The Passive Investors Due Diligence Checklist

[Justin Moy]

As a passive investor your work is done upfront in the due diligence process. There are a few key items you need to check off your due diligence checklist before making an investment:

Due Diligence on the Operators:

1. What is their experience with this asset class and in this market

Most operators will specialize in a specific type of investment, and many think success in one asset type equals success in others. That is many times not the case and even as operators expand their horizons they can experience growing pains.

Understand what their experience with the asset type you’re investing in is, and if they have strategic partnerships to help them avoid mistakes if they’re taking on a new asset class.

With multifamily: Understand their experience in that class of property (A, B, C, D). There are operators who absolutely crush it in certain asset classes and may struggle with others.

Understanding the market: Real estate is hyper local. One of the biggest benefits an operator can have is hyper local knowledge. If they aren’t boots on the ground, is there a partnership that is providing that? Not understanding the market is a big red flag, and also with bringing on a new staff, managers, contractors, and new geographical team, there can also be growing pains here.

2. What does their organization look like

Are they a huge organization? A smaller local operator? Family business?

There is no wrong answer to the type of operator to invest in, but each will have their pros and cons. Some investors like to be part of a larger organization, others might like the intimacy of a smaller one.

One thing that is a personal preference of mine is I would not invest with a solo operator. Nothing against them, but if something happens to that one operator it can jeopardize the investment.

(In Kevin O’Leery’s famous words: “What happens to the business if you get hit by a bus?”)

3. The big question

One thing I think all passive investors should ask their operators is “Out of the investors who choose not to invest with you, besides lack of liquidity, what is the #1 reason they choose not to?”

This will tell you a lot about the operators because if the #1 reason is a reason that’s really important to you, you can know they may not be a great fit, but if the #1 reason isn’t important to you, you may feel more comfortable with that group.

As a bonus, it also allows you to know how well the operators understand their business and track feedback to continue improving.

Due Diligence on the deal:

1. Headwinds or tailwinds?

Is the asset class we’re investing in going into headwinds, or tailwinds? Tailwinds are things that will push that industry forward, a great example is what multifamily was experiencing over the past few years. With robust rental assistance programs tenants were willing to and able to pay more, and collections saw historic highs and vacancies saw historic lows.

Headwinds are what the multifamily industry is seeing now, with rental assistance programs drying up and rents pushing affordability beyond what tenants could naturally pay, we’re seeing vacancies increase and rent growth stall or decline in many markets.

Headwinds can also provide more opportunities, so headwinds aren’t totally bad, but the business plan would have to be sustainable for a longer term deal to weather those headwinds.

2. Tenant income

We want to know the average income of our prospective tenants in the area. Most people understand housing costs have greatly outpaced tenant income, and in some markets these ratios are stretched to their limits.

We want to know how much the average prospective tenant for this property will be making and see if our rent growth projections can be sustained at current income levels, if we’re seeing tenants incomes are already stretched to their max we might be hesitant to project more aggressive growth.

BONUS: The debt

Debt is generally the #1 killer of real estate deals. Almost all distress in CRE is debt related and forced sales typically come from balloon payments coming due.

When analyzing a deal you really want to understand the debt on that deal:

How long is the loan? Is the rate fixed or floating? If it’s floating is there a cap? Has the property been underwritten at the max interest rate? What are the prepayment penalties? And very important for short term loans, what are the extension options?

Asking these key questions will help you avoid forced sales and will statistically be one of the best pieces of due diligence you can conduct to avoid deals going bad.