In my last blog post, 10 Ways to Reduce the Risk of Commercial Real Estate Investing I stated that it’s a myth to believe that owning commercial real estate is a passive investment.
I’m aware that for every rule there is an exception. Investing in a single tenant building, with a credit rated tenant, such as a Walgreens, with a 20 year lease and four, ten year options is certainly a passive investment. Both the risk (low) and the reward (modest) have been identified.
That said, for most investors who have money to invest and realize that they don’t have the expertise nor the interest or time to acquire and manage an income producing property, there is nothing wrong with seeking out an experienced real estate sage (sponsor) to latch onto. In fact I would encourage you to do so. That’s what crowdfunding is all about. Crowdfunding provides small real estate investors the opportunity to pool their money with other investors to acquire quality real estate while employing the services of a commercial real estate expert.
But whether you use crowdfunding or a more conventional word-of-mouth search for a real estate sponsor, there is wisdom letting someone else do the heavy lifting of investing if that’s not your strength. Your responsibility is to vet the sponsor that you’re placing your trust and your money in. Are they for real or are they a snake oil salesman, someone to avoid like the plague?
Here are some tips to consider when vetting your commercial real estate investment expert.
- Assess the sponsor’s real estate experience. More experienced sponsors have a higher probability of success than beginners. So how many years of experience does your sponsor have investing in commercial real estate? What is their track record? Have they ever lost money in investing in commercial real estate? How did they weather the Great Recession? Ask pointed, revealing questions.
- Assess the sponsor’s experience with the location. The sponsor may have an excellent commercial real estate investment track record but all of his experience may be located in one geographic region. Does he have any experience in the city where the investment is located in? Does he know this particular market?
- Determine how much money your sponsor is investing in the property. A while back I was asked to find financing for a property that had a nationally recognized commercial property investment syndication firm as the managing member of the LLC. In the investment memorandum they were providing a decent preferred return for their investors but I was unable to determine how much money the syndicator was investing in the acquisition of the property. It was purposely vague. So I asked. The answer was NOTHING. They were receiving a very healthy fee from their investors for putting the deal together and they were receiving excellent profits after the preferred return for the investor was achieved, but they were taking no risk whatsoever. If the property tanked they would not lose a single dime. All the risk was shared between their investors and the lender who had the most to lose.
- Carefully review the pro forma for conservative assumptions. Your goal should be to understand whether you’re dealing with conservative or aggressive assumptions. How do proposed rents compare to current market rents? Is the pro forma vacancy reasonable when compared to similar properties in the market area? Are proposed operating expenses in line with the historical operating expenses? If you’re not able to answer these questions find a third party that can and pay them for their time and effort.
- Review the profit splits. How are the monthly cash flows split between the investors and the sponsor? When the property is sold how are the gains split? Some will recommend that the investor should seek investments offering a preferred return. I’m not one of them, and here’s why. An investor gives up something for receiving a preferred return: he limits his upside potential gain when the property is sold. I would rather not have a preferred return so that I receive my pro rata share of the cash flow and the pro rata share of the gain at time of sale.
- Review all legal documents. Have a competent real estate attorney review the Operating Agreement of the LLC or the Private Placement Memorandum. Can you understand the legalese? If not, ask questions until you do. Does this legal document divide up risk and reward appropriately or does it inordinately favor the sponsor?
Very few commercial real estate investments are truly passive. In the next couple of years it will become readily apparent that some investors have invested with sponsors who have the morals of snake oil salesmen. Don’t be a lemming running with the herd head long into the ocean. Vet your sponsors to avoid this from happening to you.
Have a need for financing? Call me today to discuss at (503) 614-1808
Sources: Top 10 Steps When Reviewing a Passive Real Estate Investment Opportunity, astudentoftherealestategame.com, September 9, 2015; Crowdfunding’s Potential Pitfall, Marshall Saunders, ScotsmanGuide.com, November 2015.