What to know before buying mortgage notes

[Editor’s Note: This is a guest post from website advertiser Michael Episcope, the founder of Origin Investments. It is a bit of a part 2 to his previous, well-received guest post. I have no money invested with Origin at this time but obviously have a financial relationship. However, this is not a sponsored post. I neither pay for nor receive money for guest posts and they are judged solely on quality of the content. If you have chosen to venture outside of index funds for a portion of your portfolio, doing due diligence on your investments is critical to controlling risk and obtaining adequate returns. I learned something from this article that I can apply when doing due diligence on real estate deals and hope you do too.]

Every commercial real estate deal starts with a promise of high returns. But it’s rare for a deal to follow the path of its pro forma. A few will exceed projections, others will fall short and many will actually lose money.

The problem with relying on projections to make investment decisions is that any deal can look great by tweaking one or two variables. So the challenge for investors is trying to figure out which deals will meet or exceed expectations, and which ones will become a “learning” experience.

Most real estate managers build models with good intentions, believing that the assumptions can be achieved. Others build models to appease their investment audience in an effort to attract capital. Projecting real estate returns is an inexact science. There are hundreds of assumptions that go into building a financial model and every input is at the discretion of the manager. By tweaking a couple of variables here and there, a manager can make it look like any deal will work. I’ve yet to see a deal that didn’t work on an Excel spreadsheet.

It’s the manager who decides what price to pay for an asset, how to build value, appropriate capital structure, how to course correct when things go wrong and when to exit. A good manager will be realistic and thoughtful about the assumptions. Finding a real estate manager who will behave reasonably and responsibly is paramount to success in this industry.

That makes asking the right questions critical during the due diligence phase to understand if the manager’s investment strategy fits your personal risk profile. Open-ended questions are great as they force the manager to think about what they are going to say instead of offering up a scripted answer. But you need to listen to cues along the way and read between the lines. Think of this as a job interview, and you’re hiring the manager to be a good steward of your capital and a good partner.

So what to ask? Basic due diligence questions include probing the real estate manager’s historical track record, the quality of their team and their strategy. Simple tactics like a Google search on the company and the company’s principals can also provide valuable information. We’ve put together 10 questions and tactics below that should help give you a telling picture of a real estate manager’s approach, ethics and potential performance.

# 1 Question every assumption – Go Deep!

One of the best ways you can ascertain a manager’s approach is by questioning every assumption in the model. Projections are only as good as the inputs, and every one of them is at the discretion of the manager. How a manager underwrites a deal will be a telling sign of how aggressive or conservative they are.

The first thing to note is the projected IRR. If you look at ten opportunities in the same industry and the IRR projections range between 16% and 19%, what is the likelihood that another sponsor can achieve a 30% IRR? The market is generally efficient, so beware of aggressive marketing tactics. How does the location of the property and its physical attributes stack up against the competition? Is it an apples to apples comparison? Real estate can change dramatically block-by-block, so comparing the property to one that is five miles away may not be appropriate. What rental rates do they need to achieve compared to the market? If competitive properties are achieving $23 rents, why do they think they can get $25 rents?

Set yourself up for success by getting into deals with assumptions that are easily achievable. What is their exit cap rate assumption, and is there a built-in cushion for expanding rates? It’s easy to make a pro forma look great by simply tweaking the exit cap rate. Generally, exit cap rates should be 50 to 100 basis points higher than today’s cap rates to account for risk. [Editor’s Note: Remember if the buying capitalization rate is higher than the selling cap rate, you get a higher return than if the opposite situation occurs.] Make sure that the value creation is not financially engineered.

Good managers create value by increasing net operating income. How are they going to achieve this? Net operating income is impacted most by occupancy and rental rates. What is their assumed growth rate of revenue and how do they determine it? What is their terminal occupancy rate? Every pro forma has an occupancy assumption at stabilization. Make sure the property is in line with the rest of the market, or slightly below it.

How do they treat expenses such as property taxes and are they applying a realistic inflation rate to all of the expenses? Property tax increases can have a big impact on the bottom line. Make sure the sponsor is resetting them based on the new purchase price and not using historical figures. They will go up, and sometimes substantially.

Most importantly, what is their business plan and do you believe it is realistic? Use a common sense approach. Can a class A property also be home to low income renters? A business plan should be easy to understand and make sense intuitively.

If you can’t get past this section, don’t bother with the other 9 questions below.

# 2 “How much of your money are you investing in the deal?”

Alignment is everything. Your manager should be investing a significant amount of his or her own capital (not capital funded by others) right along with you. And the bulk of his or her earnings should come from investment returns — not transactional fees. “Skin in the game” ensures that they are motivated by the right outcome. You want them to win when you win, and lose when you lose.

