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 deals in my inbox each year. In the end, maybe 2 to 4 of the investments I make do survive.
Basics of property due diligence: “Pro-forma popping,” sensitivity analysis, and “stall and see.”
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 an effective investment today. Some of the information may be outdated, inaccurate, or irrelevant. See “How will Covid-19 Mainly Affect my Alternative Investment Portfolio?” for more information on analyzing investments in this new era.
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 deals 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 welcome feedback from other conservative investors and will incorporate ideas I like into the articles. Furthermore, aggressive investors should find that this helps them better appreciate and assess the larger risks they end up taking. (If you are a non-accredited investor, much of this information is irrelevant to you.) Instead, read this non-accredited investor guide).
Summary of the Series
Here’s a quick 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: Fundamental Property Due Diligence (takes minutes to weeks or months depending on the transaction): This section covers “pro-forma popping,” “sensitivity analysis,” and “wait and see.”
- Part 4: Advanced property analysis (can range from minutes to weeks or months per transaction): This section includes information on recession stress testing, legal document analysis, and other subjects.
Finally, I have an investment (and a sponsor) that I’ve put through its paces and am very happy to include in my portfolio.
Okay, things start to get interesting in Part 3. The deal has made it this far and could be a good one. So it’s time to do some basic property research.
Because I’m still seeing many more deals than I have time to process fully, I have a two-step elimination process to cut down on the time I have to spend on the duds. If the deal is bad (most of them), it may be filtered out in minutes or hours. A great deal could take weeks or months to vet (between this step and part 4) thoroughly. Even so, some will drop out at the last minute, which is always disappointing. A dropout, on the other hand, is a million times better than a poorly chosen investment. And if and when a deal makes it through, I’m confident it fits my conservative risk profile.
First Position Debt Funds Are Not the Same
A debt fund is a Mutual Fund scheme that invests in fixed income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments, which provide capital appreciation. Other terms for debt funds include fixed income funds and bond funds.
Several key benefits of investing in debt funds include a low-cost structure, relatively stable returns, high liquidity, and reasonable safety.
Debt funds are ideal for risk-averse investors seeking consistent income. Debt funds are less volatile and thus riskier than equity funds. Suppose you have been saving in traditional fixed income products such as bank deposits and are looking for consistent returns with low volatility. In that case, Mutual debt Funds may be a better option because they help you achieve your financial goals more tax-efficiently, thus earning higher returns.
One quick note: first-position debt funds make up a significant portion of my portfolio. Doing due diligence well, however, necessitates a different process than most funds. My hard-earned money loan funds due diligence checklist discusses the due diligence process I’ve developed for those funds.
We’re talking about investments that aren’t first-position debt funds for the rest of this series.
I perform these checks first because they are quick, and I can often weed out a deal in minutes if it isn’t up to par. They are as follows: leverage, debt length, complexity, and performance splits and fees.
The most vulnerable/potentially dangerous aspect is usually the leverage/debt. As a conservative investor, I prefer to see a deal that is not overly leveraged. If that’s the case, I’m out. Even if you are not a conservative investor, these guidelines will help you understand the risk you are taking.
What is the difference between aggressive and nonaggressive behavior? It is heavily dependent on the strategy. The average core fund is leveraged around 20%, the average core+ fund is leveraged around 40-50%, and a nonaggressive value-added fund is leveraged around 65%. If a deal exceeds these thresholds, it is not worth the risk, and I am not interested.
One sponsor “trick” to keep an eye out for is double leverage. “Value-added fund with only a 65 percent leverage ratio.” the sponsor may say. However, digging deeper, you’ll discover that the 65 percent limit only applies to individual properties, and the fund is leveraged by another 15 to 20 percent. This turns seemingly safe leverage into something extremely risky. No, thank you.
Even though the physical cycle is drawing close, the financial cycle is only halfway through, as I noted at the end of Part One. This means that the next physical downturn won’t have an accompanying financial downturn that will devastate the real estate market. Nevertheless, it is impossible to know for sure (in previous recessions, a financial downturn was 50% likely to accompany it). As a result, I take a “prepare for the worst before hoping for the best” approach to business, approaching transactions as if the financial cycle is about to bottom out within the next few years.
If this occurs, medium-term debt deals with terms of 3 to 5 years will become extremely risky. Because they couldn’t refinance their debt, many of these deals failed and imploded during the Great Recession. I avoid these transactions entirely because I don’t want to be stuck in that situation. I’m out if I see medium-term debt.
I prefer long-term contracts of 7 to 10 years, with extended options. This gives the sponsor plenty of time to weather any price drops.
Exotic vs. Simple Structures
Good real estate deals purchased at a good price are frequently set up very simply. A basic nonaggressive debt and equity structure provide a good return with minimal risk to the investor.
