JF2445: 10 Questions to Ask Before Passively Investing | Actively Passive Investing Show With Theo Hicks & Travis Watts

May 13, 2021 | Joe Fairless | 00:25:58

JF2445: 10 Questions to Ask Before Passively Investing | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis share 10 questions to ask before passively investing. 

 

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TRANSCRIPTION

Theo Hicks: Hello, Best Ever listeners, and welcome back to another episode of The Actively Passive Investing Show. As always, I’m Theo Hicks, with Travis Watts.

Travis, how are you doing today?

Travis Watts: Hey, Theo, I’m doing great. Let’s rock and roll.

Theo Hicks: So today we are going to review some questions that you as a passive investor should ask the commercial real estate operator, the sponsor, whoever it is you are passively investing with. So this is based off of a blog post that we wrote, and Travis and I as always are going to elaborate on that and give us more of our personal perspective on that. But these questions are coming from an actual sponsor and an operator. So these are the frequently asked questions that they have received, and kind of condensing them down to five major themes. And I have a lot of experience on the active side as well, and I agree with these questions one 100%. Travis is a full-time passive investor, he also agrees with these questions. And then we’ve got some bonus questions, so I guess it’s more than five questions, that we’ll go over at the end. But in a sense, that’s why we are talking about this today.

So before we dive into those questions, Travis, anything else you want to mention?

Travis Watts: Yes, I think you hit it right. It’s a mash-up, inspired by the blog post; I took the blog post, took some of the content there, kind of went a little above and beyond, put some of our own spins on things. So yes, I think it’ll be really good. Everyone kind of loves a quick and dirty “Here’s three things you must do, one thing I wish I would have done.” So that’s what this episode is, and maybe a short one, but I’m excited to get into it.

Theo Hicks: Perfect. Let’s jump into the first question.

Travis Watts: Sure, I’ll do the first couple, and I’ll hand it over to you after that. So the first one is, as a passive investor, you want to ask whether or not the person you’re looking to invest with is an operator or a syndicator. I’ll define the two. So an operator would be a group or person who actually acquires the property, sells the investment, they’re going to manage the business plan, they’re going to be very hands-on, very active, they’re probably going to raise a portion if not all the capital for the deal itself… So that’s what an operator is. And these terms get used interchangeably.

Theo Hicks: Exactly.

Travis Watts: I’m notorious for doing the same thing. But a syndicator, technically, they may not operate the actual investment. So they may be the co-sponsor or co-GP, or they may just raise capital for a group, or just have certain duties in alignment with the firm, but they call themselves a syndicator, because they’re perhaps not actually operating per se, the actual deal.

So the bottom line here is, you want to know whether the compensation model is aligned with the success of the actual project. That’s kind of the key. So in other words, is the compensation of the operator or the syndicators based on the cash flow, the value of the deal? Is it based on something else, like maybe a management fee or a percentage of the equity that they raised for the deal? Or maybe it’s a combination of both, but you just definitely want to be aware, just for your own sake of due diligence, just to know whether or not this person is truly in alignment with this deal that you’re investing in.

So one of the greatest things about investing in syndications to me is that you do have people co-investing with you, unlike the Wall Street model, where they say “Oh, just buy a bunch of these funds and stocks and things”, but they’re not actually investing in those things, oftentimes. So there’s a little lack of alignment of interest there. So that’s number one.

And then quickly, a number two, I would say always ask the difficult questions. The notorious one is “Tell me about a deal gone wrong.” Most material you’d receive in a pro forma or an overview is obviously going to be positive, right? It’s going to be the rosiest looking, best pictures of the best properties and all these things looked over 1,000 times. So ask about a deal gone bad.

The key is that you want to learn how an operator or a syndicator managed the situation, that’s really what you’re looking for. It’s not to say, “Oh, you’ve had a deal gone wrong? Well, I’m not investing with you.” Anybody knows who’s a true investor or a hedge fund manager or whatever you are, you’ve had deals go bad, you’ve had stocks that have lost money; things go wrong. It’s the real world.

