Conservative Investor's Guide to Picking Real Estate Investments: Part 4 Advanced Property Analysis
Updated: Oct 25, 2020
Recession stress testing, legal document analysis, etc.
(Usual disclaimer: I'm just an investor expressing my personal opinion and not a financial advisor, attorney or accountant. Consult your own financial professionals before making any financial decisions. Code of Ethics: We do not accept any money from any sponsor or platform for anything, including postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves in the club above what we negotiate for the benefit of members.). IMPORTANT COVID-19 UPDATE: this info was posted before anyone knew we would be facing a global pandemic in the spring of 2020. So it may be missing crucial information necessary to making an effective investment today. Some of the information in it may be dated, no longer accurate and/or irrelevant. For information on analyzing investments in this new era, see: "How will Covid-19 / Coronavirus Affect my Alternative Investment Portfolio?"
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).
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.
So here in part 4, I have a very, very interesting investment that may indeed be a jewel. Now is the time I really dig into it even harder, to see if it is a true contender, or just another pretender.
"Under Pressure": The Recession Stress Test
As I talked about in part one, I believe we're close to the end of the physical cycle and a downturn will be coming sooner rather than later. So I will not invest in anything unless I feel comfortable with how it can handle a recession. So I do what's called a "recession stress test", where I simulate the stress of a severe recession on the investment and see what happens. Many deals crumble like an ice cream cone under a dump truck, and if they do then I throw the deal out and move on. But a few hold firm, and when that happens that I know I have a potential winner.
First, I find the historical performance data for the geography and asset type of the deal. I can usually find this on Google from brokers like Marcus & Millichap or data providers like Axiometrics. Occasionally, it may require contacting a local/county property appraiser office. Typically that can be done by phone, but occasionally it can be handy to belong to an investor club where someone local can drop by to squeeze the information out of a difficult source.
The critical data for equity investments is primarily vacancy increases and rental income drops. And to be safe, I go back a couple of recessions and make sure I pick the absolute worst. (For example, commercial real estate did worse in the S&L crisis while residential real estate did worse in the Great Recession). Then I find the most difficult year in the pro forma (where cash flow is lowest), and pretend the recession hit that year by running the numbers through it and watching what happens. I keep a close eye on the final result: the cash flow at the end. If that goes below $0 on a leveraged equity deal, then the deal would have blown up. And a blowup means the fund would have defaulted on debt and investors would have lost 100% of their investment. If I see this, I breathe a sigh of a relief that I'm not the one exposing myself to this risk, and move on to the next deal.
If it passes, some people might be perfectly fine with that, but in my case I'm still not done. Every recession is different and the next recession has a good chance of being worse in some ways than previous ones. So I actually want an additional cushion in case that happens. To check for this, I will overstress the investment (for example, 2x the worst vacancies, 3x the worst rental income drops). If I do this and it still doesn't default on its debt, then I'm very happy.
Debt deals are similar, but focused on different data: historical default rates. So if I'm looking at a hard money loan first position debt fund that does construction loans on multi family properties in California, I look for the worst recession for that (S&L crisis recession). Then I create a spreadsheet that calculates the return of the fund, and run the numbers through and watch what happens. If I start seeing huge losses of principal, then I move on. Again, I will also overstress the investment (1.5x worse default rate, 2x, etc) to make sure the investment has a cushion in case things next time are worse.
If this is a "Stall and See" situation, then the fund has financials which can provide very helpful additional information.
(Note: These techniques do depend on the auditing firm being legitimate. The vast majority are, but there are a few that are not on the up and up. So before starting, I Google for information on the auditing firm, and look for complaints or potential issues. And I also check if there any reports of fraud with the SEC.)
After that, I ask the fund for as many years of the results as they have. First I want to check to see that the fund really did perform the way the pitch deck claimed. Believe it or not, a few funds have failed this test. In my opinion, it's not worth taking a risk on a fund that can't be trusted on something so basic. So when I see this, I move on.
Assuming it passes, I do a "Ponzi scheme check", to make sure I'm not investing in the next Bernie Madoff. This does require the ability to read accounting documents, which I know not everyone knows how to do. If you don't, you can get help from your accountant, or from other investors in a good club.
To do the check, I look at how much money the fund truly made and then compare it to the distributions. If the distributions are higher than the money made, then there's a potentially big problem. I bring that up to the sponsor and ask if there's some legitimate reason. If the reason they give doesn't hold water with me, then I'm out.
Sometimes I've seen the opposite where the distributions are much lower than what the fund is making. It's possible the sponsor is holding back reserves for something legitimate. But if I see this I also inquire further to find out the reason and make sure I'm okay with it.