If, on the other hand, a sponsor purchases the property and overpays for it, they must be more creative to make the numbers look acceptable. That’s when they frequently start slapping more exotic structures on top, such as preferred equity, mezzanine debt, and so on. Alternatively, they divide investors into multiple equity tiers. When things go well, these structures can pay off handsomely for investors.
However, they are usually the first to suffer when things go wrong. And any transaction that necessitates an exotic structure is far riskier than one that does not. So, at this point in the cycle, I’m out if I see an exotic structure (such as a mezzanine debt investment or a second position mortgage). All of that will be saved for the recovery after the next downturn.
Before we go any further, fees and sponsor compensation are extremely difficult for many newbie investors to understand. So, in response to a request, I’ve expanded how I do this into a full article, which you can read here: Is the Sponsor Being Paid Fairly? Or are you ripping me off?
I, like most investors, do not want to pay more than necessary. As a result, I prefer deals that are at least average. If something is out of place, it could be a problem.
Furthermore, because I am a conservative investor, higher than usual sponsor compensation introduces additional risk. The greater the value, the more financially incentivized the sponsor is to push the risk envelope. This is the polar opposite of what I want to see. You may prefer the situation if you are more aggressive.
If a deal seems a little out of place, I’ll check to see if I like the sponsor and the deal. If I truly believe it, I will proceed. And if not, I’ll decline.
If it’s completely out of whack, it’s an easy pass. These transactions usually indicate a sponsor who caters to inexperienced investors. Because those deals are rarely a good fit for me, I move on to the next.
One thing to keep an eye out for is that many sponsors fail to fully disclose all of their fees when summarizing them in their investment overview and pitch deck. And if they have an especially uncompetitive and bad fee, it’s almost always buried in legalese. So you must always refer to the legal documents to ensure that you have them all.
What are my cut-off points? It is determined by the strategy, options, and so on. I compare it to other deals to determine whether it is reasonable or completely ridiculous.
Mainstream deals, such as multi-family, typically yield a preferred return of 6 to 8 percent, with profit splits of 10 to 25 percent going to the sponsor. I’m not interested in a deal offering the sponsor a 5 percent preferred equity stake and a 30 percent profit cut.
For fees, the same holds. Fees for asset management, acquisition, and property management typically range from 1 percent to 4 percent. A red or yellow flag can be raised by anything that is out of the ordinary.
Market averages favor the sponsor in specialty categories, where deal flow is lower. Managing a mobile home park requires a unique set of relationships. Thirty-five percent of the profits go to the sponsor quite frequently. Another option is to split the sponsor’s 50 percent stake in the second waterfall tier. As much as I would prefer not to pay more, I do so when comparing them to other similar sponsors and deals.
So there you have it, the quick checks (leverage, length of debt, complexity of structure, performance splits, and fees). If the deal has made it this far, it is more promising than the average deal. So it’s worth my time to conduct extensive property-level due diligence.
Due Diligence at the Property Level
There are two kinds of deals: blind funds and nonblind funds. And each necessitates two distinct types of property level DD.
Non-blind Investment Funds
Approximately half of all funds identify the target property or properties in advance (and usually will put them under contract before the investment starts). This makes it very simple to perform “Pro-forma popping.” I can look at the Pro-forma (the sponsor’s annual performance projection) and successfully or unsuccessfully poke holes in it. I can also look at the assumptions to see if they are conservative. Usually, it crumbles under scrutiny, and I move on. If it survives, it is also relatively simple to conduct a recession stress test (discussed next).
Here’s an example of a pro forma:
“Pro-forma popping” means going through each item in it and imagining that it’s most likely complete nonsense, and then seeing if I can find some way to prove that it is, in fact, nonsense.
We begin with the simple things that feed into the pro forma, such as the purchase price. If they overpaid significantly, it could increase the risk of the transaction. So, if I see that, it’s a simple no. If I’m certain about the area and asset class, I might have an idea of a reasonable cap rate (and thus a fair purchase price). If not, I can use a sales comp report to compare it to other properties in the area.
One common ploy to avoid: if the sales comp report comes from a broker, it will frequently use comparables from a much higher class to inflate the price. So go through each property and examine the interior and exterior to see if they are in the same class. Then get rid of the “shills.” If you don’t understand how to do this or any of the following, joining an investment club is a good way to learn from other investors.
Were they able to obtain a reasonable interest rate on their debt, or were they forced to pay more than the market rate? A princely rate is a triple whammy because it not only reduces profitability and increases the risk of default during a downturn but also implies that lenders looked at this deal and decided it wasn’t strong enough to warrant a reasonable rate. I look for quotes from lenders online if I don’t know a good rate. Another option is to approach someone in an investor club.
If the purchase terms seem reasonable, I look into the annual projections. I begin with each item in the income category. The sponsor’s temptation here is to inflate, so I’m looking for too large numbers.
Overestimation of occupancy is a common trick here (and thus rental income). For example, if I see that the rental income is based on 99 percent occupancy and I google statistics for the area and see that the average over the last ten years is 92 percent, I know there’s a problem. Another common occurrence is a strategy that includes a large value-added project (that will kill occupancy during the renovation) but does not include it in the projections.
