506(c) syndication and real estate crowdfunding have changed the face of the passive commercial real estate (CRE) market forever. The days of requiring personal relationships with real estate operators are long gone, which has opened the door to a far more versatile arena. However, a lack of institutional screening has put individual investors under immense pressure to conduct due diligence on prospective CRE sponsors.
You must do this long before agreeing to any private equity real estate deal. Otherwise, you could be set for a nasty fall.
In this article, we’ll explain why due diligence on a commercial real estate sponsor is needed and how to conduct due diligence on a proposed CRE deal or on the operator or LLC.
Why Due Diligence on a CRE Sponsor is Needed
The CRE market can produce fantastic returns, but it does come with potential risks. You are quite literally trusting the operator to utilize your capital in the most effective manner to produce returns. All investments come with a degree of risk, but failing to conduct your due diligence can significantly increase those risks.
Potential negative outcomes include but are not limited to;
- Have money stolen by unscrupulous operators that won’t use the money as suggested.
- See your capital fall due to poor investment decisions by the operator.
- Long delays before seeing any return on investment.
- Increased stress caused by poor communication and a lack of timely tax form filings
Conducting Due Diligence on the Proposed CRE Deal
First and foremost, you need to know that the passive real estate investment opportunity is one that suits your risk tolerance level. There are several key factors to consider at this time as you look to match yourself to the right deal. Ask yourself the following things:
- Would you prefer high-risk, high-reward strategy or a low-risk, lower-reward strategy?
- Do you have a preference on the type of properties involved?
- Are you looking for a longer term investment or a value-add shorter term flip?
- Do you want to invest in a particular location or market?
While you will be trusting someone else to act on your behalf, an deal profile that isn’t right for you should be avoided. Any subsequent further scrutiny into the sponsor behind said deal isn’t necessary.
Conducting Due Diligence on the Operator or LLC
Passive commercial real estate performance relies heavily on the sponsor and its team, especially when a third party else will be utilizing your hard earned capital. Aside from giving you the best shot at selecting the right commercial real estate opportunity, this is an opportunity to put your mind at ease too. Focus on the following factors, and you won’t go wrong.
1. The Manager
Conducting the necessary due diligence in regards to the deal/funds sponsor is probably the most important aspect of the entire due diligence process. Key issues to analyze include:
- Experience levels. As a rule of thumb, experienced Managers are better equipped to succeed than emerging ones because they have been there and done it before.
- Transparency. An experience sponsor appreciates the importance of a thorough investor communications program. Your need to ask about the ‘how’, ‘where’, and ‘when’ your capital will be invested is no big deal for a qualified sponsor. Good communication is a key factor in the GP/LP relationship.
- Organization. Managing a commercial real estate investment requires juggling many balls. Make sure the sponsor you are working with has the ability to handle the responsibility of being a steward of your capital.
Background checks may also save you some headaches by uncovering principal or sponsor dishonesty or a poor track record.
2. Returns & Splits
The success of any investment ultimately relates back to money. So, you need to know the proposed figures. While the financial projections regarding the overall investment are one thing, your main concerns revolve around the investor returns and splits. The two key issues to look out for are:
- A preferred return, which is an agreement that means investors see their money before the Manager’s take their splits.
- A profit split that is at least a 50-50 share. In fact, most investors want at a 60-40 or 70-30 share instead.
While there are no guarantees on success, your capital deserves to earn the correct return for the risk you are taking with the investment.
3. Conservative Underwriting
Every investor wants to see a business plan that shows strong risk-adjusted returns. But you should avoid overly optimistic sponsors completely. Whether they are consciously or unconsciously leading you to a poorly underwritten investment is irrelevant. If any of the following red flags surface, you’ll want to look elsewhere:
- An unrealistic, base case scenario is used as a base case model
- No below the NOI line items are taken into account
- Very little information on the opportunity is shown
Essentially, conservative assumptions are far better than aggressive ones. Otherwise, even a good great return can feel like a letdown.
4. Documentation
Finally, all offering documents need to be analyzed and scrutinized. it. You should scrutinize the following files:
- Operating Agreement or Limited Partnership Agreement.
- Private Placement Memorandum (PPM).
- All tax-related documents.
Interested In Learning More?
Even after you’ve completed your due diligence, there’s nothing forcing you into a specific deal. Sometimes in life, you have to listen to gut instincts. If the sponsor or operator makes you feel uneasy, avoid it. It’s better to miss out on a good opportunity than swallow a bad one.
Besides, there are plenty of other CRE deals waiting for you.
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
