How We Do Credit: Part I – The Real Estate Company
Commercial Real Estate
At RealtyMogul, investor protection is the crux of our business. In fact, it is one of our core values. That being said, we have ensured that our credit policies and procedures are comprehensive, appointed a Chief Credit Officer with over three decades of thought leadership in the industry, and assembled an investment committee with over 200 years of collective experience underwriting, managing, and acquiring commercial real estate. This same team has taken it upon themselves to clearly identify the four pillars of credit and this quarter we’ll be releasing a series of articles to cover them – so stay tuned and don’t forget to visit our blog regularly for new insights.
Many real estate companies, or “sponsors”, have long promoted the importance of active property ownership and oversight. These sponsors attribute outperformance to a hands-on mentality which distinguish their teams from other institutions with arguably less management bandwidth for each endeavor. In earlier posts, we reviewed some of the factors related to investment due diligence, as well as our general underwriting framework. In How We Do Credit: Part I, we will address the art of identifying capable sponsors and the factors our team considers when evaluating their qualifications.
In every transaction we consider, the character and experience of the governing sponsor is of paramount importance. Investors should be confident that their operator has a solid reputation, track record, and otherwise the requisite skill and knowledge to optimally manage their investment in a trustworthy and professional manner.
Believe it or not, McKinsey research reveals that the vast majority of private equity companies underperform the stock market over time – nearly 75%. What is more interesting, however, other than the fact that many of these companies are well capitalized, is that the few companies that do outperform the relevant market indices do so consistently and by a considerable margin. So on what basis can a reasonable investor begin to distinguish and qualify these professionals? McKinsey concluded that the delta was not derived from pricing arbitrage, exceptional market timing, or superior financial acuity as some would suspect. In actuality, the source of success was found to be the governance model employed by these companies. The amount of effective diligence and active oversight applied by the top 25% of firms far exceeded those of their underperforming peers.
The bottom line – real estate ventures do not manage themselves and we believe active, disciplined management is essential.
How can investors gain comfort with a new investment opportunity run by an unfamiliar company? In our view, at RealtyMogul, the answer is diligence. Our process begins with a series of questions – what we see as the right questions – in an effort to better understand a sponsor’s core management values and history:
What’s more, top-performing operators develop business plans around a well-researched and articulated investment thesis. Examine the following:
In addition to asking insightful questions, it is equally crucial to obtain basic diligence items in order to validate all verbal information. This typically includes a general company overview, proposed organizational and entity structure, list of historical transactions, schedule of current real estate owned, historical reporting sample, industry and banking references, credit and criminal background checks, tax returns, and more.
Since a sponsor usually takes some sort of management and/or acquisition fee in connection with a proposed real estate project, it is also important to understand the structure of those fees and how they compare to those of other operators.
Ronald Kahn, the Global Head of Scientific Equity Research at BlackRock, once said “of the three dimensions of investing – return, risk, and cost – investors have direct control only over cost.” Since fees typically make up the majority of deal costs, whether fixed or incentive-based, an understanding of their inclusion and structure are important to tracking incentives which impact important management decisions. These fees generally relate to the three stages of a real estate transaction’s life cycle – acquisition, operation, and disposition.
Fee magnitude alone, though, should not be a standalone concern. Instead, consider what a proposed fee structure says about a sponsor’s value proposition and expectations for the property. Focus on when and how the sponsor intends to be compensated. Are they charging financing, disposition, or development fees? What may initially appear to be a fee-rich investment may be perfectly appropriate for the allocation of return and risk. Conversely, investments with depressed fees are not necessarily a signal of a more accretive deal. Remember, investors should analyze fees in the overall context of a transaction’s many components.
In summary, while an investor can never be completely assured that the objectives of any particular real estate investment can be realized, an appropriate level of questioning and due diligence of an investment’s sponsor is essential. At RealtyMogul, we are building relationships with active, reputable, and disciplined operators so that we can provide premium deal flow to our investors. As with all investments, investors should evaluate each individual real estate opportunity to see which best fits his or her investment strategy. Real estate investments carry risks and do not guarantee a return of any sort.
We invite you to learn more about our opportunities and process by contacting a member of our Investor Relations team here.