JF1545: 7 Due Diligence Items For Passive Investors & Passive Investing Opportunities #SkillSetSunday with Hunter Thompson

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Hunter is back on the show today to share a valuable skill set for almost everyone listening. If you’re a passive investor, you can use this information to vet all the deals that come your way. For active investors, putting together deals and looking for money from investors, you can use this information to bring the best package to your investors possible. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

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TRANSCRIPTION

Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.

Because today is Skillset Sunday, we’ve got a special skillset for you, and we’re talking to you, passive investors – investors who want to passively invest in deals… And you know what, we’re also talking to deal sponsors (general partners), and I’ll tell you how we’re talking to both of you… For passive investors, guess what – we have a skill for you… And when I say “we”, I mean Hunter Thompson, our guest; I don’t have the skill that he’s gonna talk about in the degree that he’s discussing it, because he’s the one who has seven parts of due diligence that he recommends passive investors go through when they’re assessing an opportunity… And active investors – deal sponsors – listen up, my friends, because these are things that you should think about when you’re putting together deals and prior to offering the deals to your investors, because things will be evaluated… So how are you doing, Hunter Thompson? Nice to have you back on the show.

Hunter Thompson: Hey, thanks again, Joe. I really appreciate you having me on.

Joe Fairless: A little bit about Hunter – you probably recognize his name, and that’s because you’re a loyal Best Ever listener; episode 1220 he was on the show and he gave his Best Ever advice, so you can listen to that episode. He’s the founder of Cashflow Connections, which is a real estate syndication company. He has helped investors allocate capital to over 100 properties, with a combined asset value of 350 million buckaroos. He’s the host of Cashflow Connections podcast, and he’s based in L.A., California. With that being said, Hunter, do you wanna give a quick refresher about your background, and then we’ll dive right into the seven parts of due diligence?

Hunter Thompson: Sure. I think a lot of people listening to this really had an interesting moment when 2008 happened. I think that we saw the opportunity that was going to be there for people that didn’t lose their shirts, at least; that was definitely a light bulb turning on moment. That’s kind of how it was for me. Generally speaking, I like to be counter-cyclical, so when everyone’s really concerned about real estate, I jump in… And I’ve been really fortunate in the timing of the market, obviously, but also in the people that I’ve met. I built relationships with some of those people in the heart of the real estate collapse; it ended up being that a lot of them ended up being some of the most influential people in the real estate sector, particularly in the state of California, so I’ve been able to develop a network and develop a company ever since starting out as kind of a small family office, going from friends and family, to now we have about 250 investors, and spread across many properties, like you mentioned, so… Happy to talk about this today.

I think the timing of this conversation is really important. You mentioned the sponsors listening up, as well; I think in the conversation there may be some sponsors that start to cringe when we talk about some of the details of passive investment due diligence, but there’s been such a significant paradigm shift that’s taking place in the real estate investment sector. So many people have access to deals, and the amazing run-up we’ve had in the last ten years, people have been able to invest passively in real estate, particularly since the Jobs Act – they’ve been able to receive incredible results, generally speaking, because of how favorable the market has been. So I think it’s really important right now for passive investors to take an honest look in the mirror, look at their processes, how they’re making decisions on these investments, so that they can yield similar returns over the next ten years.

Joe Fairless: Seven parts of due diligence process – what’s number one?

Hunter Thompson: The first one – and really the entire thing is all really about this, which is the sponsor. If you’re investing in a passive deal and you’re depending on someone else’s expertise, the entire due diligence process is really focused on them. So when we talk about sponsor due diligence, some of the things that I look for – obviously, you wanna look at the track record, you wanna look at references etc, but in terms of actually validating some of the claims they’re making, some of the things I like to do is call their third-party service providers and verify that things match up with them.

I like to talk to the lenders, their CPAs, their attorneys… Not only their investors. Some of those are obviously gonna be biased, because they are the ones that send you those references… Anyway, but let’s say if they say that they have a contractor that’s completed 100 million dollars of assets with them, we can call that contractor and just verify that that claim actually matches up. And if you’re going through and verifying different things, you’re gonna have some yellow flags that pop up if they’re making things up and if they’re not being honest. So that’s really one of the things that I think is a really good idea – just contact the lenders, the loan companies in particular.

