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By Bruce Kellogg
What About Enhanced Diligence?
In the beginning, commercial real estate brokers invented the term “due diligence”. Lacking a specific definition, it basically means, “Check it out”, when making a real estate purchase. Nowadays, the term has received wider use in home purchasing, turnkeys, syndications, and more, but its application still has no formula. This article aims to correct that for syndication investing with what can be called Enhanced Diligence.
Initial Philosophy
When an investor purchases a syndication share in a distant location from a promoter, the investor is investing in the promoter as much or more than in the property. The property could be bad, or good, or so-so. The promoter could be competent and honest, or incompetent and honest, or competent and dishonest, or incompetent and dishonest. BUT the investor’s funds are tied up for 3, 5, or 7 years, and the success or failure of the project might not be known until the end of the holding period. This is why Enhanced Diligence is so important.
A Recent Example
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There was a “meetup” attended by about 70 people with an attorney speaking on the subject of “Asset Protection”. At the close, the organizers called out, “Who here is an accredited investor? Come up to the table to learn about our multi-family syndication in the south side of Chicago.” Now, Chicago has the highest murder rate in the country by far, and the south side is where it happens. Can you just imagine the robberies, the violence, the drug dealing, the arrests, the vacancies, the turnover costs, the lawsuits, and the insurance claims? And some “real estate entrepreneurs” from the Bay Area of California are going to successfully nurture this syndication for 5 years? Uh, huh. No doubt they just graduated from some “guru’s” “boot-camp”.
The Basics
Syndication” is a generic term for a group investment. It can take the form of a joint venture (JV), Limited-Liability Corporation (LLC), Limited Partnership (LP), Tenancy-in-Common (TIC), or possibly another legal structure. The LLC is most popular lately due to the ability to pass through to the investors such things as depreciation, interest expense, operating expenses, and other deductions. A “sponsor”, or “promoter” puts the syndication together and runs it during its term.
Diligence and the Promoter
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An article appeared in the November/December, 2013 issue of
Personal Real Estate Investor Magazine, entitled, “12 Ways to Earn Money as a Real Estate Syndicator”, written by Kim Lisa Taylor, Esq., a securities attorney. It very thoroughly laid out the many ways an enterprising person can get rich investing other peoples’ money. Today, there are “gurus” traversing the countryside teaching syndication.
When evaluating a promoter, several things need to be investigated, as follows:
- What is the promoter’s background, education, and experience with similar projects?
- Who are the promoter’s team—accountant, property manager, attorney, etc., and what are their qualifications?
- How much is the promoter investing? Is it CASH, or is it “equity”, which could be anything. Beware of non-cash promoter contributions!
- What other projects and assets does the promoter have? Is the promoter spread too thin?
- Does the promoter put together serial syndications, leaving the older ones to neglect?
- What provision is there for removing the promoter if they are not working out? Is there any?
Under Enhanced Diligence a “background search” should be performed on every decision-maker involved in the syndication. Certainly, this is the promoter, but it also includes anyone else in authority. This involves ordering a report from Lexus-Nexus, Trans-Union, or another data base firm. The report will usually include any liens, judgments, and bankruptcies, along with addresses, professional licenses (including any revocations), relatives, phone numbers, and email addresses. Costs of reports are only a few dollars for those with subscriptions to these companies. Otherwise, call 3-5 private investigators for quotations. Their costs are under $15.00, and they have the necessary systems. The Social Security number of the promoter is not needed, and neither is their permission needed because this is a public records search. They will not know the search is being done.
C’mon, is this really necessary? It depends. If you are comfortable wiring $50,000 – 250,000 to a promoter out-of-state who you don’t know very well, then go for it. The author has discovered syndicators in bankruptcy, with federal tax liens, and civil judgments. Would you trust them with your money? You can’t know your promoter too well!
Diligence and the Property
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When it comes to the property, bear in mind that the promoter will be presenting it in its best light. Here are the primary items that need to be investigated:
- Age: Nothing older than age 30-35 should be considered. Syndications intended to add value to deficient older properties usually turn out poorly due to excessive rehab costs.
- Building Class: A=Luxury, B=Professional, C=Working Class (“Blue Collar”), D=Low Income (“War Zone”). Luxury apartments don’t cash flow as well, and low income units are, frankly, treacherous. Stick with class B or C.
- Pictures: Hire a service such as wegolook.com to take pictures of the property and its surroundings, or go to Google View, or Bing Street View. Properties need to be fairly clean-looking. No industrial properties or strip centers close by. Schools, a hospital, and houses of worship are a plus. You probably know “nice” when you see it. Tenants do, too!
- Crime Rate: Go to ciity.data.com and check out the neighborhood crime rate. While you are there, check out the school ratings and the household income. Renters are attracted to low crime areas with good schools, and you need that to keep your building full.
