What are some things I should consider when doing real estate due diligence?
6 things to consider when doing real estate due diligence:
As an investor, you have probably heard that real estate investments could offer diversification benefits due to the fact that they are less correlated with the general stock market. In addition, investments in real estate could potentially deliver stable income and appropriate returns. Since the passage of the JOBS Act in 2012, we have seen a proliferation of real estate crowdfunding platforms. These platforms allow investors to invest as little as $1,000 in commercial real estate deals that were once only available to institutional investors and ultra-high net worth individuals.
As the broker-dealer that works with some of the largest real estate crowdfunding platforms in the United States, the team at North Capital has conducted due diligence on hundreds of debt and equity commercial real estate deals ranging from multifamily, retail, office, hospitality, self-storage, and mobile home parks. Every real estate deal has a different business strategy, investment term, capital structure, and risk factors. However, through our experience, we have found six things that every real estate investor should consider before making an investment in a real estate project.=
Experience and Track Record of the Sponsor
The Sponsor is considered to be one of the most important factors that determine whether or not a real estate deal turn out to be successful. How do we define a Sponsor? The Sponsor (also known as real estate operator or general partner) is the company that manages the real estate offering from start to finish and carries out all of the investment plans.
The first thing we look at is the track record of the Sponsor. Now imagine that you are an NBA scout searching for basketball talents for your team. Would you recruit a player without conducting any due diligence on the player? Probably not. You would probably have to look at his previous experience and how he performed in college before making a decision. The same thing can be applied for real estate due diligence. Investors should do research on the Sponsor’s investment track record and the team experience. A couple of questions that investors should ask are:
How many deals has the Sponsor completed in the past?
Is the Sponsor experienced in the current market? For instance, if the Sponsor is purchasing and renovating a multifamily property in North Carolina, have they completed any other multifamily deals? Are there any deals in North Carolina market?
Real estate investors should also keep an eye out for past litigation, bankruptcies, liens and judgements. If a Sponsor has had multiple bankruptcies in the past and he/she is the sole decision maker in the deal, you may need to assess whether he/she is the best person to lead the project. Or if the Sponsor has a pending litigation for breach of contract or securities law violation, that is a major red flag. Investors could also do a quick Google search on the Sponsor. An easy way to search is to type in the name of the managers and Sponsor with words such as “fraud”, “lawsuit”, “scam”, or “ponzi”.
Lastly, investors should pay attention to how much equity the Sponsor is contributing if it’s a joint venture (JV) equity deal. The risk here is high since JV equity investors get paid last, after senior debt and mezzanine debt in the capital structure. Therefore, investors should make sure that the Sponsor has “skin in the game” and Sponsor’s and their interests are aligned. The typical Sponsor equity portion is between 5 to 10 percent of total equity contribution.
Sponsor Fees and Promotes
In real estate deals, there are two ways for the Sponsor to make money:
Sponsor fees, including acquisition fee, property management fee, asset management fee, construction management fee, and property disposition fee
Promotes, also known as carried interest
Any significant deviation from the standard industry fees and promotes should be red flags. Fees should align the Sponsor’s interest with investors’ interest. The standard fees are below:
Acquisition fee: 1-2% average
Property management fee: 3-4% average
Asset management: 1-2% average
Construction management fee: typically 10% of construction cost but the fee can vary depending on the deals
Property disposition fee: 1-2% average
The standard promotes would usually be 8% preferred return, then 80/20 split of cash flow up to a certain internal rate of return (IRR), and then 50/50 split for anything above that IRR. This structure incentivizes the Sponsor to manage the real estate project efficiently since they would not make any money if the project return is below the preferred return. In other words, the higher the return the Sponsor could deliver to investors, the more potential money they make for themselves.
Financial Terms and Cash Flows
Investors should carefully review the business plan of the deal and go over the terms and assumptions used in the financial model. Are the assumptions in line with historical operating numbers? In the case that the Sponsor’s business plan is to acquire a property that has not been managed properly, do some renovations and increase rents to market, vacancy is expected to pick up during the first and second year of the investment term. If the Sponsor plans to increase rent by 20% but the vacancy assumption in the financial model remains at 90% or above, that could be a red flag.
Market Data and Comparables
Think back to the last time you bought a house or rented an apartment. The first thing that you probably did is look for different properties in the area and compared the purchase prices or rents between each property. When investing in commercial real estate, the Sponsor usually goes through the same process and compares the subject property with other properties in the submarket. In addition, the Sponsor typically conducts analysis on the market trends such as rent growth, unemployment rates, absorption, average income growth, population growth, etc. Here are some questions that investors should keep in mind:
How is the purchase price per square foot of the subject property compared to others? Is it relatively in line with the average market price?
Are there any indicators that point toward an upward movement in demand? These include, but are not limited to occupancy rate, growth rate in rent per square foot, unemployment rate, cap rates, population growth, average income in the submarket, etc.
How are rent and rent growth in the market? In a deal where the Sponsor plans to do renovations on the property and increase rent, is there room for the Sponsor to increase rent to market?
Third-party reports include property appraisal, environmental site assessment, and property condition report.
An appraisal report establishes the property market value, and investors can determine if the Sponsor is purchasing the property at a price that is below, equal, or above the market value.
The environmental site assessment (ESA) provides details of any areas of environmental concerns inside and outside the property. If there are findings of environmental concerns, such as potential sources of contamination, the report itself will also outline the required actions; it is recommended that investors review carefully what the Sponsor’s plan to resolve those concerns as well as how long that could take.
The property condition report identifies immediate repairs required at the property. In addition, it also outlines the major repair costs required to keep the property in good condition over the next five to ten years. The Sponsor typically highlights how much capital expenditures are required for the project. Investors should reference the capex budget from the Sponsor with the short-term and long-term repairs costs in the property condition report.
There are many risks involved in commercial real estate investing, and the risks related to each investment are different. Investors should carefully review risk factors that are usually disclosed in the Private Placement Memorandum (PPM) or on the crowdfunding platform. Some risk factors that investors should think about include:
General market risk – This can also be referred to as systematic risk. According to FINRA, market risk can be thought of as the risk that the overall market will decline, “bringing down the value of an investment regardless of that company’s growth, revenues, earnings, management, and capital structure.”
Idiosyncratic risk – This is the risk specific to a particular real estate project. Examples include environmental risks (e.g., pollution, soil contamination), construction risk, development risk from a ground-up construction project, entitlement risk (i.e., the risk that the Sponsor is unable to acquire approvals from government agencies for the project to proceed), etc.
If a Sponsor is not disclosing risk factors or if the risk factors are not presented in a transparent way, that could be the signal for investors to look elsewhere to invest their money.
About North Capital:
North Capital provides comprehensive solutions to transact exempt offerings, supporting security token issuers and advisors, funding platforms, and other broker-dealers. Through North Capital Investment Technology and its registered broker-dealer North Capital Private Securities Corp., the firm also provides technology-enabled escrow, streamlined investor vetting (including KYC/AML and accredited investor verifications) and a wide range of other broker-dealer services. For more information, visit www.NorthCapital.com. Securities offered through North Capital Private Securities, member FINRA/SIPC.
Disclaimer: All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.