Legal Doc Review
Every deal comes with a mammoth legal contract that's at least 50-100+ pages. In 506B and 506C offerings it's called the Private Placement Memorandum (PPM). In some publicly registered offerings it's called a 10K. In others it's called a Prospectus.
And although I'm only mentioning it in this very last article, by the time I've gotten here, I've been forced to read quite a bit of it to complete other steps. For example, many times the fees are not actually completely laid out in the pitch deck, so I have to dig into the legal docs to make sure I have everything. But now is the time for me to bite the bullet and I read every single page of it.
This step is not fun, and is easily the absolute worst step of the entire due diligence process. But I do it, because several times I've discovered hidden clauses in the contract that were so ridiculous that I had to back out of the deal. And they can be embedded in any section, so there's no way to find them without reading it all.
There's a crowdfunding platform podcast that has actually tried to "help" investors by advising them on which parts of the legal documents they should read so they can skip others and finish faster. In my opinion, this is hogwash and a dangerous idea.
If you ask a dentist, "Which teeth do I need to brush every day?", he'll tell you "only the teeth you want to keep." Every part of a legal document has repercussions for you and your money. So if someone asks me "Which parts of the legal document must I read?", I'll say, "only the parts concerning money that you want to keep."
"Is This for Real?"
The first time you read a legal document you'll probably be struck by how unfair and one-sided it is. You'll most likely be a little bit shocked as you read about how it strips you of most of the typical rights and protections you would enjoy in normal LLC run by a fiduciary, and how it essentially gives the sponsor as much unlimited power and freedom from responsibility as possible. So if your stomach isn't churning by the end, I'd say you probably didn't read it very carefully and may need to look at it again.
At the same time, investing passively does mean turning over complete control to another human being. So this is actually par for the course, and in my opinion not reason to throw the deal out (at least not yet). But if for you that's a red flag, then maybe you might want to consider owning real estate directly yourself instead. (Which is something I do also as part of my portfolio).
So I personally don't allow the simple fact that the above is being attempted, to be an automatic red flag. Instead I take a closer look at how they attempt it -- things like the following:
"7 Things I Hate about You"
1) Strategy commitments that are too broad. Many attorneys will tell sponsors to make the strategy in the legal contract as vague as possible, to give them the most flexibility. But many investors understandably are not willing to invest in funds that are allowed to stray too far from what they are told they are purchasing. So I watch out for strategy commitments that are too broad for me.
For example, if I'm investing in a multi-family fund, it's because I like the risk profile of that class. If I see that they are also allowed to invest in hotels, which are much riskier, then it's of no interest to me, and I pass on the deal. If you ask the sponsor, they will typically say, "oh, our attorney told us to put that in there, but we will never use it." Maybe it's not true or maybe it is. But even if it is true, I feel I can always find a sponsor who took the time to better align themselves with the investor by committing to the strategy (that they claimed they are following) and to what I want for my portfolio. So for me, when I see this, it's a red flag and I'm done with the deal.
Another example is a fund that pitches itself as unleveraged, or only leveraged to X%, but then the legal document allows them to go way over that.
2) Additional capital calls. Some deals have provisions in case they run into trouble. If they do, you may be required to put in additional money (make additional capital calls) to keep the deal alive. Usually you have the option to decline, and simply get diluted. This to me is a fair option for both sides.
However, other deals are more punitive, and will penalize the investor by reducing their funds, charging interest, etc.. I have a problem with this, because I have no idea when I might need to have cash for this in the future, which makes it very difficult to plan for. When I see these kind of clauses, I pass on the deal.
3) Clawbacks. Some contracts will allow the sponsor to take back money that they previously distributed to you, if the deal runs into problems. Some aggressive investors would not care about this, but as a conservative investor, that means I need to keep the money around for this possibility and can't necessarily redeploy it. That is a problem in itself. Some deals get even more extreme and allow clawbacks to occur years after the fund is closed. When I see excessive clawbacks, I say "no" to the deal.
4) Onerous hidden fees. Many deals contain hidden fees that are not disclosed in the pitch deck. If the fee is something minor, then to me it's not a dealbreaker. But if it's something major then I usually have a problem with that. I subscribe to the "cockroach theory" and if I notice one cockroach in plain view, there's probably 100 more that I can't see. So I usually walk out on the deal.
5) Can't understand it. I've read hundreds of legal docs and, despite that, every once in a while I will run into one that is written in such ridiculously convoluted legalese that I have no idea what a lot of it is saying. If I ask the sponsor, they will typically blame their attorney, which is often plausible. But to me it also suggests a certain immaturity of the sponsor: maybe they haven't had enough experience with negative feedback and multiple funds to change it to something that is more investor friendly. If it looks like I may have to spend additional weeks just asking questions before I can fully understand a document, it's not worth it to me.
