When evaluating a sponsor or private security investment, it is prudent to begin with conducting due diligence on the sponsor first, because ultimately the deals are only as good as the sponsor offering them. A common mistake many investors make, is asking questions orientated towards the positive, when they should be asking questions that can elicit red flags.
Public companies make public filings with the SEC, which are supposedly seen and reviewed, but numerous other investors essentially allow for a crowd sourced due diligence. If red flags are identified, the market price of the stock reflects the identified risk. The are no such filings by private companies. Often there are not audited financials, limited track records, and if there are any 3rd party reports, chances are the sponsor paid for them; so if you are seeing it, it may represent what they sponsor wants to represent.
If you’re thinking about investing in private real estate, there are a number of questions you should be asking prior to making a commitment. If you find that the company does not seem upfront or forthright, it could be a potential red flag. Our next three blog posts will be a three-part series on questions to ask prior to making an investment. In today’s post, we’ll examine what types of questions you should ask about the sponsor.
Questions about the Sponsor/GP
- What makes you different from other commercial real estate companies? Every company wants to claim they’re “disrupting the industry” or “doing something different” – but that can not always be true. Many successful commercial real estate companies may have similar business models, but what makes one stand out more so than the others, can be prior relationships built, and the company’s team. Take a look at the commercial real estate company’s website and examine it. See who’ve they dealt with. Ask to speak with their development team, etc.
- Can I contact your referrals? Because many investments are built on relationships, this is a fairly common question to ask in commercial real estate, but also very important. When it comes to investing, a person’s word can go far beyond what’s on paper. Ideally the company will provide a list of both current and former investors.
- Send me your historical track record In this case, every prior win and loss should be documented. Not every company is perfect. If the company does provide examples of subpar investments, that’s actually a good sign of them being upfront, and potentially a red flag if they state they haven’t lost money. If that is provided, be sure to follow-up with “How have you learned from this mistake?”
- How long have you been in business? This may sound unfair to startups, however it’s a valid question. According to the Small Business Association, 30% of new businesses fail during the first two years of being open, 50% during the first five years, and 66% during the first 10. So as you can see – longevity does translate to success. Has the company or any of its leadership ever declared bankruptcy? If so, why?
- Has the company ever experienced any violations from FINRA, the SEC, or other regulatory bodies, or is the company under current or expected litigation? These questions are of particular importance just to make sure the company you’re dealing with has a clean track record. A company that hires sales reps, directors, or managers should be under particular scrutiny. If they’re the ones who are selling you an investment, it’s important to know they have always acted in good faith. Additionally, pending lawsuits are important to note just to make sure the company isn’t in jeopardy of potentially going bankrupt.
- What’s your investment philosophy? In commercial real estate, there are 4 main asset classes to focus on – Core, Core Plus, Value Added, and Opportunistic (you can read more about them here). Ideally the company your working with focuses on one or two of them, rather than equally on all four.
- What returns do you target? Targets that are too high, and you should be skeptical. Targets that are too low, and you’ll be disappointed. As a general rule, we like seeing Core have annualized returns between 5%-11%, Core Plus of 8%-12%, Value Added of 12%-20%, and Opportunistic of 18%+. However, hold periods and risk preferences are also necessary to account for.
- Have you ever lost any assets to bankruptcy or repossession? This question is paramount to ask a commercial real estate company. Lost assets are not necessarily a deal breaker – especially if the company was around during the 2007/2008 financial crisis. If a company has lost assets, an important follow-up question is “Why did the company lose those assets, and how have you learned from it?”
- How many assets have you exited? Did you hit your proforma on all of them? Value added and Opportunistic developers/investors should have higher exit rates than Core and Core Plus. While exit rate numbers aren’t always the “end all, be all” – the more, the merrier. A company that has 100 exits will give you a better idea as to what you can expect in terms of historical returns based on IRR, multiples, and hold period. The less data you have, the more guess work and due diligence you’ll have to run.
There’s no golden rule on a company hitting its proformas. However, a 90%+ success rate is ideal. Proformas also give a great window into how aggressive an analysts’ models are. If the company is consistently missing their proforma by 20%, then there are questions to be asked.
- Are you a registered investment advisor? If so, can you send me your Investment Adviser Registration (known as an ADV)? If the company you’re talking to is a registered investment advisor, then you should ask for proof. It is mandatory for RIA’s to send you their ADV prior to you making an investment.
Investments should always be met with a certain amount of skepticism. As an investor, you should be suspicious in nature – it’s a good thing. It’s important to gather as much information as possible and ask questions based on what you know. At Northstar, we do our best to be upfront about our historical investments. We openly send all of our investors our historical track record, and love talking about our 18-year history. Like all companies we’ve endured tough times like the 2007/2008 financial crisis – but it managed to make us smarter and stronger. We encourage all of our investors or prospective investors to ask us about our history or current investments. Be on the lookout for our next two posts – Questions you should ask about the investment, and questions you should ask yourself.
This post was written by Northstar’s Director of Equity, Danny Mulcahy. If you’d like to learn more about Northstar’s potential investments, you may contact Danny at firstname.lastname@example.org, or view current opportunities at https://invest.northstarcommercialpartners.com/.