Identify strategic risks & rewards before you invest.
Real estate has always been regarded as an equal-opportunity wealth creator. However, caveat emptor: Real estate historically has been full of scams. Based on my experience managing distressed real estate funds, that fear of being deceived and losing it all is the number one reason why smaller investors don’t invest in commercial partnerships.
These 10 essential questions will teach you how to clearly identify the strategic risks and rewards associated with any partnership deal.
Question #1: How much is the operator (the person managing the deal) investing personally?
When somebody comes to you promoting an investment opportunity, you should ask them directly: How much is their stake in the deal? They should have a meaningful, personal stake in the deal. Although this is not a rule of law, especially if this is your operator’s first deal they should put some meaningful skin in the game because the risks are quite high that they will make mistakes.
Why it matters: If the operators don’t have a stake in the deal and things go wrong, they are likely to walk away from it.
Question #2: Is there a huge upfront fee or load?
Never take your eyes off the fees. Fees should be considered as imagined, meaning they are paid after the investment process has begun. If the fees come off your investment up front – for example, they take 10 percent off the top of a $1,000 investment – that is a bad deal for you. You will start out with a $900 investment instead of your original $1,000!
Why it matters: Sophisticated, experienced operators know that fees structured as “a load” or taken up front are not good for investors or investments.
Question #3: What is the exit strategy?
When you ask this question, you are asking, “How will I get out of this investment?” It is not an unreasonable question. Do not invest in any real estate funds that present no clear-cut exit strategies for their investors. There are only two ways investors can get taken out of any commercial real estate deal: One is a refinance, and the other one is a sale.
Why it matters: You should partner only with an investment group that is either capable of successfully closing a sale or qualified to get the property refinanced to get its investors taken out.
Question #4: How many smaller investors do they have?
When managers or operators say, “Well, we were taking $50,000 as a minimum, but I’ll let you in for $10,000,” that usually means that they are desperate. They may be raising a lot of money
by pulling the wool over their investors’ eyes about what volume of investment capital they need. This is not the same as a manager who says forthrightly, “We would prefer $50,000, but we’ve taken eight investors on at $10,000” or “We set our minimum at $10,000.”
Why it matters: If the managers thought they could get enough investors at $50,000 and have been unable to do so, that may indicate trouble somewhere. Ask yourself if (and why) “bigger money” might have walked away from the deal.
Question #5: Where does the money go?
You’ve heard people say, “Follow the money.” Investors should ask their fund managers questions about where their capital is going. Ask your prospective fund manager:
- How do I see where my dollar is going?
- Where in the capital structure will my investment dollars go?
Why it matters: If your prospective fund manager appears clueless about the future location of your investment capital, think twice before you proceed with that investment plan.
Question #6: What is your operator’s experience?
Many potential real-estate investors buy on emotion and won’t ask questions about their operator’s experience(s). You must ask questions like these:
- Did the operators ever do anything tangible with real estate?
- Were they an entrepreneur beforehand?
- Do they have personal experience with the type of project they are managing?
- What kind of financial backing does the project have?
- Where is the asset located? In my experience, the right thing to do, professionally (for the manager) is to get into an asset that is within an hour’s drive from home.
Why it matters: Inexperienced operators tend to make more mistakes with your investment capital, and managers who cannot visit their assets are less likely to notice problems developing.
Question #7: Are they overpaying for the asset?
Of course, your operator may not answer this one directly. It will be up to you to do the detective work on this one. One red flag will be if the operator is not using any of their own money in the project. If they are not using their own capital, what do they care if they overpay for the asset?
Why it matters: If your operator has no stake in the deal, they will not really care about the safety of the capital in the deal. That is one of the biggest dangers in the industry.
Question #8: How much leverage are they using?
Leverage has always been referred to as “the juice” on the street. Leverage is good sometimes, but if your operators are using too much of it, they’re probably trying to use that juice to make a marginal deal look like a home run. This leads to higher prices being paid for properties that may otherwise have cost less than that.
Why it matters: It will likely be difficult to sell such an asset in the future, and you may not be able to ever recover your initial investment.
Question #9: What other assets does your operator currently have?
Ask to know the intention of your operator’s crowdfunding exercise: Are they raising money from you to pay off legacy assets that are not that good, not as desirable, and not performing that well? Are they paying off their previous bad investments with the new money they have raised from you and others?
Why it matters: The answers will indicate your potential fund manager’s level of expertise and motivations for the project.
Question 10: Do they have partners?
If yes, do you have a partnership agreement or a document that clearly defines your working relationship? Don’t hesitate to probe your potential operators until you get a satisfactory answer concerning this question.
What you want to hear: The best-case scenario is a couple of experienced operators working together after a long time off. The last thing you want is a bunch of folks who haven’t worked together before, and husband-and-wife teams are red flags too.