The Conservative Investor's Guide to Picking Real Estate Investments: Part 3 - Property Basics.
Property-level due diligence basics: "pro-forma popping," sensitivity analysis, and "stall and see"
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This is a 4-part article series on how I pick conservative real estate investments for my portfolio. There are many ways to do due diligence, and I've come up with a process that I like for myself. My process is ruthless and starts with thousands of deals in my inbox each year. In the end, maybe 2 to 4 per year survive that I invest in. This series details exactly what I look at and why. I welcome the feedback of other conservative investors, and will add ideas I like to the articles. And aggressive investors should also find this helps them better appreciate and gauge the bigger risks they end up taking. (If you're a non-accredited investor, a lot of this info doesn't apply to you. Check out this non-accredited investor guide instead).
Quick Series Overview
Here's the quick recap of the series:
Part 1: Portfolio Matching (takes a few seconds per deal)
Part 2: Sponsor Quality Check (takes 15-45 minutes per deal)
Part 3: Basic Property level due diligence (takes minutes to weeks or months per deal): is about "pro-forma popping," sensitivity analysis, and "stall and see".
Part 4: Advanced property analysis (takes minutes to weeks or months per deal): is about recession stress testing, legal document analysis, etc.
At the end, I have an investment (and a sponsor) that I've put through the ringer, and am very happy to put in my portfolio.
Part 3
Okay, here in part 3, things start to get interesting. The deal has survived this far, and might be a good one. So now it's time to do basic property level due-diligence.
Since I'm still seeing a lot more deals than I would have time to fully process at this stage, I have a two-step elimination process that minimizes the time I need to spend on the duds. If the deal is no good (which is most of them) it may get filtered out in a few minutes or hours. A really good deal may take weeks or months to fully vet (between this step and part 4). Even then, some of them will fall out right at the last minute, which is always disappointing. But a dropout is a million times better than a poorly chosen investment. And if and when a deal survives all the way through, I feel very comfortable that it meets my conservative risk profile.
First Position Debt Funds Are Different
One quick note here: first position debt funds are a huge part of my portfolio. However, doing the due diligence well requires a completely different process than most funds. I talk about the due diligence process I've developed for those funds, here: my hard money loan funds due diligence checklist.
For most of the rest of this series, I'm going to assume we're talking about investments that are not first position debt funds.
Quick Deal Checks
I do these checks first because they are quick to do, and often I can weed out a deal in minutes if it isn't up to snuff. They are: leverage, length of the debt, complexity, and performance splits and fees.
Leverage
The leverage/debt is usually the most vulnerable/potentially dangerous aspect of it. As a conservative investor, I want to see a deal that's not aggressively leveraged. If it is, I'm out. But even if you're not a conservative investor, these guidelines will help you to at least understand the risk you are getting into.
What's aggressive versus nonaggressive? It depends a lot on the strategy. The average core fund is leveraged about 20%, average core+ fund is leveraged about 40-50%, and a nonaggressive value-added fund is leveraged at 65%. If a deal goes above these, it's not worth the risk to me and I'm not interested.
One sponsor "trick" to look out for here is double leverage. The sponsor may say "we're a conservatively leveraged value-added fund at only 65%". But then when you dig into it, the 65% limit applies only to individual properties, and the fund itself is leveraged maybe another 15 to 20%. That transforms a safe-looking leverage into something that's really risky. No thanks.
Length of the Debt/Deal
As I mentioned at the end of part one, I believe we are close to the end of the physical cycle but halfway through the financial cycle. So I don't believe the next physical downturn will be accompanied by a real-estate crushing financial downturn. But there's no way to know for sure (past recessions have had a 50/50 chance of being accompanied by a financial downturn). So I "prepare for the worst before hoping for the best", and look at deals as if the financial cycle may have a downturn in the next couple of years.
If that happens, medium-term deals with 3 to 5 year debt will become extremely risky. Many of these deals collapsed and imploded during the Great Recession, because they could not refinance their debt. I don't want to be stuck in that, so I avoid these deals entirely. If I see medium-term debt, then I'm out.
For the length of the deal, I like to see long-term, 7 to 10 years, with options to extend. That gives the sponsor plenty of time to ride out any pricing downturns that might occur.
Simple versus Exotic Structures
Very often, good real estate deals that are purchased at a good price are set up very simply. A basic structure of nonaggressive debt and equity provides a good return for the investor with minimal risk.
On the other hand, if a sponsor purchases property and pays too much for it, they have to get more creative to make the numbers look okay. That's when they often start slapping on more exotic structures on top, like preferred equity, mezzanine debt, etc.. Or they split investors into multiple tiers of equity. These structures can pay investors handsomely when things go well. But if things go badly, they are also usually the first to get hammered. And any deal that requires an exotic structure to be underwritten is much more risky than one that doesn't. So at this stage of the cycle, when I see an exotic structure (like an investment in mezzanine debt, or a second position mortgage), I'm out. I'll save all that stuff for the recovery after the next downturn, when the timing is in its favor, rather than against it.