Something else you could do is you can pull title on properties that they claim to own… Because anyone can just point to a property and say “Oh, we own that massive office center over there.” Well, if you can actually pull the title, you can follow the entity trail, so that you can actually understand if that entity is the entity you expected it to be, if the property is in good standing, if there’s a lien against the property etc. I think those two steps right there are gonna really help you start to validate some of the claims they’re making… But at the end of the day, again, it’s a gut check. When I’m looking at a sponsor, especially up front prior to me funding, I wanna talk about how frequently are they responding to e-mails, and how frequently are they answering their phone etc, because if they’re not doing a 10 out of 10 job now, they’re surely not going to do it later once you have funded.

Now, keep in mind, most real estate investments are long-term, 7 to 10 year holds, so the real question is do you wanna deal with this person for the next 7 to 10 years? I think those steps right there – that’s a good starting process, for sure.

Joe Fairless: How does the investor pull the title on a property?

Hunter Thompson: Good question. There’s a couple of service providers that can provide this. Soldifi.com, Chicago Title Company and the RealQuest. Those will all be able to do that; it’s just a matter of who you like more, the prices that you’re trying to accomplish etc.

Joe Fairless: How much does it cost on average?

Hunter Thompson: You can do it for free if you have a good relationship with them, but I’ve seen anywhere from $50 to $150/title. If you have a relationship with the title representative, they’ll do it for free.

Joe Fairless: And when you get the lender’s contact information, what information will the lender provide you with if you are secretly looking into if they’re telling the truth about a loan?

Hunter Thompson: Yeah, that’s a good question. I personally would not typically go that route. I usually let everyone know that I’m gonna contact who I’m gonna contact, just letting them know prior to doing that, just so that we can get on the same page… This also actually provides an insight, because you basically “Look, if they’re gonna say anything weird, you can just tell me now.” That’s  actually something that saved me in the past. Same with running background checks, which is something you can do on tlo.com. They provide that, as well.

Prior to running a background check, I say “Is anything weird gonna come up on this?” Because number one, background checks don’t catch everything sometimes, and number two, they need an opportunity to explain if something weird happened in their past, or they have some yellow flags that may come up.

Usually, the lenders won’t give you specific information unless the sponsor is obviously allowing you to do so, but that’s the way that I handle that situation.

Joe Fairless: Number two?

Hunter Thompson: The on-site property manager… And I think this is important. This is something that Jeremy Roll says a lot – he’s a mentor of mine, and I know that he’s been on your program as well… Which is that you can invest in a 100% occupied property in Beverly Hills, that is in the most prime real estate in America, basically, but if the property manager commits fraud, everyone’s losing money. So I wanna look at the property manager, their relationship with the sponsor and how frequently they’ve worked with them before; do they have other properties in the market? Are they knowledgeable about the specifics of this particular asset?

Then I wanna look at things like what software do they use? What do the communications look like between the on-site manager and the sponsor? How sophisticated are they in some of those data points? And again, there’s a lot of different software companies out there, so you’ll get a lot of different answers, but if you start asking questions like this, you’ll start to see the range of what’s going on behind the scenes.

Joe Fairless: What’s a good answer, and what’s a bad answer?

Hunter Thompson: Well, Yardi is probably the industry standard. Each asset class, self-storage, has its own — a lot of people use U-Hauls, self-storage software, which is web self-storage… That answer is that they can scan a copy of the handwritten notes that they’ve provided. That’s the kind of person that we wanna buy a property from, not the kind of person that we wanna have manage our property… So that will kind of give you an idea.

Joe Fairless: Yeah. Okay.

Hunter Thompson: Number three is the loan, and I think this is really critical. Probably for most passive investors, they aren’t thinking about this as critically as they should. I would say that 99% of all the horror stories in the U.S. have something to do with debt financing. Loans coming due at the wrong time, you can have an inability to refinance, interest rates changing, stuff like that. Almost all of the stories that have to do with loss of principal have to do with the financing portion… And keep in mind, the financing is the majority of the purchase, so this makes sense.