So if you’ve never had a deal gone bad, or so the GP is telling you, it could be a lack of experience;  maybe they’re just the newer operator, they’ve only done one deal and it hasn’t gone bad. So technically, they don’t have a deal gone bad. So that could be attributed to lack of experience or track record. And it could be a cover-up, too. So that’s what you’re trying to uncover, is,are they being transparent, telling you the truth? And if they had a deal go bad, what did they do about it? How they handled it? Did they make the investors hold? Did everybody just take a big loss and they walked away from it? What happened?

So it just helps you. Again, you’re just trying to read between the lines always as a passive investor to figure out, does this meet your goals? Are these people being transparent? Do I want to be in a business relationship for 3, 5 or 7 years with this particular group?

Also, one thing to tag on to that – I like to ask these “what if” questions. I’m sure a lot of operators don’t like this, that I do that. But I like to be the devil’s advocate. What if the Fed raises interest rates to 6%? What if we’re back in the 2008 recession in five years? What if this bridge loan doesn’t work out and we can’t refi? I like to ask all the “what ifs”. And I would encourage you to do some of that; don’t make that your whole conversation, it’s a huge turnoff. But definitely do get those in there; kind of mix them up with tell me something good, and then tell me the what if. Bottom line, align yourself in philosophy, check for red flags, do your due diligence. So those are the first couple, Theo.  I’ll hand it off to you.

Theo Hicks: Yes, question number one, I never thought of that one before until I heard Ryan Gibson say that.

Travis Watts: Yes.

Theo Hicks: And it’s interesting, because again, as a passive investor, you can kind of gauge and figure out how experienced and trustworthy this individual is. So obviously, then by the time a deal went wrong, it can indicate their level of experience and how transparent they are. But the operator or syndicator thing is interesting, because you can have two people who state that they’ve done $500 million worth of deals, but being an operator with $5 million worth of deals comes with a lot more expertise than simply raising capital for those deals. They’re both pretty big deals, but if you’re raising capital and then you’re also asset managing and you’ve found the deals and you’re overseeing the property management company, I would be more trustworthy of that person and giving them my money, than someone who’s just simply raising capital and doesn’t necessarily have all that control of the business plan.

I really like that question. Obviously and I like Travis’s “what ifs” as well; again, don’t hop on the phone and immediately start doing that, but I think those are all amazing questions. And again, you’re just kind of gauging their transparency to kind of just tell how they answer these questions if you can trust them.

Break: [00:07:14] to [00:09:15]

Theo Hicks: So number three is going to be what are your mission, vision and values? So this is in a sense going to explain to you the whys, right? Why are they doing what they do, and then how are they doing it. And if you look at Ryan Gibson’s company, they have a lot of mission, vision, values on their website. And the way I think about this is, it kind of gives more of a professional feel when they have that well-defined mission, well-defined vision, well-defined values. And then if you see that they’re actually aligned with those values and they’re living out those values, they’re hiring people based off of those values, they have that culture, you can make sure that that actually aligns with what you want, what your mission and what your values are. Everyone’s got different reasons for why they’re doing what they’re doing, and you might have that extra connection by investing with a company that has the same why or mission statement in life as you.

And then a really good practical tip – make sure that they don’t have what’s called the say/do gap. Because sure, I can just create this really nice mission and say, “This is our vision and then here are our values”, but we need to actually live these out. So a practical tip would be to ask them not just what are your mission, vision and values, but ask, say, “What’s an example of a time you’ve recently used your mission or recently use your vision or values to make a business decision?” This really isn’t a deal-breaker if you don’t have a mission, vision and values. It’s kind of like an extra thing that gives extra credibility, extra professionalism, as we mentioned, that it’s important to build trust.

And then number four would be asking questions about their team or who is on their team. So it’s kind of like a multi-layered question. First, you want to make sure that the actual structure of their team will set the deal up for success, right? So you don’t want just one guy or girl just doing everything. They’re the asset manager, they’re the director of acquisitions, they’re the investor relations person. You want to have an actual company that has the GP at obviously at the top, but then they’ve got a bench of executives and then directors and managers and analysts and assistants and associates… Basically, they’ve got a group of people who are exclusively focused on one part of the actual business.

