platform podcast has attempted to “assist” investors by instructing them on which parts of the legal documents they should read first to skip others and finish faster. This, in my opinion, is nonsense and a hazardous idea.
A dentist will tell you, “Only the teeth you wish to keep,” if you ask him, “Which teeth do I need to brush every day?” Every word in a legal document has consequences for you and your money. So, if someone asks me, “Which sections of the legal paperwork do I have to read?” I’ll tell them, “just the bits about money that you want to keep.”
“Is this really happening?”
When you first read a legal document, you will likely be struck by how unjust and one-sided it is. You’ll probably be surprised to learn that it deprives you of most of the regular rights and protections you’d have in a standard LLC run by a fiduciary. It essentially gives the sponsor as much unfettered authority and freedom from responsibility. So, if your stomach isn’t churning by the end, I’d think you didn’t read it closely enough and should go over it again.
At the same time, passive investing entails handing over total management to another human being. So this is normal and, in my opinion, no grounds to cancel the transaction (at least not yet). However, if that raises a red signal, you might want to consider directly owning real estate instead. (This is something I do as part of my portfolio.)
So I don’t consider the fact that the above is being attempted to be an immediate red signal. Instead, I look closely at how people go about it, such as the following:
“Seven Things I Despise About You”
1) Overbroad strategic commitments.
Many attorneys will advise sponsors to make the strategy in the legal contract as ambiguous as possible to offer them as much flexibility as feasible. However, many investors are understandably hesitant to engage in funds that are permitted to deviate too far from what they are told they are getting. As a result, I keep an eye out for strategic commitments that are too wide for me.
If I invest in a multifamily fund, it’s because I enjoy the risk profile of that asset class. If I notice that they are also permitted to invest in hotels, which are even riskier, I lose interest and pass on the business. If you ask the sponsor, they usually say, “Oh, our lawyers told us to put that in there, but we will never use it.”
Perhaps it isn’t true, but it could be. But, even if this is true, I believe I can always find a sponsor that has taken the time to better align themselves with the investor by committing to the strategy. So when I see this, it’s a red signal for me, and I’m out of the deal.
Another example is a fund that advertises itself as unleveraged or merely leveraged to X percent, but the legal documentation permits them to go far higher.
2) Additional capital is required.
Some agreements include contingency clauses in case something goes wrong. If they do, you may be asked to contribute more funds (make additional capital calls) to keep the agreement alive. You usually have the option of declining and merely being diluted. This seems like a reasonable solution for all parties.
Other arrangements, however, are more punitive and will penalize investors by lowering their funds, charging interest, etc. This is a problem because I have no idea when I may need cash for this in the future, making it tough to plan for. When I encounter stipulations like this, I pass on the sale.
3. Clawbacks.
If the deal fails, certain contracts allow the sponsor to take money that they previously distributed back to you. As a conservative investor, some aggressive investors may not worry about this, but I must retain the money on hand for this scenario. I may not be able to redeploy it. This is an issue in and of itself. Some accords go even farther, allowing clawbacks to occur years after the fund has closed. When I detect numerous clawbacks, I decline the transaction.
4) Expensive hidden fees.
Many deals have undisclosed costs that are not stated in the pitch deck. If the charge is minor, it is not a deal breaker for me. However, if it is something substantial, I usually have an issue with it. I believe in the “cockroach theory,” which states that if I see one cockroach in plain sight, there are 100 more that I can’t see. As a result, I usually back out of the arrangement.
5) I don’t understand.
Despite having read hundreds of legal documents, now and then, I come across one that is written in such incredibly complicated legalese that I have no idea what a lot of it is saying. When I question the sponsor, they usually blame their attorney, which is often plausible. However, it also reflects the sponsor’s immaturity: perhaps they haven’t had enough experience with negative feedback and multiple funds to adapt it to something more investor friendly. If it appears that I will need to spend additional weeks simply asking questions before I can completely comprehend a document, it is not worth it to me.
6) Conflicts of interest are unacceptable.
In my experience, there isn’t a legal document that doesn’t expose the sponsor’s conflict of interest. For example, to be in business, every deal must charge fees or split sponsor splits, and the fact that they are making money off of the investor creates certain conflicts. Those are unavoidable, in my opinion, and are not deal breakers (and can be mitigated in other ways like with skin in the game, as discussed in Part 2).
