Conducting Due Diligence on an Investment Opportunity

[Randy Smith]

You’ve learned a lot since you started the journey of investing in your first passive real estate deal: you’ve weighed all the differences between asset classes, zeroed in on your ideal geographic market, and put on your investigator’s hat to get comfortable with a few operators. Now, you need to review the deals these operators put in front of you and choose which one is the best place to allocate your funds. In this article, we’ll review the main items you’ll want to review before making your decision.

Does the opportunity meet your investment needs?

Investment opportunities come in all shapes and sizes, so it’s important to compare the investments to your specific needs. You’ll want to know if it is this a cash flow deal, a deal geared more towards growth, or a deal that has a healthy mix of both. If it is a cash flow deal, how quickly will it start providing cash flow and specifically, how much cash flow will it provide?

When I first started investing in this space, I didn’t know what questions to ask, but I found out very quickly that all deals are not created equally, and operators have very different strategies when it comes to providing distributions to their investors. There’s not necessarily a right or a wrong way to pay distributions, but it is important to make sure the deal provides the cash flow or growth opportunities you need to meet you investing goals.

How is the debt structured?

The financing of the deal can have a tremendous impact on the overall returns and hold period of the investment. You’ll want to get a good understanding of the type, terms, and prepayment options associated with the loan as you do not want your operator to be forced to sell before they’ve been able to perform the complete business plan if it is not in the best interest of the investors.

Some items you’ll want to acquaint yourself with are the difference between bridge and traditional loans, prepayment penalties or defeasance fees, interest only periods, rate caps, and refinance options available for the specific loan your operator is leveraging. This might seem a little overwhelming, but it’s not necessary to become an expert on all these items. Simply knowing at a high level what they mean and the impacts they can have on the deal are often enough to weed out the bad deals.

What is the operator assuming in their financials?

You’ll often see a section in the investment presentation that covers the assumptions that are being used in the development of the financials and the pro forma. Be sure to understand these assumptions and give them a “gut check” to make sure that they make sense. As an example, if the operator assumes that rents are going to go up 5% per year without any added value, it’s safe to assume that the expenses will also go up at a proportionate amount. I also like to see some type of relevant stress tests on the deal as well that provides a few if/then scenarios as the performance is not likely to hit on all estimated metrics throughout the hold period.

As always, there are many other areas that you can investigate in your due diligence process, but you can feel confident with just the items above if you’ve done all the work up to this point. The next big item is submitting your “Soft Commit” for the investment and getting ready to wire your funds. We’ll discuss that in a future article.