# 3 “What is your competitive advantage in the market?”

What does the manager believe his or her team does better than anyone else in the market? If they don’t have a competitive advantage, then why invest with them? A competitive advantage is generally something quantifiable. For example, if their competitive advantage is in sourcing opportunities, then how many deals do they look at before they pick the best ones to do, and where do they find them? If it’s in operations, then they should be able to benchmark themselves against an industry standard.

# 4 “How do you ensure that my capital is protected in a down market?”

What is it about their strategy and their track record that makes you feel comfortable? Have they consistently beaten their own projections? How much leverage do they use? Some avenues to explore here include the following:

• Ask about their underwriting and how they take into account a rising interest rate market and a rising cap rate environment. You don’t have to agree with them on which way interest rates are going, but every model should account for higher rates because that’s where the risk lies. And real estate investing is all about protecting against the downside.
• Do they cross collateralize assets? Cross-collateralization of assets is when one asset is used to guarantee the debt on another asset. In a fund structure, assets should not be cross collateralized because it destroys diversification and magnifies risk. This practice played a large part in why investors lost so much money during the financial crisis. Nowhere is this more prevalent than in debt funds, so read the fine print.
• How much leverage do they use? Used responsibly, leverage can enhance returns. But beware of deals that are financially engineered with mezzanine debt and preferred equity.
• Do they personally guarantee loans? Personally guaranteeing loans can be catastrophic for a manager and the investors if that loan gets called. How much do they charge the deal or the fund for that guarantee?

# 5 “How can the deal lose money?”

Every deal can lose money, and you generally won’t find this question addressed in the materials the manager provides. Listen for a sincere, well-reasoned answer. A good manager will have thought this through. Ask them for a stress test model to better understand the “what if” scenarios. Question the assumptions in the model. The easiest one to question is the exit capitalization rate. A good manager will assume a higher capitalization rate at exit to account for rising interest rates, the age of the building and potentially lower lease terms. For example, if the market capitalization rate today is 6%, then the exit capitalization rate should be between 6.5% and 7%. If the manager doesn’t follow this rule, then the other assumptions probably are not realistic either.

# 6 “Tell me about your worst deal and what you learned.”

This is always a telling question that’s worth the time. Do they take ownership for the loss? Every manager has a bad deal in their past. It’s your job to decide if it was an ill-conceived business plan or the function of a bad market. Did they communicate to investors during this period? This is important because how they treated the investor during this period is an indicator of their integrity. Ask to speak with one of the investors in that deal to verify their story. Did they do anything for the investors in that deal? Again, you are trying to vet their integrity. While no one is obligated to go above and beyond what they state in their documents, an honest manager will have done something to make amends.

# 7 “Can I speak with one of your current investors AND someone who no longer invests with you?”

Try to pick a random investor instead of one they give you. Generally, you won’t learn much from a current investor, but you can from speaking with a former investor. What was their experience? Would they recommend the manager? If you really want to get creative, get in touch with one of their former employees through LinkedIn and ask them about the company.

# 8 “How is your company funded?”

This question is designed to determine whether or not the company has ample cash flow to pay the bills. Is there risk that they will go out of business? What does their balance sheet look like? If the project runs out of money, will they lean on you for additional capital? Avoid managers who operate on shoestring budgets or are just starting out. If you are buying into a fund, it’s best to wait until Fund II or III, after the kinks have been worked out. But whether investing through a fund or not, experience matters and  it may be best to wait until the management team is more experienced and better financed.

# 9 “How’s your team incentivized? How do you retain team members? What’s your retention rate of key team members?”

Making sure that the team is aligned through performance is also critical. Conflicts of interest are prevalent in this industry and minimizing them is important. One way to do so is by making sure that the team is compensated based on performance and not on the transaction. Also make sure that the team that’s in place today is the same one that was responsible for delivering the manager’s historical returns.

# 10 “What is included in all your fees?”

This question often makes managers uncomfortable. Is the deal a fee frenzy, or is it reasonable? Make sure you ask about every fee throughout the structure. Sometimes fees are buried in other LLCs below the investment entity. Ask for an organizational chart, and then inquire about fees in each and every one.

Just because a manager may not meet every criteria on this list in a way that satisfies your expectations, doesn’t mean they should be written off. But do listen for cues in their answers that shed light on their honesty and integrity. Does it sound like they are hiding something? Unfortunately, too many deals get funded with nothing more than great marketing materials. And there are many unqualified investment professionals in today’s market passing themselves off as experts.

Don’t commit your hard-earned capital without taking the time to get to know a manager on a personal level. Only then can you be sure you are investing with true professionals in every sense of the word. It’s better to be with a great manager in a good deal than in a great deal with a bad manager. Most importantly, don’t fall in love with a deal and then justify the manager. That’s the tail wagging the dog. Any deal can look great on paper and, prior to forming Origin, I learned this lesson the hard way.

What do you think? How do you do due diligence on real estate investments? How do you balance the need to do due diligence on managers with the need to diversify with various managers? Comment below!