Not All Real Estate investments are created equal
By: Zack Siezmagraff
We all know real estate can be a great investment. There is no shortage of real estate investment opportunities available including; direct investment, rental properties, and those in the Exempt Market - MICs, REITs, Limited Partnerships.
As I watched the heartbreaking story of a recent exempt market real estate investment go sideways, I was struck by the realization that with a few simple questions, investors could have unravelled the spin and hype around the product in question and found out that the investment’s promised success was questionable from the beginning.
How can you tell if a real estate investment is good? How can an investor separate the wheat from the chaff? Here are 7 key questions any real estate investor should ask before signing on the dotted line.
(1) Where is the property?
This is the most obvious and basic of questions - where is the investment property or properties located? What are the econometrics of the region and does the business plan of the investment issuer align with medium range forecasts?
One key indicator of the economic health of a region is to look at what other types of investments are being made in the area. For example, if the property is in an industrial area heavily dependent on the oil and gas sector, what kinds of investments are the big O&G players making? You can bet that the big O&G companies have armies of economists and data miners that the average investor does not have access to.
Another angle is to look at the behaviour of big retailers in the area. Is there a new Wal-Mart opening up in town? Did the local Rona recently close its doors? Big retailers and chain restaurants have economists on staff who help guide investment decisions. Learn from them.
(2) What is the value of the property?
The value of the property is a basic metric that investors can use to assess the health of a real estate investment. The Issuer should have this. Ask to see a valuation and its comparables to back up their figures.
In the aforementioned failed investment, the Issuer raised more than 5 times the value of the property from investors. That is an alarming ratio, and it wipes out any notion of security that the investors may have had. It is common practice to raise a total offering larger than the current property value, with the provision the raise is going to complete value-added work to the property but the capital raise-to-value ratio should be in line with the nature of the work being done.
(3) Has there been a lift? If so, is it reasonable?
Often in real estate deals that are structured as Limited Partnerships (LPs) or Undivided Interests (UDIs), the Issuer has already purchased the land, and is now selling it to investors. The difference between what the Issuer paid for the land, and the price the Issuer is selling it at, is called the lift. It is not uncommon for there to be a lift, as often the Issuer injects capital and does value-added work, in addition to basic land appreciation. However, if the lift is overblown, this should be a warning sign to investors, as it means the Issuer is making money right off the top. Ask the Issuer what they paid for the land, and how they justify the lift. Ask to see appraisals and verification of value-added work to justify the lift.
(4) What is the intended use of investment proceeds?
Peel back one further layer and ask what the purpose of the investment proceeds are. This will determine at what stage the overall development is at.
Many real estate investments are designed with the investment proceeds going to purchase the land (and then the issuer proceeds to develop it). In this model, the investor carries a lot of the risk, as the first (pre-construction) phase of land development is one of the riskiest. Obtaining proper zoning, subdivision approvals, development permits, engineering assessments, etc all require the cooperation of the municipality. Failure to execute this phase of the development properly can add months or even years to the development, which in turn costs the investors.
If the investment is turn-key (all approvals, permits, zoning, etc are in place), and the purpose of the raise is to commence the construction phase of the development, the investor’s assets are more secure, as there is very minimal risk of a delay from the municipality.
(5) What is the Business Plan?
How is the Issuer planning to make you money? What are the input factors, and what contingency does the management of the Issuer have if the assumptions don’t work out?
Take a deeper look at the assumptions in the business plan. If a development plans to generate revenue through sales of serviced lots, for example, ask what price point the model assumes for the lot revenue and how management arrived at that figure. Are there comparables? What assumptions are behind that input price? What happens if the market softens?
(6) Can they execute the plan?
Take a good hard look at the Issuer’s business plan. Does the management team have the experience and skills to execute the project? Who are their strategic partners (engineers, architects, construction, brokers, etc)? Do your research. Call or email the management of the Issuer and ask questions.
Some development-type investments underperform as a result of poor planning and execution. For example, if the development calls for a subdivision plan - has the management team executed a subdivision plan previously?
If not, ask how they are confident in their ability to execute one at this point in time.
(7) What’s in it for THEM?
The first question on most investor’s minds is: ‘What’s in it for me?’ The question that should be first on investor’s minds is: ‘What’s in it for the Issuer?’ The greater the alignment between the investor’s goals and those of the issuer, the more stake the issuer has in the investment’s success.
Does the issuer make money when you make money? If, worst case scenario, the investor loses money, does the Issuer lose money as well? Do they make all their money upfront? Do they make additional revenue through management fees and commissions? If so, ask what value does that add to your investment.
This list was by no means exhaustive, but was meant as a checklist of key points with which to assess the strength of potential real estate investments.