And then similarly, you want to make sure that — again, this is not a good deal-breaker, but it is better when more things are in-house and less things are contracted out, because that’s going to have a higher level of alignment of interest. So on the one hand, everything could be outsourced – general contractors, property management, compliance, even underwriting and accounting sometimes… Or it could all be in-house, right? The company could have an investor relations person, a director of construction management, an in-house legal compliance person, they have their own in-house property management company, underwriting team, things like that.

So understanding that they have these individuals covering these roles, and then ideally, those are actually within the company… And then also what are the qualifications for each the individuals who are covering these roles? Are they coming from something that’s completely different and then you’re training them to do that? Or do they have a long track record in property management or in underwriting and then you’re bringing them on? So basically, that they have top talents, and are not creating top talents.

None of these things that Travis mentioned are absolute deal-breakers. If they don’t have an in-house product management company, it doesn’t mean you shouldn’t invest with them. These are just things you want to know, because these minor distinctions do create a higher level of alignment of interests. And if that’s something that you really, that’s’s very important to you and your investment goals, then, obviously, you’re going to want to invest with a company that has that higher level of alignment of interests.

Travis Watts: Exactly. Well said, Theo. We’re all so different as investors; there just isn’t a one-size-fits-all. So this is all just some food for thought. Take some notes; I hope everyone listening is just taking a few bullet points here. It just helps you get a little bit better each time you do an investment. “Oh, I should have asked this question last time. I’ll ask it next time,” that kind of thing.

And to your point, Theo, it’s tough to be great at everything, so hire experts in each area of the business. That’s a quick summary of that.

So last one, and then I’ll throw in some bonus stuff that I’ve put in previous presentations and stuff. I like to find out what the core business model is. What I mean is, just because someone’s involved in commercial real estate or they’re syndicating or they’re an operator, it doesn’t mean that that’s their core business. There’s a lot of folks that are just getting started in this sector and they’re full-time W-2, or they’re active duty military or whatever they are, they’re kind of 9-5 over here and then they’re [6:00] to 9:00pm over there, or they’re working the weekends or something on the side hustle. And there’s nothing wrong with doing that. Think of it this way, though… To me anyway, I like to seek out full-time operators, because it’s fine if you have a podcast or you do some coaching or you do some little side gigs, but I like the primary focus to be on the actual investing or the investment itself. Because at the end of the day, think about it – a general partner is basically a money manager, from my perspective. I’m a limited partner, I’m saying, “Here’s a check for $50,000, go do your thing. I trust that you’re going to do the right thing.” So I’m less inclined to do that with someone that says, “Oh, I’ll check on that investment next week, or maybe this week, and if I have time, I might look into how things are going.” It’s like, “No, I want to know right now how things are going. If something happens on the property, you need to be aware, you need to be on top of that. This needs to be your job. This needs to be your career focus.” So that’s how I see it. Everyone’s going to see that a little bit different.

So those are the five questions loosely based off the blog, loosely based off Ryan Gibson, as you mentioned, at Best Ever Conference during his speaking event. I want to give you maybe five additional quick bonus round questions. These are things, as I mentioned, I’ve put in presentations and stuff; just questions I ask as a limited partner. So if you’re taking notes, I’ll be brief. I’ll be quick, to the point.

I like to ask “How do you handle key person risk?” What that means is if a general partner quits, retires, passes away, leaves the partnership, gets in feud and it breaks apart, what happens to the investment? What happens to me, a limited partner, in that deal I invested in with Joe Schmoe and whoever else? If they’re no longer part of this picture, what am I left with?

There’s different things here. There could be insurance policies in place, there could be other staff members in place. If there’s more than one general partner, usually the other will take over… But you just need to know. Again, not a right and wrong answer, just be aware. It’s a due diligence question.

The other thing I like to ask is, “Do you have a stress test or a sensitivity analysis?” I was mentioning those “what if” questions; what if interest rates do this? What if occupancy does that? Usually, that’s addressed in what’s called a stress test or sensitivity analysis, which shows you these bad scenarios that could play out and what that means for the overall investment itself. So if they have that, maybe ask for that first, get your questions answered there, and anything that doesn’t address, you can ask additional “what ifs” after that. So a little helpful hint there.