There’s a couple of different metrics that I wanna look at, and it’s important to look at the entirety of them to understand who you’re dealing with. Obviously, loan-to-value is important, but what is that loan-to-value based on? Is that an appraisal? If that appraisal is the way that the loan-to-value is being established, is that appraisal based on after repair value? If there’s a significant capital expenditure, if there’s significantly rehabbing a property, that rehab needs to be completed before that loan-to-value is accurate.

So you wanna look at loan-to-value, and also you wanna look at purchase price, which will give you a more transparent understanding of the true worst-case-scenario if there was gonna be a problem, especially early on. You also wanna look at the debt service coverage ratio. Sort of the industry standard is usually somewhere close to 1.25%. In certain industries, let’s say mobile home parks in particular, you can see much higher debt service coverage ratios as you add value by raising rents. You can do so relatively quickly, because that asset class is on monthly leases.

And then you also wanna look at the interest-only period. This is something that you really have to read between the lines and understand this in order to assess the difference between two different properties. The interest-only period is obviously the time at which the loan is not paying down itself, and it’s just paying the interest only. Once that interest-only period is over, the payments increase. We usually see a range of 1-2 years, sometimes 5, but keep in mind, the longer the interest-only period, the more aggressive, the less time in which you have to pay down your debt before the refinance happens.

The really important reason that I mention this though is that if you’re looking at two properties that are relatively comparable, but one has a one-year interest-only period, and the other has a five-year interest-only period, you’re gonna think that the one with the five-year interest-only period is much more advantageous, but it’s because there’s a different risk component. I used to kind of think that if you were doing five years interest-only, that the sponsor was aggressive, because that’s kind of a long time.

But I especially think right now it’s interesting to take a look at properties where the loan-to-value is very low, let’s say 55% or so – then you get to have a five-year interest-only period, and the fact that you’re taking such a low loan-to-value means that you basically would be in the same position if you only had a one-year interest-only period with a more normal loan-to-value. I know that may be a lot of numbers for listeners that aren’t as familiar with these terms, but the whole point is that there’s a lot of moving parts to this, and it’s important to look at the entirety of the capital stack and the loan, debt portion particularly, to move these metrics around to see really at the end of the day who you’re dealing with, if that makes sense.

Joe Fairless: You mentioned the loan to purchase price – what range do you look for there?

Hunter Thompson: Typically let’s say 85% or so, I think that makes sense. We wanna invest in properties which are undervalued or we’re able to get a good deal, so… Typical commercial real estate assets, somewhere between 65% and 70% loan-to-value, so it would make sense if you were able to get a discount, loan purchase price would be in that 85% range… And I feel comfortable with that, depending on the overall big picture thesis of the investment.

Joe Fairless: Number four?

Hunter Thompson: This is about the property performance in the proforma. Looking at the proforma generally, if you start to look at the proforma and ask questions about the proforma, you’re going to be one of those few investors that actually does this. One of the things that I think is a really good starting point is to either look at or request the Trailing 3 and Trailing 12 month financials for the property, and compare those previous financials to the year one, year two, year three projections. And really, the thing you wanna look at is what are the major differences between the Trailing 12 month financials and the first year; and then any big differences that come up, you can ask the sponsor to kind of validate that.

The biggest one, and probably the first thing that I usually look at, is the operating expense ratio. If something is off there, you can then find out what it is, but if you have a property that is operating in the 55% operating expense ratio, meaning that 55% of the income is going towards operating expenses, then in year one that jumps from 55% to 45%, you really wanna figure out what is changing that’s validating that? It’s not a red flag, but it is something worth asking about.

When you go through and ask those types of questions, you’re gonna get some really interesting answers and it’s gonna paint a much more clear picture as far as how detail-oriented the sponsor is being in that underwriting and how he validates that change in operating expenses.

