How We Do Credit
At RealtyMogul.com, 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.
Real Estate Ventures Do Not Manage Themselves
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.com, 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:
- How much capital is their company willing to contribute to this transaction? The sponsor needs to have adequate skin in the game. We typically look for a contribution of no less than 10% of the total equity required.
- What percentage of their personal net worth is secured in this transaction? We want to see that this figure is meaningful to the Sponsor, as it’s our experience that investor’s financial contribution and level of attention are correlated.
- How much debt financing do they typically like to secure, and from whom? Some lenders are more sophisticated than others. A track record with favorable, well-structured financing by established companies speaks volumes.
- Does their team intend to outsource non-core components of their business plan to experts (e.g. property and construction management)? Pay attention to affiliated management and construction companies. Some operators are well-suited for these additional roles while others should seek outside specialists to maximize value.
What’s more, top-performing operators develop business plans around a well-researched and articulated investment thesis. Examine the following:
- How robust is the sponsor’s investment memorandum – their business plan, financial projections, and market research? We need to see their homework and thought process. This information should be accurate and compelling.
- Have they operated in this market before with comparable assets? Look for recent success effecting similar business plans, on the same types of assets, within markets the operator understands.
- Have they weathered a turbulent cycle and, if so, how did their strategy adapt? Compare how their group performed relative to peers during various stages of the real estate cycle.
- Are incentives structured properly to maximize value for all investors? Review the possible outcomes – good and bad, most likely and least likely, then decide if the proposed returns, fees, and overall deal structure are conducive to maximizing the value of your investment regardless of the scenario.
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.
Fees & Incentives
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.com, 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.