Investment Selection Process
Investing in institutional quality commercial real estate requires a rigorous process that we have perfected over the years. Repeatedly selecting sound investments entails asking a lot of questions and analyzing many details in order to ensure success.
Our due diligence process involves analyzing 3 main categories:
1) Our Operating Partners
Our partners are the most critical aspect to success. Their role is to acquire the property and execute on the business plan. Our operating partner selection process requires many conference calls, emails and meetings in person and it takes a long time. It takes longer to choose the right people than it does the right property.
When we evaluate operating partners we are always asking ourselves, “are these the people and the firm that we want to invest with for the next 10+ years?”. It’s an arduous and essential process and on several occasions we have spent over a year underwriting an operating partner before investing with them and we’ve been told numerous times that we have very high expectations.
Our operating partners must have an established team both in the back office and on the ground handling day to day operations. We prefer vertically integrated firms with in-house property and asset management where we can capitalize on their economic efficiencies. We run background checks on all principals and evaluate their track record including current asset performance and exited investments. Typically our operating partners are specialists in 1 asset class and we really look for investment opportunities that are highly likely to succeed, where the deal matches very closely to many prior deals that they’ve been successful in.
Once we truly like and believe in an operating partner and their deal, we often test them with a small equity investment. By investing with them you very quickly get to learn how they communicate, how well they execute on the business plan and essentially how good they really are. They also get to know us better, understanding our conservative analysis and they learn that most deals do not meet our buying criteria. This is how we have successfully created long term relationships and consistent deal flow.
Over the years we have and continue to invest and partner with many of the top 50 largest real estate operating partners in the U.S. Our partners are experts in managing their respective asset classes and they are on the ground sourcing deals and provide us a first-look at participating in the equity.
2) The Investment Property
After analyzing thousands of real estate investments, we have become quite selective. Once an operating partner shares an investment opportunity with us we start by reviewing the business plan for the investment ensuring the deal meets our buying criteria.
The property’s current physical condition must be of good to high quality and located in a desirable submarket. The investment must provide immediate cash flow generally not less than 5% in year 1, an average of 7-10%+ cash on cash over 5-10 years and an average annual ROI and IRR of 15-22%+. It must already be stabilized with high occupancy and also include a compelling, conservative and realistic value-add strategy to grow the NOI and have the option to provide a return of investor capital through both a refinance and property sale.
Many investments do not meet our buying criteria. For those that do, we proceed to run a risk analysis and analyze the following:
We seek opportunities in markets experiencing growth and which have a strong future outlook. The economic diversification and size of the local submarket, employment trends, populations trends, median household income and industry growth are all key factors we analyze.
Here we seek conservative underwriting assumptions and projections. It can be relatively easy to manipulate a pro-forma to show high projected returns and this is exactly what we watch out closely for. Each line item and the underlying assumptions must be analyzed including rental growth rates, expense projections, stabilized occupancy rates, payroll and management fees, repairs and maintenance etc. Analyzing the trailing 12 and 3 month performance of an asset can often provide a current trend and baseline to work from.
We conduct sensitivity analysis to determine how the performance of the property may be affected by changes in the underlying assumptions. By adjusting and testing several key metrics including exit cap rates, occupancy rates and net operating income, we measure and gauge how the investment may perform under various scenarios.
The debt structure of an investment is a critical component to pay close attention to. In today’s market we prefer investments with fixed rate agency debt and conservative loan to values typically between 60%-70%.
We analyze and compare property sales, price per unit, price per square foot and nearby rental rates to ensure the asset is being acquired in line with or below similar properties trading in the local market.
3) The Deal Structure
The third category of our process involves negotiating and ensuring that the legal terms and investment structure reflect a strong performance based partnership.
Our investments are designed to incentivize performance and we ensure cash flows and profits are paid first to investors. This is often accomplished through a preferred return. A preferred is a minimum return that investors must earn prior to management participating on the cash flows and profits. We require the preferred return to accrue annually to ensure that investors are compensated after the first few years of a value-add investment when cash flows may be slightly below the preferred return. The preferred returns we seek ranges between 6-10%.
Once investors earn their preferred returns, additional cash flow and profits are split with our operating partners. This is where we want our operating partners to truly be compensated for the investment performance and their hard work executing the business plan. The profit splits above the preferred return fall between 50%-80%, in favor of investors. The exact split is dependent on how much heavy lifting the investment requires and our ability to negotiate favorable returns for our group.
We analyze any fees to confirm our operating partner’s motivation is aligned with investors and the performance of the investment and we require our operating partners to co-invest in the equity of the deal and have “skin in the game”.
We pay close attention to the capital call provisions and terms around additional capital to be contributed by investors. We prefer to avoid investments where the legal documents stipulate a penalty may be incurred if investors do not contribute additional capital when requested by the operating partner. In addition we must have the ability with a clearly defined process to withdraw our capital should the need or desire arise. And although we have never had the need, there must be stipulations allowing investors the right and ability to vote to remove the manager.
Once an opportunity passes through each category of our due diligence process, we consider it for an investment.