Due Diligence Questions Passive Investors Should Always Ask

Passive real estate investments allow investors to leverage their capital with experts’ time, energy and management systems. However, when you participate in a passive investment, you are putting a significant amount of trust in the operating partner, or “sponsor,” who is in charge of overseeing and executing the business plan of the property.

Because these investments rely so heavily on the sponsor, it is critical to focus your due diligence efforts on that individual to make an educated decision about whether or not they are someone you should trust.

Simply using the six key questions below as guidance while conducting due diligence on a sponsor can quickly provide a good understanding of how the sponsor is positioned in the sector, how their incentive structure compares to their competitors’ and how likely they are to deliver on their promises to you as an investor.

1. What is their background, their track record and the current state of their business?

Here are a few of our typical minimum requirements for the sponsors we work with:

• 10 years in the business.

• 10 comparable assets purchased.

• 1,000,000 square feet under management.

• $100 million under management (leveraged).

Evaluate whether their results have been due to favorable market conditions as opposed to management expertise. This is particularly important to consider if their firm was created after the Great Recession.

If they are including their previous employment in their track record, make note of any significant differences in the capacity of their current firm compared to their previous firm. For example, a completely different skill set is required to manage $1 billion of assets with the help of Goldman Sachs’ personnel and technological solutions as opposed to the infrastructure of a boutique firm with only a few key principals.

2. Is their current bandwidth sufficient for their upcoming projects?

The question here is: Do they already have an infrastructure in place that can handle their anticipated deal pipeline, or will future opportunities require significant changes to the systems and staff of the firm? The latter isn’t necessarily a deal-killer, but it is certainly something to take note of in terms of potential uncertainty about the opportunity.

3. Can they provide professional referrals to verify their claims?

While contacting referrals of previous investors can be beneficial, I have found connecting with the sponsor’s CPAs, attorneys and property managers can be much more reliable. Verify their relationships with the sponsor, confirm the number of assets they own and attempt to get a sense of what it is like to work with them.

4. Can they pass a personal and business background check?

Always run a background check. It is quick and easy and can save you from making a huge mistake. Many attorneys can provide this service, or you can sign up with a company like TLO.com or Trustify.com to run your own.

Before running the report, make sure to ask the sponsor if they have anything problematic that may come up when the background check is conducted. This way, you know what to expect, and it gives the sponsor the opportunity to provide context for anything that could be a yellow flag. Perhaps more importantly, sometimes background checks don’t catch everything. When you ask beforehand, the sponsor may reveal something the background check might miss.

Once you run the report, take note if the sponsor has ownership of other business entities that you don’t recognize, especially if they are no longer active. This could mean the previous businesses failed and the sponsor created a new entity in an attempt to wipe the slate clean. Make sure to ask them to clarify if something like this comes up.

5. Does the sponsor actually own the properties they claim to own?

6. What does your gut feeling tell you about the key principals in the firm?

What are your first impressions? In my experience, the initial communication is critical. If the principals aren’t extremely easy to contact while they are courting you as an investor, they certainly won’t be easy to reach if something goes sideways during the hold period.

Is the sponsor making an effort to position themselves to deliver on their promises? The sponsor’s underwriting standards should be conservative, and they should be able to justify any projected improvements to the key metrics of the property when compared to its previous performance. The fee structure should be heavily weighted for back-end performance, meaning that the sponsor only gets significantly compensated after you have received your preferred return as well as a return of your original investment amount.

How do you feel about the sponsor over the longer term? At the end of the day, if you are investing in real estate, you are typically locking up your capital for five to 10 years. If you don’t have a good feeling about the sponsor going into the deal, you should not let it slide. Just move on — there are plenty of great operators out there who will be a much better fit.

With the guidance of these six questions, you will be well on your way to a more thorough understanding of the sponsors with whom you might be investing. Remember, in order for these questions to help, you have to actually ask them. So get out there, network and have some conversations with experienced real estate sponsors. Once you start getting a range of responses, you will begin to get a sense of what is available in the marketplace, what suits your personality and which sponsors are best positioned to achieve your goals as a passive investor.

– Due Diligence Questions Passive Investors Should Always Ask