Performance Splits and Fees
Before talking about these further: fees and sponsor compensation is very difficult for many newbie investors to analyze. So, by request, I've expanded how I do this into a complete article which you can read here: Is the Sponsor Taking Fair Compensation? Or Ripping Me Off?
Like most investors I don't want to pay more than I have to. So I prefer deals that are at least in line with the averages. If something's out of line, then it's a potential problem.
Also, since I'm a conservative investor, higher than normal sponsor compensation brings an additional risk. The higher it is the more it financially incentivizes the sponsor to push the risk envelope. And this is the opposite of what I want to see. If you're more aggressive, you may actually prefer the situation.
Usually if a deal is a little out of line, I'll check to see if I love the sponsor and deal. If I truly do then I'll go ahead. And if not I'll pass. If it's way out of whack, then it's an easy pass. I found that these kind of deals are usually the sign of the sponsor that markets to unsophisticated investors. Since I find those deals are rarely a fit for me, I just move on to the next one.
One thing to watch out for here, is that many sponsors do not fully disclose all their fees when they summarize them in their investment overview and pitch deck. And if they have a particularly uncompetitive and bad fee, it's almost always buried in the legalese. So you always have to go to the legal documents, to make sure you have them all.
How much is too much?
What are my thresholds? It depends on the strategy, options, etc.. What I do is compare it to other deals to see if it is reasonable or completely ridiculous.
On mainstream deals, like multi-family, the average preferred return is 6-8%, and profit splits on the average deal range from 10%-25% to the sponsor. So if I see a 5% preferred and 30% profit split to the sponsor, and I haven't been completely blown away by anything else, I throw the deal out.
The same thing goes with fees. Asset management fees are usually about 1%, acquisition fees about 2% and property management fees about 4%. Anything way out of line can be a yellow or red flag.
Specialty categories have less deal flow, and market averages favor the sponsor more. For example, mobile home parks require special relationships for sourcing deals and doing proper property management. So it's not unusual to see 35% to the sponsor. And there may even be a second tier of the waterfall with a 50% split to the sponsor. While I never enjoy paying more, I compare them to other similar sponsors and deals and use that as my threshold.
So those are the quick checks (leverage, length of debt, complexity of structure, performance splits and fees). If the deal has survived so far, it's much more promising than the average deal. So it's worth the time for me to put in some deep property-level due diligence.
Deep Property Level Due Diligence
There are two different types of deals: blind and nonblind funds. And each requires two very different types of property level DD.
Non-blind Funds
About 50% of funds identify the target property or properties in advance (and usually will put them under contract before the investment starts). This makes it very straightforward to do what I call "pro-forma popping." I can look at the pro-forma (which is the yearly performance projection by the sponsor), and successfully or unsuccessfully poke holes in it. I can also examine the assumptions and see if they are conservative or not. Usually, it falls apart under the scrutiny, and then I move on. If it survives, it's also pretty straightforward to do a recession stress test (talked about next).
For example, here's a sample pro forma:
"Pro-forma popping" means going through every item in it, and imagining that it's probably complete B.S., and see if I can find some way to prove that it is in fact B.S.
First we start with all the simple things that feed into the pro forma like the purchase price. If they overpaid a lot, it can add a lot of risk to the deal. So if I see that, it's an easy No. If I'm familiar with the area and asset class, I may have a general idea of a fair cap rate (and thus a fair purchase price). If not, I can compare it to other properties in the area using a sales comp report. One common trick to watch out for: if the sales comp report comes from a broker it will often use comparables that are in a much better class, to inflate the price. So go through each property and look at the interior and exterior to see if it's in the same class or not. And then remove the "shills". (If you're not sure how to do this or any of the other things that follow, joining an investor club is a good way to learn how from other investors ).
Did they get a reasonable rate on the debt or were they forced to pay more than market rate? An expensive rate is a triple whammy, because not only does it take away from profitability and increase the risk of default during a downturn, but it also suggests that lenders looked at this deal and didn't feel it was strong enough to give it a decent rate. If I don't have a general idea of what a good rate is, I look for quotes from lenders online. Or again, asking someone in an investor club is another way.
If the purchase terms are plausible, then I dig into the yearly projections. I start with each item under income. The temptation to the sponsor here is to inflate, so I'm looking for numbers that are too big. A common trick here is to overestimate occupancy (and thus rental income). For example, if I see the rental income is based on 99% occupancy, and I google stats on the area and see that the average is 92% over the last 10 years, then there's a problem. Or another common thing is a strategy that includes a huge value-added project (that's going to kill the occupancy during the renovation) but not including this in the projections.
