Due Diligence Matters
Private real estate firms can provide you, the high net worth investor, with access to institutional quality deals. This is an exciting new trend which has opened up new opportunities to millions of accredited individuals.
However, as a non-real estate professional, how can you properly navigate this specialized and opaque industry? There’s no easy answer, but fortunately, there are some guidelines you can follow to protect yourself.
Because these are private deals, you cannot assume you’ll have the information you need to properly evaluate the risks and merits of a deal. As a firm committed to transparency, we believe that an educated investor is the best partner.
Your money is at risk, so as with any investment, you need to do your own due diligence. We wrote this investor guide to help you in that process.
Suggested Investor Checklist
1. Transparency. When investing in the public markets, we’re used to the transparency available from annual 10K reports and other regulated requirements. In the private real estate market, you don’t have the same transparency. So you may not have the information you need, or the quality of information you need, to make sound investment decisions. That’s why we recommend that you only consider firms that are seriously committed to transparency.
a. Audited financials. As a first step in transparency, does the firm provide compliant, audited financial statements? If not, you may not be able to rely on what is reported to you.
b. Third-party administration. Another important way to gain transparency is to work with firms that utilize a third-party administrator. Third-party administrators can give you a higher level of confidence since they manage the financial and operational side of the venture. This frees up management to focus on their main business—real estate and can provide you with an important check and balance. Companies that are serious about transparency should have no issues using a professional third party administrator. Look for it when you evaluate your options.
2. Fee structure. Fees always matter, so be sure to check the fee structure out thoroughly. Investors should receive priority distributions before managers. Ideally, you as the investor should receive a baseline return, then share profits above that with the management.
3. Skin in the game. How much is the manager contributing to each deal? You want the manager to have enough “skin in the game” so they are extremely motivated to make every deal a success.
4. Specialization. All real estate is not the same. It’s best to look for a firm with some competitive edge which is often found through specialization. For example, Light Tower specializes in recession-resilient asset classes such as self-storage and multi-family housing. A niche can give you an edge, especially when the management team has skills in exploiting undervalued or overlooked properties.
5. Experience. As we all know in our respective professions, experience counts. When your money is on the line, you don’t want to be part of anyone’s learning curve, so it’s vital to evaluate the experience of the team. What’s their reputation? Who are their investors?
6. Economic Terms of Each Deal. If you are not an experienced real estate investor, there are many terms of the deal that you will need to understand. Having a tax advisor review it with you helps, but you should also seek to understand the structure and how it impacts you. Things to pay attention to:
a. Will leverage be used and if so what are the conditions?
b. What is required of the investor in the case of a capital call?
c. How is the deal structured between “preferred” units and common (the company’s interest)? These conditions can provide you with protections.
d. How often will distributions be made?
e. What is the tax treatment of distributions?
If you’re busy, find a professional who can review deals for you, so you’re not negatively surprised after you’ve already invested.
General things to note before investing:
1. Liquidity. When you invest in private real estate, you will not have a liquid investment. Find out the anticipated term of the investment. Are you prepared to keep your money invested for that entire time period?
2. Risk of Loss. Understand what happens to your investment in a worst case scenario. While it may not be probable, it’s certainly possible that the investment may not go as planned. Find out what happens if the project fails.
Final Advice: Avoid Promises of High Returns
As a high net worth person, you know that there’s no free lunch in life. Higher returns always require more risk. If a firm is telling you they can always generate high returns that should serve as an important red flag.
As an investor, you want to work with people who understand and respect risk, and do their best to protect your money and theirs, while making a fair return. Promises of high returns without equally high risk of loss may indicate inexperience or worse.
While none of this is rocket science, it’s easy to get burned if you’re not disciplined in consistently doing your due diligence. So please use this guide either yourself or along with your tax advisor or attorney to make sure you’re comfortable before signing on.