Number three, does the GP co-invest in the deal? We talked about that loosely; that’s very important, to me, and it’s one reason I shied away from doing a lot of the stocks, bonds, mutual funds and into real estate in the syndication space, because I feel like it’s more of a partnership. I feel like it’s more of if the ship’s going down, the captain is going down with it. We’re all in this together, we all want this to work. It’s not just you should go invest over there and then that didn’t work out and it’s, well, I’m off the hook. I didn’t invest in myself. So how much, that’s up to you if you want to ask that question… But for a successful general partner that’s been in business a long time, they’re usually putting in an adequate amount of money into a deal; it could be 100k, it could be even a million bucks… It just depends on the deal size and how wealthy the individual is, but more importantly, how long they’ve been doing this. If it’s your first syndication deal and you’re a general partner, maybe it’s only 25k. I’ve seen some people not co-invest. And again, it’s not to say never do a deal if they don’t co-invest. It’s just to know, are they, and how much, and am I comfortable with that, is that a good alignment of interest? That’s all you’re trying to figure out.

Break: [00:17:27] to [00:18:07]

Travis Watts: Number four is are the projected returns gross or net? So gross,  I’ve seen pro forma this way, where it’ll say 10% cash flow on this deal. Well, they didn’t tell you that they’re going to take 2% out of that, and then 1% over here and then at the end of the day, you’re really getting 7%. You need to know that was a gross number displayed on a pro forma. Usually, it’s a net number. They’re showing you projections based on “We’ve already factored our cuts and our splits and everything else”, when you look at IRRs and things like that.

And last but not least, is the operator projecting a higher exit cap rate? The reason I bring this up is we had a confusion comment on one of our videos that we did previously when I was making this comment… But here’s the thing, if you’re buying at a five capitalization rate today in the market, to be conservative, you’re wanting the GP or the operator to project a higher cap rate. That’s not a good thing, by the way; that means the market’s soften, that means the purchase price went down… This is not what you actually want to have happen. I want to make that very, very clear.

But to be conservative, what the GP or the operator is doing is they’re saying “Even if the market softens in the future, even if demand falls for this type of asset, even if interest rates go up, even if bad things happen, even if employers move out of the city, if all that goes bad, these are still the projections that we think we can hit with this type of investment.” Versus doing the opposite, which is what you actually want to have happen in reality – you buy at a 5-cap, you sell it at a 4-cap. That means the market’s compressed, the purchase price went up, the demand was heavier. That’s great, and that’s what we’ve been seeing for years and years and years. But just like with interest rates, we’ve been seeing it for years – interest rates are dropping and dropping and dropping. It doesn’t mean they’re always going to go down. It doesn’t mean we’re going to go negative interest rates. We might, but we might not. So you always want to anticipate, what if interest rates go up, even though we’ve got this 20 year or 10-year track record of going down.

So that’s the last thing I like to look at. I’ve seen a lot of—I don’t even want to say newer operators, but I’ve watched some different presentations where they leave that part out. They say, “Here’s your projected returns, all is well, it’s all rainbows and butterflies.” And then I ask them, “Hey, what about the exit cap rate?” And it’s exactly what I described. “Yes, we’re buying at a five, we’re going to sell it a four.” And it’s like, “Man, too aggressive,” in my opinion, too aggressive. But everyone has their own criteria, you may personally be comfortable with it. I’m not. So those are my five bonus fire round questions to ask.

Theo Hicks: I’m going to say for that last one, I’m not going to say [unintelligible [00:20:39].28] but I will say that a lot of the really big billion-dollar-plus operators out there, that’s what they do. I just did another blog post a month or two ago that was analyzing some of the major COVID takeaways from an operator who manages a fund of $3 billion or something like that. And her big thing was—I can’t remember exactly what it was, but I think they had a full percentage point higher after five years, not even 0.1% per year, but 0.2% per year on deals. And this was before COVID, just to be conservative. But as, Travis said, do whatever you want; this is kind of what we do and what we see other people doing.

But that first question you did, about the passing away, whenever you bring that up, I always want to know what they say when you asked that question; like, what’s like a common response you get?