6) Unacceptable conflicts of interest. In my experience, there isn't a legal document out there that doesn't disclose some sort of conflict of interest that the sponsor has. For example, every deal has to charge fees or sponsor split in order to stay in business, and the mere fact that they are making money off of the investor create certain conflicts. Those to me are inevitable and aren't deal breakers (and can be mitigated in other ways like with skin in the game, as talked about in Part 2).
On the other hand, sometimes there are conflicts of interest disclosed that I just can't stomach. For example, some hard money loan funds are allowed to make loans to construction companies owned by the sponsor. I personally can't see how such loans can possibly be underwritten to the same standard as an arm's-length third-party loan. And it's difficult for me to imagine a sponsor foreclosing on themselves as aggressively as they would a neutral third party. So when I see conflicts like this, I ask the sponsor if there is some factor that mitigates the risk. Sometimes there is, and then I continue on. But if there isn't, or if the sponsor says "our lawyer made us put that in there", then I reject the deal.
7) Undisclosed Risks: I have heard "advice" given on blogs and podcasts that investors can avoid doing the hard work of reading every line of the legal documents, by focusing mostly on the section that discloses risks. I think this is not a completely horrible idea, because the sponsor has an incentive to disclose as much of the risks as they can think of, to limit their liability. Sometimes, it talks about things I hadn't thought of fully before, and gives me new questions to ask and avenues to explore.
At the same time, many of the disclosures are very generic and I've never seen a legal document where the risk disclosures covered everything. And again, lots of the hidden gotchas are buried elsewhere in the document. So I agree it's important to review, but not enough to do on its own and then call it a day.
More Sponsor Checkups
If it survived this long, here's where I do more sponsor checkups.
I finish up on my "death by Google" checks that I described in part 2.
I also ask for 2 to 3 references and call them to get more information. I've been able to get all sorts of negative information on sponsors that I never would have been able to find without checking directly like this. If I doubt the authenticity or neutrality of a reference, I ask them for someone that they have referred the investment to. Legitimate references usually have friends or acquaintances they can themselves refer. So I interview them as well, basically reference-checking the references.
I also do a background check on all the principals. I check on criminal, bankruptcies, foreclosures, etc. to see if I can find anything. The background check databases aren't perfect, and sometimes they come up with false positives. If I find something, I always ask the sponsor to clarify with proof that they didn't do what the database says, and very often they can.
Also, usually way before this point, I've been able to tell how transparent the sponsor is. Every sponsor tells me, "please ask as many questions as you want", and in fact many legal documents disclose that this is a responsibility that the sponsor must undertake. In reality, I'd say about 15% of sponsors start to get annoyed if they feel "too many questions" have been asked.
There are some investors who are fine with this, and will simply back off and not ask any more questions and send in their money. I'm not one of those people. I don't ask questions unnecessarily, so if I'm going to hand over complete control over my money to a stranger, I feel they can take the time to answer as many legitimate issues as I have. In my opinion, someone who gets annoyed or stops responding to questions isn't someone I want to do business with, and I can find much better customer service elsewhere.
Finally, some investors I know will do an on-site visit of every sponsor before investing. I haven't, and maybe I should… I haven't decided yet if the time and expense reveal enough to make it worth it to me. I like belonging to an investor club, where there's a good chance that someone lives around the block from the sponsor and can drop by and check them out, if I don't.
Some investors will do a surprise visit, to catch them off guard, and see if the sponsor is completely unorganized or not. This seems like a good idea in some ways, but in other ways could backfire if the sponsor happens to be busy that day and doesn't have the time to spend answering questions. Others will announce the timing of their visit in advance to make sure they have scheduled time. Probably the most thorough technique would be to combine the two, but if the sponsor lives in a faraway state, this might not be time/expense practical.
"Wow, I'm actually finished?"
As you can see, I have a very demanding due diligence process. So it's extremely rare for sponsor to survive all the way through. When someone does, my mood feels great for months. All the hard work of vetting them (and numerous other sponsors who failed) has paid off.
Most sponsors who survive tell me that no other investor has ever researched them as thoroughly as I have. At first I was shocked by this, but I now realize that many investors follow a "spray and pray" strategy (put their money into numerous investments that aren't fully researched, and hope that diversification protects them if something goes wrong). In my opinion, this is as risky as day-trading. When a bad downturn hits, many things that looked diversified during good times, end up going down the drain together. So my due diligence process works better for me.
Many sponsors also tell me that while it was uncomfortable to be put under this type of microscope, it also let them see things about themselves they hadn't realized before, and enabled them to improve their company and their offering.
At that point, I'm happy to tell everyone I know about the great new sponsor I've discovered. I feel first-class sponsors are rare, and spreading the word is the least I can do for all the hoops I make them jump through to earn my business.