Passive investing in private real estate deals remains one of the best investment opportunities for long-term focused investors. Until recently, these deals were accessed through closed networks and executed entirely on a trust basis.

As these deals have become more accessible, operators are forced to become more transparent and investors must learn to scrutinize sponsors, deal structure, and the opportunities themselves.

While one approach to selecting deals is to simply pick the best sponsor, I think it’s extremely important for investors to know enough to ask the right questions to assess the riskiness of an investment opportunity.

The challenge is that real estate, although simple on the surface, is a complex business. Each asset class, market, and investment strategy are unique. Since I’m focused primarily on value-add multifamily deals, here are the questions you should ask (or aspects to review) when evaluating value-add multifamily investment opportunities.

*For the sake of this post, I’m assuming this is a garden-style property built in the 1980’s and located in a secondary suburban location.

Acquisition

  • Why is the Seller exiting? Does the story add up?
  • Is the property being acquired below replacement cost and comparable sales?
    • Confirm the all-in basis (acquisition costs + renovation costs) is below replacement costs and comparable sales.
  • What’s the going-in cap rate? What NOI is this based on?
    • One of the difficult things about using cap rates to compare deals is that they’re oftentimes calculated differently; T12, T6, or T3 expenses? Reassessed for taxes?
      • Oftentimes the going-in cap rate for value-add deals is less important since the property is distressed.

Market

  • How has the population, income, and wage growth been over the past 3-5 years? What about projected forward?
  • What is the median income? Do the income levels support the underwritten rents?
    • Assume tenants need to make 3-4x the annual rent to qualify.
  • What is the market vacancy?
    • While the market stats are important, I prefer to focus on the 3-4 main post-renovation comps within the market.
  • Is there localized employment? Is the employment base diversified?
  • How’s the access (local and regional)?
  • How’s the school district? Look at each the elementary, middle, and high schools.
  • Are there any crime issues?

Physical Property

  • How’s the Property visibility? How many cars pass by daily?
  • What’s the status of the major systems; plumbing, windows, roofs, siding etc.?
    • Did you video the pipes?
  • Are there any physical limitations which put a cap on rents?
  • Are there any major ongoing capital issues?
    • During due diligence, operators will review the historical work order log.

Business Plan

  • What’s the target hold period?
  • What’s the breakdown of the capex budget?
    • Is the capex budget based on bids from subcontractors?
    • How large is the contingency?
      • The contingency should likely by ~10% of the total budget.
    • How long will it take the investment to stabilize?
  • What are the post-renovation rents based on?
  • What’s the spread to the higher quality, class A deals, in the submarket?
  • Is there a model value-add deal in the market?

Income

  • How does the Year 1 total income compare to the trailing 12 financials?
    • What assumptions are being used for vacancy, bad debt, and concessions?
  • What annual rent growth factor is being used?
    • Long-term rent growth should be in the 2%-3% range.
  • What annual growth rate is being applied to the ‘other income’?

Expenses

  • How do the year 1 expenses compare to the T12?
  • What assumptions are being used for the property tax reassessment?
    • Buyers will usually get a 3rd party tax analysis, but typically should assume the property is reassessed at ~80%+ of purchase price.
  • What annual growth rate is being applied to the expenses? How does that compare to the income growth rate?
  • What annual recurring replacement expenses are you underwriting?
    • These should be $300-$500 per unit depending on the age and quality of the property.
  • What are the annual partnership expenses?
    • These include asset management fees, accounting costs, travel expenses, technology expenses etc.?

Debt

  • Are the debt assumptions based on actual quotes?
  • Have they locked rate?
  • How does the debt structure align with the intended business plan?
    • Floating rate versus fixed-rate? If floating, was an interest rate cap purchased?
  • What refinance assumptions are being used?
    • We typically use a conservative interest rate and assume no interest-only on the refi.

Return Analysis

  • What’s the stabilized return-on-cost? Is it trended or untrended?
    • The stabilized ROC should be a ~200+ bps premium (~20% margin) to today’s cap rates depending on the deal risk profile.
  • When looking at the projected IRR, what % is attributed to cash flow and what % is attributed to the refi/sale?
    • Generally speaking, the higher % of the IRR attributed to the refi/sale, the riskier the return profile.
  • Here are the return metrics that matter most to investors.
  • Request to see the sensitized returns such as the exit cap to IRR and hold period to IRR.

Sale Assumptions

  • What exit cap rate is being used? How does that compare to the going-in cap rate and today’s stabilized cap rates?
    • Generally speaking, exit cap rates should be higher than the going-in cap rate.
  • What are the sales costs?

While this list is by no means exhaustive (I’m sure I missed certain things) and investors don’t need to ask every single one of these questions, it’s a starting point to assess the most important aspects of value-add multifamily investment opportunities.

Passive investments can be a great way to diversify your investment portfolio and those that provide cash flow can truly be life-changing. But, while passive investments can be great, some are more attractive than others and some are outright bad opportunities that present high risks for investors.

Click here to see more posts on passive real estate investing.

What would you add to this list?

TOP TIPS FOR PASSIVE REAL ESTATE INVESTORS

19 of the top real estate professionals share their most valuable passive real estate investing advice.