Another thing to watch out for are unrealistic rental increases. If the pro forma shows 6% increases but the area has only averaged 3% over the last 10 years, then again there's probably a huge problem. On the other hand, if I see them actually using numbers that are more conservative than necessary, that means there's lots of cushion for unexpected things to go wrong and it's a huge plus. When I see this, sponsor gets huge brownie points from me. If this is a value-added deal, the sponsor is making improvements to the property to increase the rent. Are these realistic or overinflated? To find out, you need to look at the rental comp report (a report of nearby properties that are at the class of the planned upgrade). This will tell you if the market will support the planned rent or not. A common trick here is to again use comps that are much nicer than the planned upgrade to inflate the rent. So make sure to look at the exterior and interior of all of them and weed out the fakes. When it's done, you want to see that all the projected rents are no more than the competition average. If they are higher, you probably have a problem. The most conservative sponsors and deals actually use #s that are less than the competition. This gives additional cushion and protection in the deal to hit its numbers. When I see that, it's a great sign.
After I'm done with income, I do the same thing with expenses. The temptation to the sponsor here is to under-report, so I'm looking for numbers that are too small. Some sponsors "forget" to report certain expenses, so the first thing I do is make sure all the main categories are there. (If you're not sure what those are, then you can compare it to other pro-formas). I challenge each and every number. A common finding is underestimated maintenance. (Compare the percent devoted to maintenance to other pro-formas to see if they are realistic or not). The real amateurs will often underestimate property taxes. Also look for expenses that go up too little from year to year. For example, unless there is some sort of local ordinance, a pro forma showing a 2% increase in property taxes is probably way under-reporting.
The cost of renovations is another area where things can go badly wrong on the value-added deal. First, renovation projects almost always run over budget, and practically never under. So if I don't see the sponsor put in a cushion for this, I become very skeptical. I can also do some sanity-checks by comparing the cost of the budget on metrics (like cost per square foot or cost per door) to other pro-formas to see if they seem reasonable or not. This can be difficult for a novice investor, which can be one more reason to stick with very experienced sponsors who have a track record of estimating accurately...and avoiding newbies that don't.
If the pro forma survives all of the above, then I take a look at the sensitivity analysis. This is a spreadsheet that shows what will result from fluctuations in the unknown variables (prices don't go up as much as projected, vacancies go up higher than projected, rental income doesn't go up as quickly as expected, etc). I save the really hard-core stress for the recession stress test in a later step. But for now I consider the non-recession possible outcomes and whether I would be okay with them or not.
Blind funds
About 50% of funds are "blind" because the investor doesn't know which property/properties will end up being purchased when they invest.
At first glance, blind funds may seem like a disaster for doing property level due diligence. But with a little bit of ingenuity some decent due diligence can be done. And with a little-known technique that I call "stall and see", I can actually do better due diligence than on a non-blind fund.
Removing the Blinders
At the very least, a blind fund sponsor should have previous funds and investments that they will disclose the pro-formas and numbers on. (If they don't or they won't disclose those, then that's a red flag for me and I'm out). This provides all the info I would normally get when doing a "pro-forma popping", and then on top of that I get to see the actual performance of the assets. I especially like to look at what happened to investments that had the bad luck to be timed poorly and went through a downturn, or that under-performed. This can give a lot of good insight into whether the sponsor is truly conservative or not, and how good they are dealing with adversity.
The one downside of this method compared to non-blind funds, is that I don't know for sure that the sponsor will underwrite future purchases like they did previously. If the sponsor has an exceptionally long and distinguished record, I may feel confident that they will continue doing business like they did before.
But if not, then I may feel they are too risky to take a chance on it. That's when a little-known technique can sometimes come in really handy, which I call...
"Stall and See"
This is a great trick that I picked up from another investor. Most blind funds purchase pools of properties, rather than a single property. (The diversification is really nice, because I can purchase in one shot what would take 20-100x more money...and hassle...to purchase from individual property funds).
It usually takes these funds at least a few years to buy the properties, and they don't want to take in all the cash at the beginning and have it sitting idle. If they did, the cash drag would kill their returns. Instead, they take only what they need as they purchase, and usually accept new investor money during that time also.
That gives a shrewd investor a unique opportunity. Rather than jumping in the fund at the beginning, when everyone else is, I can wait a year or two before pulling the trigger. And then, not only can I see the performance of past investments, but I'm no longer blind and can see what they actually invested in! Instead of just looking at theoretical numbers like in "pro forma popping", I'm looking at real, actual numbers. So I love this technique.
The one danger is that I may stall so long that the fund fully subscribes and I can no longer invest in it. So when I do this technique, I make sure I stay in regular contact with the sponsor, to gauge how much time I have.
"I'm a survivor"
By this time, at least 90% of the deals that started step 3 have gotten thrown in the trash. So if a deal has survived this far, it's in rare company and is getting very, very interesting to me. Now is the time I really dig into it with a recession stress test, legal document review, etc. Click here to read about Step 4.
