Investment Series Part II - Questions to Ask About the Investment

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Continuing with Part II of our investment series, today we’ll focus on questions you should consider asking about a specific real estate investment (Click here to read Part I – Questions to Ask the Manager). When it comes to a commercial real estate opportunity, don’t be afraid to get down into the weeds, and ask for specifics. If you don’t recognize a term or if the verbiage is confusing, then feel free to ask for clarification. Take for instance Internal Rate of Return, or IRR – it’s something that can be casually thrown around, and many CRE professionals take for granted that it’s an uncommon term outside of real estate investing. If it’s something you don’t recognize, then ask! If you’re putting $10,000, $50,000, $100,000, or more towards an investment, it’s important that you understand what exactly you’re getting into.

With most investments, when it comes to the opportunity itself, you always want to start with the numbers. However, not in the way you think. Don’t only focus on the positive of how much money you could make – try to focus on the negative to help setup realistic expectations. How much could you lose? What are the specific risks? What happens if a capital call occurs? These are just a few important questions to pose prior to putting your money at stake.

Questions about the investment

Does the Sponsor have a Private Placement Memorandum and Subscription Agreement?  Technically, a sponsor does not need to provide accredited investors with any documentation before or after they invest; it can actually be all done with a handshake. A sophisticated Sponsor will provide a PPM that provides all the various risk disclosures, a summary of the investment, summary of all the fees, budget, and more. In addition, there should be a copy of the company operating agreement which outlines all the responsibilities, and liabilities of both the manager/sponsor and the members/ investors. When things go wrong with an investment, it’s documents like these that help to protect the investor.

How much leverage is being used? Is there mezzanine financing? Is the loan fixed or adjustable? One of the biggest risk factors in commercial real estate investing is the use of high leverage, but it is also a big part of why investment returns in commercial real estate outpace most other asset classes. In today’s market, the standard loan should have about a 70-30 debt-to-equity ratio.  If the sponsor and investors are looking for income, they will use less debt, if they are looking for growth they will use more. A few follow-up questions to ask are: What are the loan terms? Interest only? What is the amortization schedule, is it assumable? Are there prepayment fees?

What position in the distribution am I in? What is the equity structure? Is there a preferred equity share class? In every real estate investment, the profits are split between the sponsor and the members. A common distribution structure allows for the investors to accrue a preferred return between 6-12% annually and a return of all their invested capital before the profits are shared with the sponsor.  Thereafter, it can be as simple as 80% of the remaining profits go to the investors and 20% to the sponsor, but more often than not, there is a “Waterfall” distribution. At Northstar, we typically offer a 10% preferred return, return of equity, then 70% to investors and 30% to the sponsor until the total return to investors exceeds 25% annual, and then the remaining profits are split 50/50. The preferred return should not be confused with Preferred equity members – preferred equity is a different share class that typically accepts a lower return than the common equity, but in exchange, they take less risk by being paid before the common equity.

Will there be any scheduled capital calls? The operating agreement should provide a detailed schedule and/or a detailed explanation for when and why there will be additional capital calls.

What is the likelihood of unforeseen capital call? Nobody wants to put money towards a capital call – especially an unscheduled one. It shows that the budget has likely been spent, and that a property’s future could be in flux. That said, it’s not necessarily the end of the world. Ask the manager how often they’ve done capital calls in the past, and that should give you a good indication of the likelihood of one in the future.

What happens if I don’t make a capital call? Typically, if you do not contribute to a scheduled capital call, then there are likely penalties such as aggressive dilution or the ability to be bought out of your shares at a severe discount. For unforeseen capital calls, the same penalties could exist but more often you will simply be proportionately diluted in the overall investment.  In either case, the manager may decide to treat the capital call as a member loan that not only has a high interest rate associated to it but it also will take precedence in the distributions; this can have a severe impact on your return.  It’s vital to know what happens if you decide to not make a capital call.

Can the members remove the manager? You should have the ability to remove a manager if a majority of the members elect to do so. This typically happens more often for funds rather than individual investments, and removing a manager is a drastic step that likely signals that an investment is in jeopardy. While it may seem good to have this power, as members are shielded from liability by being passive, so it is important to recognize that whoever is elected to replace the manager will incur some liability exposure.

What are the exact uses of the equity? As an investor, you want to know where your investment is going. You should ask for a business plan that goes into deep detail over where an influx of capital will go. X amount to buying the building. Y amount to construction costs. Z amount towards marketing the building. Ideally to avoid future capital calls, 5 or 10% of total equity will be put towards a contingency plan – for example, just in case construction costs are a bit higher, it’s nice to have both a financial and timeline buffer.

What are the primary risk factors? In asking this, you would like for the manager to be completely upfront. Simply a “There’s basically no risk involved, but the potential for huge returns” response is a red flag. All investments come with risk, which is to be expected. Ideally the manager will discuss potential headwinds, whether it’s construction costs, nearby rental rates for similar properties, or cap rates – and talk about how they are planning to address these concerns.

How much money can I expect… to lose? We know it’s enticing to always focus on potential profits. However, it’s equally important to focus on the risk. When investing, assume that you will lose your entire investment. Are you okay with that? Find out your specific risk threshold (a set amount that you cannot afford to lose), and do not go beyond that number.

How conservative or aggressive are your models? The world is a changing place, and a CRE firm that boasts potential returns of 3 times your money in 4 years maybe too good to be true. Ideally the company you’re dealing with is fairly conservative with their estimates. Don’t be timid to ask to speak with the company’s financial analysts – they hold the key to their investment models and should be fluent in their modeling decisions.

Have you done similar transactions or built the same developments in the past? Is the CRE company you’re dealing with an industry expert? If they have built 50 profitable self-storage facilities in the past, and this is their 51st, that’s a good sign. If they’ve built 50 multi-family units in the past, but this will be their first self-storage facility, then you should grow very skeptical. 

If the real estate project makes money, how do you (the Sponsor) make your money? Whether it’s through fees, commission, or a manager’s interest, it’s important to know how a company gets paid. If the advisor you’re dealing with is only paid based on your commitment, it could be a red flag that they’re incentivized to have you over-commit.

Does the CRE company have skin in the game? Any company in commercial real estate would love to simply facilitate investments with 80% debt, and 20% from outside investors – this ensures 0 risk, and only upside for the company. However, at Northstar, we believe that’s decidedly unfair. This is why Northstar’s CEO, puts his capital in our investments. We don’t sell investments to investors, our money is invested first and we share investment opportunities with investors – we think of it as co-investing.

At Northstar, we can’t stress enough that all investments come with a certain amount of risk. Especially with private real estate investing, it’s paramount to run your own due diligence. We hope these questions will help you vet a potential real estate investment.

This post was written by Northstar’s Director of Equity, Danny Mulcahy – you may contact him at danny@northstarcp.com. If you’re interested in Northstar’s current open investments, please visit our investor portal at: https://invest.northstarcommercialpartners.com/.

Posted on June 5, 2018 .