The Importance of Extreme Due Diligence Before Investing in Commercial Real Estate
Do you remember where you were when the Space Shuttle Challenger shattered and plummeted to earth?
I do. I was on the way to lunch at the college cafeteria. I’ll never forget the horrifying images as the shuttle exploded a minute after takeoff, sending a shower of smoke, steel and bodies in a hundred directions.
The families of high school teacher, Christa McAuliffe, and seven astronauts watched in helpless horror. A saddened nation wanted answers.
After a thorough investigation, the real culprit was found: a tiny failed O-ring, an item which cost pennies to manufacture.
But there was a story behind this failure. It was discovered that a group of engineers inside NASA had been warning about this potential failure for months. Tragically, their pleas fell on deaf ears.
This tragedy could have been avoided.
As a real estate investor, I’m concerned about the potential tragedies that may be unfolding around me. Though these tragedies may not make the national news and history books, they are nevertheless all too real to those who will suffer at their hands.
I’m talking about the destructive financial and devastating emotional toll caused by bad investments. The difference between a good and bad investment can be the difference between a happy, enjoyable retirement…and a stressful, toil-filled existence.
Finding a best-in-class commercial real estate operator is no simple task. If we were not in our roles at Wellings Capital, we would never have believed how hard this is. We have interviewed literally dozens and dozens and dozens of operators. Many of them are great. We like most of them a lot.
If we were in many of your shoes, not knowing what we know…and not digging the way we do…we could (likely) have invested our own funds with many of them. It might have worked out fine. But might isn’t a strategy for long-term investing success.
There's a saying in this business that you bet on the jockey, not the horse. I think it's important to say that no matter how "recession-resistant" the asset class is, the manager makes all the difference. As you know, we would prefer to be in a good deal with a great operator rather than a great deal with a good operator.
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Why is Extreme Due Diligence So Important?
Commercial real estate investing used to be the playground of wealthy real estate insiders and institutional investors. But the JOBS Act of 2012 and the proliferation of online marketing opened the door to tens of millions of new investors in the US, and many more worldwide.
This has spawned a whole new generation of real estate syndicators. (Yes, the emphasis was on new.) Hundreds of syndicators, many who haven’t lived through a down cycle in their current asset class or even in real estate, are eager to take your money and invest it. It might work out fine.
Many of these syndicators have known nothing but success in their short time in real estate. But most of them haven’t been faced with the challenges of a down market. And many of them have overpaid (some dearly) for the assets they now manage. And as badly, they’ve taken on high LTV and short-term debt. I spoke about the consequences of this a few weeks ago. It’s important to know how to look past their current success and dig into the fundamentals and underwriting.
There is a large…no, actually a massive potential difference in outcomes between a good syndicator and a great syndicator. It can literally be 2x to 3x or more over just five years. And if you compound that delta over a few decades, the potential difference is staggering.
Now I realize that 2x to 3x sounds like hyperbole, but I have the independent stats to verify this. And that gulf can be even more significant in a time when average or good operators drop into the red. Speaking of which...
In times like we now face, loss of principal is a significant concern. Solid margins of safety are therefore critical. In my last article, I spoke about the Debt Service Coverage Ratio, which is one of the most useful metrics in measuring margin of safety. It is important to know how to evaluate operator margin of safety and the role of debt in the process.
Accredited investors are often busy with their day job or other pursuits. Even if investors have the knowledge to evaluate syndicators and deals, they typically don’t have the time and energy to do so. As mentioned briefly above, online marketing has given investors a massive number of choices and it can sometimes be frustrating...and easiest to choose the one with the prettiest presentation. This is often not the best choice.
I stated above that it is very hard to find a best-in-class operator. That difficulty is compounded by the fact that many of the best don’t need capital. Many top operators, with the best track records and most seasoned teams, have institutional or other capital available. So before we go through the many boxes that operators need to check, we need to see if they are even raising equity.
Soon we will release an article on how we do our due diligence on operators and properties. It is important to note that due diligence on an operator or investment doesn’t eliminate risk. There is always risk in any kind of investing. One of the primary end goals of due diligence is to give you the highest possible probability of a successful outcome. To schedule an introduction call and hear more about our operator due diligence process, click here.
Real estate investments and securities offerings are speculative and involve substantial risks. Please do your own research, draw your own conclusions, and seek professional advice. The information contained in this article is for informational purposes only and is not intended to provide investment advice. Investors should consult their own tax, legal and accounting advisors before engaging in any transaction.