Travis Watts: Usually, there’s more than one GP or co-sponsor. So the simple answer is, “Well, if I pass away, we’ve got this other guy or girl that’s going to take over.” And then of course too, key man insurance can be key as well. So you can kind of insure against losses and things like this, additionally. But I’ve heard some interesting responses, but what you really don’t want to hear is,  “Uh, …” Crickets. You want to hear that they know what you’re talking about, first of all, and that they just thought about it, that’s it. It’s like, “Oh, yes, we have a plan for that. This is probably how we would do it.” They may not know exactly how they’re going to handle it, but if they can just speak to it and say, “Well, we might do this, we might do that. We’ve got a couple options here. It would depend on this, that or the other…” It’s just that they’re cofident. It’s all you’re really looking for, that they’ve thought things through.

Theo Hicks: Yes, that kind of plays into my final thoughts in all of this, is that just in general, when you’re having these conversations with typical operators, and really like when you’re interviewing anyone for anything, my mindset is that I don’t want to trick questions or stump them,—

Travis Watts: Yes.

Theo Hicks: …but you kind of want to see if you ask them a question that they don’t necessarily know the answer to, like, “Hey, what happens if everyone that’s on the GP dies? What do you do?” And you get that, “Um..,” and then they start just saying things they clearly aren’t— they’re just winging it on the spot, just like making something up just to answer the question. That’s always been a major turnoff for me. I’d rather just have someone say, “I’ve ever thought of it before. Here’s what I think we would do, but as Travis said, it’s just it was not a set-in-stone plan.” Or, “Hey, we don’t have a sensitivity analysis, but we’re going to do that and I’ll send that to you.” Or, “Hey, I don’t have the information off-hand, but I’ll send that to you,” as opposed to just making something up.

So a lot of these questions, the answers are going to depend on what you’re comfortable with. We can’t really tell you what the absolute 100% correct answer is to all these questions. It’s really just where are you at and then how you feel, actually having that conversation. Do you like this person? Is this person someone that you like? Because when you like someone, you’re more likely to trust them. And if you just kind of feel a weird tension or awkwardness or you don’t like them, even if all the boxes are checked, that’s just something to be aware of. So it’s kind of like an intangible that you can’t really ask like, “Hey,  should I like you?” Or, “Are you trustworthy? Are you likable?” Like, of course they are going to say, “Of course, yes, I’m great.” That’s more of like an intangible feeling that you have, and I think that’s something that’s very important, too, when you’re having these conversations. So those are my final thoughts. What about your, Travis?

Travis Watts: Yes, that’s a great point. And I had somebody tell me once, they said, “I don’t have good intuition. I’m not good at judging or knowing or understanding people.” And I said, “Okay, do you have a spouse? So that may be on these calls that we’re talking about, could they sit in with you? Or maybe it’s a friend or maybe it’s another investor that you know,” and do a call that way and then as you wrap up the call, you can kind of have a little powwow and say, “What did you think about this and that?” And that can help you too if you’re that kind of person; I just want to address that.

But three goals as a limited partner – what’s the high level, the big picture here when your passive investing? I’d say number one is align yourself with operators that you know, that you trust and that have a high probability of actually executing the business plan that they’re showing you, that’s probably first and foremost.

Number two, you’re doing the type of business model that you know and understand; keep it simple. The one time I lost money in a pretty big way – it wasn’t in real estate, it was in a private placement – I didn’t understand all the inner workings of what the business actually was. So I partnered with them and I thought, “Crap.” In hindsight, I wouldn’t done that. Had I known obviously, I wouldn’t have, because I lost money. But I meant just had I known actually what it was fully, I wouldn’t have invested.

And number three is you’re seeking a risk-adjusted return. We’ve talked about that a lot on the show, but a risk-adjusted return that helps you achieve your goals. And everybody’s goals are different. To your point, Theo, we can’t just give a black and white answer or suggestion, because Sally wants $10,000 a month passive income and Joe wants $3 million net worth over here, and they’re different ages and they have different priorities. One has a family and one doesn’t… So many factors. We’re not financial advisors or planners. So you need to seek some licensed advice, but that’s really what you’re trying to do as a limited partner. So think through that stuff from a high level. Hopefully, some of these questions were beneficial to everyone listening.

Theo Hicks: Perfect. Well, Travis, thanks again for joining us and providing us with your advice. Best Ever listeners, as always, thank you for listening. Have a best ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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