The other day I was talking to a seasoned investor who’s actively reviewing deals on the various crowdfunding platforms. He was digging into a single-family fix & flip investment on one of the well-known platforms and wanted to learn more about the operator. A simple Google search revealed that the operator was recently indicted for visa fraud and money laundering. He reached out to the platform and the deal was quickly removed. This a group that was approved by the platform which presumably had done their diligence on the deal and operator. This is really scary and one of my major concerns with the real estate crowdfunding space.
A few weeks ago I shared the top 10 steps when reviewing a passive real estate opportunity. Today, I want to highlight the 10 telltale signs that you should avoid a deal.
1. No Web Presence
Transparency is becoming increasingly important as operators market to investors with whom they have no prior relationship. Operators must have a quality web presence with a website that showcases their investment strategy, their portfolio, and the team. While not required, they should also be active on social media.
2. No Local Ownership
Real estate is a local business that requires local knowledge, local connections, and operational expertise. If the operator isn’t local to the deal, doesn’t have a local partner, or isn’t working with a best-in-class 3rd party property management team that specializes in that market and asset class, stay away.
3. No Experience with that Asset Class or Business Plan
Real estate is an operational business and each asset class and investment strategy requires expertise that must be honed over many years. If the operator is proposing an office renovation and has only executed apartment deals, avoid the deal.
4. Overly Aggressive Assumptions
Operators should be conservative with their assumptions with the goal of under-promising and over-delivering to investors. Financial engineering is easy to do while in a spreadsheet – is 6% annual rent growth achievable? What’s the exit cap rate assumption? Is a 6-month rehab realistic? What about that 4-month lease-up schedule? Is 95% stabilized occupancy achievable in this market? Question all assumptions.
5. Is the Sponsor Contributing Significant Equity to the Deal?
It’s typical for sponsors to contribute at least 5% of the total equity to a deal. If the sponsor is contributing less than 5% or worse yet, nothing, then avoid the deal.
6. Mis-Aligned Fee Structure
How is the sponsor being compensated? While an acquisition fee and AUM fee is industry standard, these fees are meant to compensate the sponsor for putting the deal together and operating the deal (not the reason they do the deal). Operators should make their real money through their promote (disproportionate cash flow split over a preferred return), meaning if the deal goes well, the investors and sponsor will do well.
7. No References
If you’re going to be a significant investor in a deal, it’s perfectly reasonable to ask the sponsor for a few references. If they’re hesitant to provide references or don’t have references, run and don’t look back.
8. The Sponsor has not been through Cycles
A rising tide lifts all boats and only when the tide goes out do you discover who’s been swimming naked. Firms started between 2009 and 2013 probably have great track records, but is their success attributed to being great operators or just great timing?
9. High-Level Investment Memo
Sponsors looking to raise capital through crowdfunding portals should put together detailed investment memos including the deal background, market overview, downside scenarios, business plan, investment highlights, property information, sales comps, and investor-level returns. If they only have a 1-2 page investment memo, there’s reason to be skeptical.
10. The Sponsor isn’t Disclosing Risk
Real estate investing is highly-risky and there’s a chance investors will lose 100% of their principal investment. While there are ways to limit risk, real estate is about understanding risk and having the skill-set to combat issues as they arise. Any operator who pitches returns without risk should be avoided at all costs.
While crowdfunding is great for the real estate business, it’s also made it easy for bad operators to raise capital from accredited investors seeking passive cash flow. These 10 signs should help avoid bad deals and access the quality ones.