Something else I think is important is cap rate expansion or compression. I think right now a  conservative underwriting standard for the cap rate — let’s say you buy a property at a 6-cap, and you’re holding it for ten years. I think that 10 basis points per year is a pretty conservative route to go. That would mean buying a property at a 6-cap, estimating to sell it at a 7-cap. Now, it’s not necessary to underwrite it like that, but I think that it’s a good sign for me if I see that. One of the things I caution people about is sometimes sponsors will say that they’re underwriting to a 10 basis points per year expansion, but they’re saying that they just got a screaming deal on the property; so they may be buying at a 6.5-cap and saying that it should be a 6-cap, and therefore they’re buying at a 6.5 and it’s turning into a 7 by year ten. But that would be closer to 5 basis points per year, if you’re following the math on that. And again, I know it’s a little bit confusing, but this is the kind of stuff that actually makes a huge difference, because the multiple of your income that you’re trading in at the end can make a huge impact on the overall return profile of the deal.

Joe Fairless: And if that was a whole lot to take in, a simple question you can ask them is “What’s your going in cap rate? What’s your projected exit cap rate, and how many years are you planning on holding it?” and then you can just determine if they are adding 10 basis points per year for the whole period… Or sometimes, if they’re just keeping the cap rate flat, or *gasp* if they’re saying the cap rates will be lower at the exit – I mean, that’s a huge red flag.

Hunter Thompson: Yeah, I appreciate you jumping in there, because that’s actually a much easier way of explaining what I was just explaining… But really, the question is “Is there a cap rate expansion? Is there a cap rate compression? What’s the rate at which that takes place?” and justifications for each.

Joe Fairless: Number five.

Hunter Thompson: This is really the market itself. The main thing I wanna look at is diversity of employment. And again, this is just my particular perspective, but I like to be in markets that are a 35 to 40-minute drive away from half a million population in the major metro. If you do that, generally you’re going to have a good mix of medical, education, government, tech and hospitality. I would say that tech in particular – there’s markets all over the place… Austin, which is obviously a great market, Denver, which is obviously a great market – they’re getting a ton of really high-paying jobs, but a lot of the tech companies are funded by VC firms; that money may or may not be there in terms of the next 5 or 10 years. It’s a cyclical business. But nothing is more cyclical than hospitality.

Look at what happened to Vegas during the last correction. It’s the first thing to go. So you don’t wanna be in a market which is over-exposed to hospitality. You may be hesitant to be in a market that’s over-exposed to high-end tech, just because it’s uncertain, a lot of these companies aren’t profitable etc.

I personally don’t like to be over-exposed to government. I don’t like it if there’s basically one tenant. I’m looking for true diversification, so that population factor is a big piece of this, but then you do have to look at the economics of the market itself. One of the vehicles I use for that is esri.com. They have a business analyst. Pretty inexpensive for what the value is… Yeah, esri.com, business analyst – that’s a good resource for anyone that’s listening.

Joe Fairless: When you say “over-exposed to hospitality and government”, what percent or how do you quantify that when you’re looking at it?

Hunter Thompson: That’s a good question. I don’t have a good number for that, because I try to stay really far away from that… But there’s some markets where, let’s say right next to an airbase, where there’s not really  a lot of population except for the air base. That would be a red flag for me. But I’m looking for a good mix, and in the market that we look at, the mix is so significant that we’re avoiding getting into that level of detail.

Joe Fairless: That’s an important thing for us as deal sponsors… As are these other things, but this one I want to mention – we look at if there’s a market and a submarket that’s more than 20% of any one industry, then we’re gonna dig deep and figure out what industry that is, and if we’re fans of that industry or not.

Hunter Thompson: That’s good to know.

Joe Fairless: Number six?

Hunter Thompson: This is the property itself. Again, this is just my perspective; I have a very niche perspective on investing as a whole, but some of the things I like to look for – again, diversification of the tenant base. With self-storage, I like to look for 400 units or more; that’s usually 50,000 square feet. With multifamily, I think a lot of investors look for 100 units or more; some people like 200 units. Really the whole point is if 10 tenants move out, are you gonna have a problem with cashflow? If 10 tenants move out of a self-storage facility with 400 units, no one is gonna know, including the investors. With something like office or retail, I like to see 10 or 13 tenants. That’s one of the challenges for me with office – there’s not a lot of buildings that have 13+ office tenants around.

The key is that the businesses can be very cyclical, businesses go away, it’s a company, they don’t care, there’s no emotional connection to the place… You can have challenges like that. With senior living, similarly, I like to see 100 beds.

