Due Diligence Mastery Lesson 1

Lesson One: Start Here

1.1 Orientation

Before you get started in this course, please read the orientation blog to help you understand the key points of real estate investing. Use the following link to view the orientation:

Click here to view the orientation.

Then, please familiarize yourself with my blog post on this:

Click here to view the orientation.

1.2 Here’s What to Expect

This course focuses on commercial real estate due diligence and its purpose is to save investors time and money and to avoid the potential pitfalls in purchasing commercial real estate. The main purpose of the due diligence process is to discover the potential problems with a property, reveal any hidden profit potential or issues that would reduce the potential profit, and to verify all information that you have obtained. All of this “intelligence” will enable a buyer to make an informed decision on whether to move forward, or not, with an acquisition. In short, a thoughtful due diligence process will provide the buyer confidence that once the acquisition is complete, there will be no major surprises.

The due diligence process is only one aspect of the commercial real estate purchase transaction, but it is of fundamental importance. This course will provide you a useful and efficient resource for learning how to focus on the important issues as well as providing a number of cost savings and money making tips.

Course Objectives:
  1. Explain the due diligence process during negotiations
  2. Discuss the cost-cutting tips that can be found during due diligence
  3. Explain what mechanical and physical inspections consist of
  4. Understand the underwriting process and financial analysis process
  5. Explain how to use due diligence to close the deal
1.3 Types of Commercial Real Estate Transactions

Due diligence is essential regardless to the type of commercial real estate transaction you are investing in. To get started in this course, let’s review the types of commercial real estate transactions. There are three different types of transactions in commercial real estate. The first type is Stabilized Properties. Permanent financing is for stabilized properties. Stabilized properties are fully leased with rents at market rate and current cash flow within the properties. With these properties, there is no more work to be done on the property to “grow or groom” the NOI. Finally, in regards to risk, the lenders are betting that nothing “bad” will happen to the project cash flows in the future.

The second type is Unstabilized or Value-Added Properties. Typically shorter term or floating rate financing is more appropriate for value added properties. These properties are not fully leased, and/or rents are not at market. In addition, there is usually substantial work to be done before the property becomes stabilized. Finally, in terms of risk, something “good” needs to happen to the property cash flow in order to stabilize the property and achieve the business plan objectives.

The third type is Opportunistic Properties. These properties typically require “specialized” financing. With these properties, there are several exit strategies to consider:

  • The exit strategies for these properties require one of the following:
  • Residential sale exits: Typically relates back to the strength of the consumer (i.e. residential land and condominiums).
  • Commercial sale exits: Typically relates to commercial land that has an exit strategy of sales to commercial developers.
  • Development/construction: The property needs to be built and leased (which creates construction risk and lease-up risk).
  • Extensive renovation or change of use: The property has no cash flow in the beginning and may need to go through a change of use (i.e. office to apartments).
  • The risk: Numerous good things need to happen.
1.4 The Total Commercial Real Estate Strategy

In this section, we will review the capital strategy in its entirety. This will begin to showcase how due diligence “fits” into the strategy.

Within the capital strategy, is structuring the deals. This is where the fun comes in. And after you’ve gone through this, you’ll understand why vetting your deal is so important. This is where you add value and where the paydays come in. If you’re planning on doing consulting, you’re going to want to pay close attention here.

There are generally three ways to make money structuring your deals. And you’ll want to have these in the back of your mind when you’re pre-qualifying these deals.

Capital Placement

This is placing capital from one institution to buyer looking to purchase or refinance a property. We call these folks “sponsors” or “owner/operators.” These institutions are usually real estate private equity funds, otherwise called discretionary lenders, family offices, pension funds, life and reinsurance companies, endowments or hedge funds.

These same institutions generally provide capital across the entire capital structure. Meaning sometimes they’re debt, sometimes they’re equity, sometimes both. What you need to know is that the capital structure comprises of the total debt and equity at the asset level.

Sponsors are important because a sponsor with equity is more valuable than someone with no money down.

How You Make Money

In any deal where you’re placing capital, you as the Intermediary are usually incentivized in the form of points or a percentage of the total loan amount.

Depending on the deal – and the market – it’s not uncommon for you as the Intermediary to get a percentage of the deal after all improvements have been made.

So if that same $5,000,000 loan is placed on a property that will be worth $10,000,000 after all improvements are made (we call this the “terminal value” of the property) then if you are good at negotiation, and are able to score a 10% equity stake (otherwise known in the industry as “hope certificates”), then that is another $1,000,000 in equity.

Lastly, depending on how plentiful capital is, you may also be able to make a yield spread on this.

Let’s put this into context: When you deposit your money into a savings account at the bank, you expect to make somewhere between 1-2% in interest. What the bank does with that money is that they lend it out at 7% interest, then pay you the paltry 1% interest (with a straight face) and pocket the 6% interest rate spread.

You can do this too. Let’s see how.

If the capital provider is charging say 8% on a bridge loan, and you operator is looking for 9-10%, tell him 9% and then tell the servicer to pay the net difference to you. To put this into perspective, on that $5,000,000 loan with a 1% simple interest spread, that could amount to $50,000 per year or $4,166.67 per month – to you.

When capital is plentiful and cheap, it becomes competitive and every percentage point matters to your borrower. Someone will always undercut the other shop to get the deal done. However, when capital is scarce (think of 2008-2010), then it’s going to be much easier for you to get what you ask for. (Right now it should be clicking that it’s far easier for you to think like a bank, rather than a landlord.)