Unrealistic rental increases should also be avoided. If the pro forma shows a 6% increase, but the area has only averaged a 3% increase over the last ten years, there is likely a significant problem. When I see more conservative numbers than necessary, on the other hand, I know there’s plenty of room for things to go wrong, which is a major plus. When I see something like this, I give the sponsor a lot of props.
If this is a value-added transaction, the sponsor is improving the property to raise the rent. Are these figures accurate or exaggerated? You must examine the rental comp report to find out (a report of nearby properties that are at the class of the planned upgrade). This will help you determine whether the market will support the planned rent.
A common trick here is to use comparables significantly nicer than the planned upgrade to inflate the rent. So inspect the exterior and interior of all of them to weed out the fakes. When finished, you should ensure that all projected rents are no higher than the competition’s average. If they are higher, you almost certainly have a problem. The most conservative sponsors and deals use numbers lower than the competition. This provides additional cushion and protection in the deal’s ability to meet its targets. That’s a good sign, in my opinion.
After I’ve finished with income, I move on to expenses. The sponsor’s temptation here is to under-report, so I’m looking for numbers that are too low. Because some sponsors “forget” to report certain expenses, the first thing I do is ensure that all of the major categories are present. (If you don’t know what those are, compare it to other pro-formas.) I put every number to the test. Underestimated maintenance is a common finding. (Compare the percentage devoted to maintenance to other pro-formas to determine whether they are realistic.) True amateurs frequently underestimate property taxes. Look for expenses that increase too slowly from year to year. For example, unless there is a local ordinance, a pro forma showing a 2% increase in property taxes is likely under-reported.
Another area where the value-added deal can go wrong is the cost of renovations. For starters, renovation projects almost always go over budget and rarely under. So, I’m skeptical if I don’t see the sponsor provide a cushion for this. I can also perform some sanity checks by comparing the budget’s cost on metrics (such as cost per square foot or cost per door) to other pro-formas to see if they appear reasonable. This can be challenging for a newbie investor, which is another reason to stick with highly experienced sponsors with a track record of accurately estimating and avoiding newcomers who don’t.
If the pro forma passes all the initial tests, I proceed to the sensitivity analysis. This spreadsheet shows what will happen if the unknown variables change (prices don’t rise as much as expected, vacancies rise faster than expected, rental income doesn’t rise as quickly as expected, and so on). I save the most intense stress for the recession stress test, which comes later. But for the time being, I’m contemplating non-recessionary outcomes and whether I’d be okay with them.
About half of all funds are “blind” because investors have no idea which property/properties will be purchased when they invest.
Blind funds may appear to be a disaster for property-level due diligence. However, some decent due diligence can be accomplished with a little ingenuity. And, using a little-known technique known as “stall and see,” I can perform better due diligence on a non-blind fund.
There should be at least one other past blind fund or investment for which the sponsor is willing to provide the financial details. (If they don’t or won’t reveal those, that’s a red flag for me, and I’m out.) This gives me all of the information I would normally get from a “Pro-forma popping,” plus the actual performance of the assets. I’m particularly interested in what happened to poorly timed investments and thus experienced a downturn or underperformed. This can provide useful information about whether the sponsor is truly conservative or not, as well as how well they deal with adversity.
The one disadvantage of this method over non-blind funds is that I cannot guarantee that the sponsor will underwrite future purchases as they did previously. If the sponsor has a particularly long and distinguished track record, I may be confident that they will continue to do business as before.
If not, I may believe they are too risky to take a chance on. That’s when a little-known technique known as comes in handy.
This is a superb move I learned from another investor. Most blind funds buy property pools rather than a single property. (The diversification is nice because I can buy what would take 20-100x more money and hassle to buy from individual property funds in one shot.)
It usually takes at least a few years for these funds to purchase the properties, and they don’t want to take in all the cash at the start and have it sit idle. If they did, the cash drag would wipe out their profits. Instead, they take what they need as they buy and usually accept new investors’ money simultaneously.
This presents a once-in-a-lifetime opportunity for a savvy investor. Rather than investing in the fund when everyone else is, I can wait a year or two before making a decision. And then I can not only see the performance of previous investments, but I am no longer blind and can see what they invested in! Instead of looking at hypothetical numbers like in “pro forma popping,” I’m looking at real, live numbers. As a result, I adore this technique.
The one risk is that I will stall for so long that the fund will be fully subscribed, and I will no longer be able to invest in it. So, when I use this technique, I regularly keep in touch with the sponsor to gauge how much time I have.
“I’m a survivor,” she says.
By this point, at least 90% of the deals that began in step 3 have been discarded. So, if a deal has made it this far, it is in an elite company and is becoming increasingly intriguing to me. Now is the time for me to delve into it with a recession stress test, legal document review, and so on.
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