- Unemployment Rate: Go to the Bureau of Labor Statistics website, BLS.gov and check this out. It shouldn’t be more than 20% above the national average at the most.
- Unit Mix: The Offering Circular from the promoter will normally say how many units are studios, 1-bedroom, 2-bedroom, and so on. Avoid projects that are largely studios and ones because turnover is higher, and so are related costs.
- Project Plan: Also in the Offering Circular there is usually the promoter’s plan for the project to add value by remodeling, adding amenities, raising rents, and so on. Consider this carefully because all of the projected returns from the promoter depend on the plan succeeding.
- Rents: Go to zilpy.com and accurent.com to check out the rents given presently and projected by the promoter. If not satisfied, feel free to call the property manager to discuss them. Don’t be shy. Your investment is at stake.
- Market Conditions: Oftentimes these are discussed in the Offering Circular. There is no formula for evaluating this, but see if they make sense to you.
Diligence and the Deal
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Lastly, you need to evaluate the deal itself, which is described in the
Offering Circular. Here is what you need to consider.
- Holding Period and Exit Strategy: See if this makes sense to you and fits your time frame.
- Dispute Resolution: How are any disputes between the investors and the promoter going to be resolved? Can the promoter be removed and replaced if necessary?
- Voting Rights: What voting rights do the investors actually have? Are you comfortable with that?
- Reporting: Reports should be monthly or quarterly.
- Promoter’s Fees: The Offering Circular will disclose these. There will be plenty because syndicators often set up a certain return for the investors, then pile on the fees wherever they can. See the article by Kim Lisa Taylor on the 12 ways syndicators can make money, under “Diligence and the Promoter”, above.
- Cash Distributions: When are cash distributions made to investors, and what are they for?
- Leverage: How much cash down-payment will be made, and what loan(s) are there? 30-40% down-payment is common. Be suspicious of overleveraging with anything less.
- Overpaying?: The commercial real estate market, especially multi-family, is “hot” right now with syndicators competing for properties and bidding them up. Your promoter could be overpaying, which would severely reduce your investment return. Usually some Comparable Sales are presented in the Offering Circular along with some discussion. Study these carefully. Does your project make sense?
- Project Financial Measurements: Projects are measured primarily on Internal Rate of Return (IRR), which is used to compare investments of all kinds, and on Cash-on-Cash Return, which basically expresses the productivity of the investor’s cash in the project. Promoters provide estimates of these and others in the Offering Circular. Familiarize yourself with these if you intend to invest in syndications, or hire an accountant, financial planner, or real estate consultant who is versed in them.
- Investor Returns: Usually there is a Preferred Return, which is paid to investors monthly or quarterly from ongoing operations. It runs 6-10%, with 8% being typical. Anything outside this range should be questioned. Beyond the Preferred Return, there can be additional distributions in which the promoter will probably participate.
- The other primary return is the Split, which applies to profits and distributions above the Preferred Return, plus proceeds from any refinancing. These rates can be 80/20, 75/25, even 50/50. They are described in the Offering Circular, and you need to decide if they are acceptable to you.
The Syndicator’s “Flip”
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Enhanced Diligence requires that you research the property’s history. To do this, contact the Customer Service department at a major title company at the location of the property. Ask for “a Property Profile” that has transactions going back 10 years. Usually, this will be provided at no cost. Look it over to see if the promoter already owns the property that they are trying to syndicate. If so, they are trying to do “a Syndicator’s Flip” as their exit strategy from ownership of the property. Usually, they will build in a nice profit for themselves upfront such that the investors pay retail or above. Then, since the promoter has their profit, they usually go on to neglect the syndication. Is this common? Not so much. But it happens, and you need to guard against it. Is it legal? Good question! Don’t bother to find out!
Conclusion
Many syndication investors take the easy path by reading the promoter’s Offering Circular, maybe seeking an advisor’s opinion, then wiring funds or writing a check. This is nowhere near enough! They need to go beyond even “due diligence” to Enhanced Diligence. This article equips investors to do that.
Good Luck!
NOTE: The author is available for Enhanced Diligence of Syndications, Turnkeys, Joint Ventures, and other investment acquisitions of most kinds. Compensation is based on an hourly rate.
Bruce Kellogg
Bruce Kellogg has been a Realtor® and
investor for 40 years. He has transacted about 800 properties in 12 California
counties. These include 1-4 units, 5+ apartments, offices, mixed-use buildings,
land, lots, mobile homes, cabins, and churches.
He writes and edits copy for Realty411 and REI Wealth Monthly magazines.
Mr. Kellogg is a recipient of an Albert
Nelson Marquis Lifetime Achievement Award, listed in Who’s Who in America – 2019.
Mr. Kellogg is available for consulting
about syndication, “turnkey” investments, joint-ventures, and other property
purchases nationally, and other consulting assignments. Reach him at [email protected],
or (408) 489-0131.