On the other hand, there are events when conflicts of interest are revealed that I cannot stomach. Some hard money loan funds, for example, are permitted to offer loans to construction companies owned by the sponsor. I don’t understand how loans could be underwritten to the same standard as a third-party loan. And it’s tough for me to picture a sponsor actively foreclosing on themselves as they would a neutral third party. When I encounter conflicts like this, I ask the sponsor whether there is anything I can do to reduce the risk.
Sometimes there is, but I keep going. But if there isn’t, or if the sponsor claims that “our legal forced us to put something in there,” I reject the arrangement.
7) Undisclosed Hazards.
I’ve heard “advice” from blogs and podcasts that investors should save time by focusing on the portion that discloses risks rather than reading every line of the legal paperwork. I don’t believe this is a bad concept because the sponsor is incentivized to disclose as many hazards as possible to reduce their exposure. Sometimes it talks about subjects I hadn’t considered before, giving me new questions to ponder and paths to take.
However, many disclosures are fairly broad, and I’ve never encountered a legal contract where the risk disclosures covered everything. Again, many of the concealed traps are scattered throughout the document. So I agree that reviewing is necessary, but not enough to complete on its own and then call it a day.
If it’s made it this far, this is where I’ll do more sponsor checks.
I completed my “death by Google” checks, as stated in Part 2.
I also request two to three references and contact them for additional information. I’ve gotten terrible information on sponsors that I would never have seen if I hadn’t checked straight. If I have any uncertainty about the authenticity or neutrality of a reference, I ask for the name of someone to whom they have referred the investment. Legitimate references typically have friends or acquaintances to whom they can refer. So I interview them as well, essentially checking the references.
I also conduct background checks on all principals. I look into criminal records, bankruptcies, and foreclosures to see if I can find anything. Background check databases aren’t perfect, and they can produce false positives. If I uncover something, I always ask the sponsor to provide proof that they did not do what the database claims, and they almost always do.
Also, I can typically determine how transparent the sponsor is far before this moment. “Please ask as lots of questions as you want,” every sponsor says, and many legal instruments state that this is an obligation the sponsor must bear. I’d estimate that roughly 15% of sponsors become irritated if “too many questions” are asked.
Some investors are fine with this and will simply back off, not ask any more questions, and send their money in. I’m not one of those individuals. I don’t ask unnecessary questions, so if I’m going to hand over the entire management of my money to a stranger, I want them to take the time to answer as many real concerns as I do. In my perspective, someone who becomes irritated or stops responding to queries is not someone I want to do business with, and I can find far better customer service elsewhere.
Finally, some investors I know will visit each sponsor before investing. I haven’t, and perhaps I should. I haven’t determined whether the time and price will be worth it. I like being a member of an investment club because there’s a decent chance that someone lives around the corner from the sponsor and can check them out if I don’t.
Some investors will pay a surprise visit to catch the sponsor off guard and determine whether or not the sponsor is fully disorganized. This appears to be a wonderful concept in some aspects, but it could backfire if the sponsor is busy that day and doesn’t have time to answer inquiries. Others will disclose the date and time of their visit to ensure they have enough time. Combining the two is probably the most thorough method, but if the sponsor resides in a distant state, this may not be time/cost-effective.
As you can see, I have a rigorous due diligence process. As a result, it is incredibly rare for a sponsor to make it through. When someone does this, my mood improves for months. The time and effort spent vetting them (and several other sponsors who failed) has paid off.
Most sponsors that survive tell me that no other investor has ever done as much study on them as I have. I was initially surprised, but I now realize that many investors use a “spray and pray” technique (placing their money in various untested products and hoping that diversification will protect them if something goes wrong). This, in my opinion, is just as hazardous as day trading.
When a serious downturn strikes, many things that appear to be diverse in good times go down the drain simultaneously. As a result, my due diligence procedure works better for me.
Many sponsors also tell me that while being put under such a microscope was uncomfortable; it allowed them to see aspects about themselves that they hadn’t noticed before, allowing them to enhance their company and service.
At that time, I was excited to inform everyone I knew about the fantastic new sponsor I’d found. I believe that first-rate sponsors are scarce, and spreading the word is the least I can do in exchange for all the hoops they must jump through to obtain my business.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.