Debt vs. Mezzanine vs. Equity: Not All Capital Is the Same

The parts within the capital structure comprise of what are called structured products that all have different levels of risk. This is something you must absolutely understand if you’re going to swim in the deep end with these institutional capital providers.

Want to solidify your credibility instantly? Always ask your sponsor or operator who is looking for capital this question: “What kind of capital do you want? Where do you want your capital provider to be in the capital stack?” This will allow you to really effectively communicate to institutions.

Asset Arbitrage

In residential real estate, it’s called “wholesaling.” That’s what the little investors call it. In commercial it’s called “crossing a trade” or arbitrage. Now that we’re grown up and we’ll be facing off with grown up men and women in the industry we’ll want to use these cocktail terms.

This is simply identifying an asset that is undervalued, locking it up under a contract or an option, then either selling it or assigning it to an end buyer. You are “arbing” the asset. You are buying at a low and selling slightly higher. Not at retail or full market value because you want to leave enough meat on the bone to make your buyer truly interested and activate his or her greed glands. Got it? Good.

Remember that you need to be careful of Real Estate Commission rules of getting paid a commission on the sale of real estate without a real estate license. Get the property under contract and then sell or assign your contract for a fee since the contract is personal property and not real estate.

Now that we got that out of the way, here’s what you need to do to make sure your deal is legitimate.

  • Lock Up The Property at a Low Basis.

This means that there is strong market equity in the deal today. We call this imputed equity. It’s being sold for a number of reasons such as a partnership has blown up and everyone wants out, or the bank has taken it back through foreclosure or has filed foreclosure and time is of the essence to get the property sold.

In other words, if I were to offer you a house for $60,000 that is worth $100,000 today, that’s a strong basis. Meaning you’re getting $40,000 worth of imputed equity today for that $60,000. But if I were to offer you that same $100,000 house for $95,000, that doesn’t sound as strong, does it?

  • You Need To Have Your End Buyers Identified and Pre-Qualified.

The best use of time during the day is to spend about 30 minutes with yourself or someone else in your office – such as an intern or a domestic VA – finding and calling Qualified Institutional Buyers (“QIBs”). You’ll want to reference this blueprint below when speaking to them.

There are several types of QIBs out there and all of them have different motives. A publically traded REIT for example will pay close to retail for most assets as it’s easier for them to raise more capital by issuing more shares of stock.

Smaller private partnerships, comparatively speaking, have a higher cost of capital therefore they are more concerned about the basis at which they are buying an asset.

Of course, it’s far easier to cross a deal when you can get terms. If the buyer can assume the existing financing, then that makes the deal as a whole look way more compelling. Your retail investors, such as mom and pop investors; like doctors, dentists and accountants will almost always be more inclined to purchase these types of deals that are structured with existing financing.

Capital Formation

The third strategy is to raise capital yourself to take the asset down to place into your portfolio. These deals are usually structured one of two ways: usually using a fund or a joint venture structure. Those who are proficient at raising capital have the appropriate tools do so and are able to effortlessly raise capital on demand. They’ve lined up prospective investors, retail or institutional, and know how to approach each.

They have an ever-greened pitch book (a PowerPoint presentation) that they can use over and over again. They are prepared and they have planned to be nimble whenever an opportunity comes. They simply “call the capital” when they need to. They leveraged other people’s proven systems to pull down the right tools from the shelf when they see opportunity.

Now, after reading this, you probably now can come to the conclusion why most people who look to raise money around real estate deals fail immediately: it’s simply because first, they fail to pre-qualify their opportunities. They can’t seem to look at these numbers dispassionately. Usually because they are desperate to close a deal, or they are being strong-armed by a seller or investment professional who has a stronger personality than they do. Then, they merely can’t communicate the deal in a convincing, persuasive, and logical format.

And if you’ve even been pitched by someone who doesn’t know what they are doing, this scenario will likely be very familiar to you:

They send you a 20MB Investment Offering via email from a broker. It clogs your email.

They can’t explain the deal, so they tell you to read the whole 200 page Investment Offering.

The only thing they know about this deal that they are asking you to put your hard earned savings into is that it’s “great,” and “a sure bet.”

You have to do all your own research. There is a tremendous amount of pressure and sense of urgency to get you to invest. They have to close immediately – if not sooner.

No documents are drawn up, and you come to the conclusion that your operator or sponsor has no experience. You wasted all this time for nothing, or

You implicitly trust this operator to make the right decisions, and pray you don’t lose your hard earned money.

Incidentally, there is a blueprint you’ll want to review that we created for some larger news publications which discusses why you should run from any crowdfunded real estate deals – as a passive investor.

Crowdfunding is seen as being the next “big thing” in real estate. History has yet to be written on the effectiveness of this approach however, here’s a blueprint you will want to download and quiz your brother-in-law who is bragging about the $10,000 he dropped in a “very significant real estate deal.” The point here is that if you truly desire to be successful, you need to wear the right clothes to this party.

And quite frankly, it’s not that difficult. Those who aspire to become Real Estate Private Equity Fund Managers need to focus on using proven system to do only two things. Find deals. And fund them.

Assignment:

Commercial real estate capital structure is often misunderstood and misused by many, but this can be avoided by understanding how the capital structure works in commercial real estate finance. There are six different capital structure products that we discussed in this course.

For this assignment, please list the six capital structure products and provide your own definition of the product and an example of who would offer the product.

This assignment is your study guide to ensure you have learned these materials before you take the required quiz.