Some of the other metrics – the daily travel vehicles is an important metric. I personally at least get a little bit uncomfortable if it’s less than 20k daily travel vehicles per day, but it’s really important to know if there’s visibility from those daily travel vehicles. Can 20k people actually see your property, or are you tucked away under an underpass where there’s 80k right above you, but you can’t really see it; I’m making a point, but I think that that’s actually kind of important.

And then also the physical occupancy. That’s gonna help you in the risk profile overall. Under 60% is usually outside of our risk profile. And mobile home parks are unique, because you can buy them cash-flowing at 60%, obviously. 80% usually lowers risk, but you’re able to add some value. 90% occupied – usually it’s a stabilized asset; you may be able to raise rents etc. but if you’re relying on cap rates, I think it’s challenging at this stage of the cycle. But I think those are some good property due diligence.

Then you go through the things — the big ones that can really cause problems are things like roofs, electrical, plumbing… Elevators are very expensive. We had to fix one once in a property a couple years ago. So those are some of the things that I look at when it comes to the property itself.

Joe Fairless: And number seven…

Hunter Thompson: Number seven is probably gonna surprise some people, but it’s the legal documentation. At the beginning I mentioned that the sponsor themselves are really what this entire thing is about. Every single thing you’re looking at, when you’re asking questions to the sponsor, you’re really trying to understand who they are as a person and how they operate as a company. The reason for this is that if you’re a passive investor and you’re investing 50k or 100k, you very well could chase $100,000 by spending $100,000 in court if something goes sideways. So the legal documents are the least important; they’re still incredibly important, they’re on the list, but when it comes to the order of importance, that’s why. But when you are looking at the legal documents, the first thing I’m looking at is how much money are they raising and is the money appropriate to be raising with or without a PPM.

Most attorneys — this is a grey area thing, but I’d say that if you’re raising more than a million dollars, if you have more than ten investors, that you should be using a PPM; just my opinion, not legal advice… But that’s something I wanna look at.

And then within the PPM, what is the quality of work? Is it a legal firm that I recognize or that someone in my network has worked with in the past? But also, does the legal documentation actually match up with my going in perspective of the deal? Does it match up with the executive summary? Is it fair to investors? Do they have voting rights? If so, under what circumstances do they get to vote?

One thing that I think is a complete non-starter for at least the way that my company is set up is we do not have mandatory capital calls under any circumstance… So we cannot invest in deals that have that stipulation or provision in there. But those are the things you wanna look at – do they require additional capital calls? If there isn’t a requirement for additional capital call, what do the terms look like if you violate that requirement?

Those are the kind of things that you really start to get an understanding of “Are they trying to paint a fair picture? Are they trying to stack the deck in the sponsor’s side, or are they trying to make things fair? Does it look like a contract or an agreement, or does it look like a complete “Never invest in this deal. Okay, sign your bottom of your lane. Here’s the wire instructions.” So those are kind of the things that I look for when it comes to legal documentation.

Joe Fairless: How can the Best Ever listeners learn more about what you’ve got going on and get in touch with you?

Hunter Thompson: I’m the founder of Cashflow Connections. You can go to CashflowConnections.com. I also host a podcast, which you’ve mentioned, which is the Cashflow Connections Real Estate Podcast. And I created a mentorship program to talk about some of this stuff. I think it’s really important to focus on this stuff right now. That’s the cfcmentorshipprogram.com.

Joe, I wanna tell you, we just covered so much… This is why your show is so awesome. You have a 30-minute program in which people are getting unbelievable content, so again, it’s an honor to come on and I really appreciate it.

Joe Fairless: I’m glad that you came prepared and you gave us a lot of really good information… And who cares if I’m glad or not…? I’m sure the Best Ever listeners are very glad, and grateful, too… So thank you for being on the show. Seven parts of due diligence as a passive investor:

  1. Sponsor.
  2. The property manager and the communication, and correspondence and the technology that they use with the asset manager.
  3. The loan. You gave us some things to look for with the loan.
  4. The property proforma.
  5. The market.
  6. The diversification of the tenant base.
  7. The legal documentation.

Thank you for being on the show again. I hope you have a best ever weekend, and we’ll talk to you soon.

Hunter Thompson: Thanks again.

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