Author Topic: Invited to invest in development project- what questions to ask?  (Read 1536 times)

NorCal

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I was recently invited to invest in a Real Estate investment project.  It is a 50-100 unit apartment building, being developed by a a family friend.  They are raising several million in equity (I'm being deliberately vague on specific numbers).  This is the developers third major project, and the first two had solid returns.  I'm considering investing $20-$30K of my $1MM portfolio.  This is minor investment in the grand scheme of things, but I want to do my due diligence.

What questions would you ask the developers before investing?

I have my list, but I'm curious what would be on everyone else's list.

waltworks

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Re: Invited to invest in development project- what questions to ask?
« Reply #1 on: March 21, 2017, 09:09:49 PM »
Easy, only one question to ask - WTF are you doing crowdfunding/friendfunding this if your last two projects did so well?

Asking friends and family for money for a project is a huge red flag in general. There are always exceptions, but people who are great at RE development aren't scrounging up $30k at a time from friends.

-W

SwordGuy

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Re: Invited to invest in development project- what questions to ask?
« Reply #2 on: March 21, 2017, 10:06:27 PM »
Easy, only one question to ask - WTF are you doing crowdfunding/friendfunding this if your last two projects did so well?

Asking friends and family for money for a project is a huge red flag in general. There are always exceptions, but people who are great at RE development aren't scrounging up $30k at a time from friends.

-W

Fair concern, but not necessarily accurate for all RE developers.   

You've assumed that because the original poster is willing to consider 30k that that's how much the RE developer is looking for.   He might be looking for larger partners.  Or he might just be a friend looking out for a friend.    (There are some of us out there.)  Plus, he might be willing to let someone he knows put a toe in the water to check it out on this deal, expecting a bigger investment the next time around.

One of the real estate metrics is Cash on Cash Return, i.e., how much do you make compared to how much you put in.

If you use OPM - Other People's Money - you won't make as much on each deal but you can make more deals with the same amount of cash.     

Get ahold of Gallinelli's book on Real Estate Cash Flow (and other metrics).   Read thru it and then ask to see numbers on the project like you see in that book.   That way, you'll have a better idea of what those numbers mean in addition to knowing what numbers to ask about.

NorCal

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Re: Invited to invest in development project- what questions to ask?
« Reply #3 on: March 22, 2017, 10:41:14 PM »
Easy, only one question to ask - WTF are you doing crowdfunding/friendfunding this if your last two projects did so well?

Asking friends and family for money for a project is a huge red flag in general. There are always exceptions, but people who are great at RE development aren't scrounging up $30k at a time from friends.

-W

Fair question.  In this particular case, I'm not concerned about the friends/family aspect.  Their first two projects were funded this way, with my wife's family (very much an "old-money" family) being some of the major investors.  I was generally knowledgeable about the first project, having given the developer some general fundraising advice, and reviewing some of the investment documents on behalf of my MIL.

Proceeds from those first projects are being disbursed, making this his ideal time for the developer to ask the original group to re-invest.  He's asking for minimum $50K investments in the initial request.  I'd only invest if he'd be willing to take a smaller commitment from us.  I wouldn't consider it a big deal if he says no.

Swordguy:  Thanks for the tip on the Gallinelli book.  I'll check that out.  I've been involved in plenty of financial math before, but never with a real-estate focus.

tralfamadorian

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Re: Invited to invest in development project- what questions to ask?
« Reply #4 on: March 23, 2017, 01:05:37 PM »
I would ask questions about the expected cap rate on the property, the status of the market where the property is being purchased and what the funding looks like.

For example, apartment buildings of this size have been the popular thing to invest in for tertiary market SC and GA the last couple of years.  Folks who were ahead of the curve went in, purchased in 2011 at the bottom of the market, got traditional 5 year financing then sold in much better markets in 2016 and made a ton of money.  The market has become very competitive, driving down the cap rates.  So, the first question is - what is the cap rate expected to be on the property?

Next, what does the financing look like?  Is the developer financing the deal with 100% syndication funds, then going to get a loan later so the investors receive a large portion of their funds relatively quickly?  Or are they just syndicating the down payment and the investors do not get their principal back until the property sells?  Are the developers investing their own funds- do they have skin in the game?  What does the financing look like?  Typical financing on buildings of this size is a five year loan with 20-40 year amortization and a balloon at the end. 

Leading to- what is the time horizon on this property?  Two years to build, 2.5 years to maximize rents and occupancy then sell at the end of year 5?  Where in the real estate cycle is that market now and where can you extrapolate it will or may go during that time frame?  Look at the worst case scenario- what if that apartment market is peaking now and will be at the bottom of the cycle in two years?  Can the property survive 50% occupancy and 15% rent drops?  Then at the five year mark- what if there are no buyers in five years and the loan on the property needs to be renewed- can the property survive an interest rate hike of 5%?   

NorCal

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Re: Invited to invest in development project- what questions to ask?
« Reply #5 on: March 24, 2017, 09:55:22 PM »
I would ask questions about the expected cap rate on the property, the status of the market where the property is being purchased and what the funding looks like.

For example, apartment buildings of this size have been the popular thing to invest in for tertiary market SC and GA the last couple of years.  Folks who were ahead of the curve went in, purchased in 2011 at the bottom of the market, got traditional 5 year financing then sold in much better markets in 2016 and made a ton of money.  The market has become very competitive, driving down the cap rates.  So, the first question is - what is the cap rate expected to be on the property?

Next, what does the financing look like?  Is the developer financing the deal with 100% syndication funds, then going to get a loan later so the investors receive a large portion of their funds relatively quickly?  Or are they just syndicating the down payment and the investors do not get their principal back until the property sells?  Are the developers investing their own funds- do they have skin in the game?  What does the financing look like?  Typical financing on buildings of this size is a five year loan with 20-40 year amortization and a balloon at the end. 

Leading to- what is the time horizon on this property?  Two years to build, 2.5 years to maximize rents and occupancy then sell at the end of year 5?  Where in the real estate cycle is that market now and where can you extrapolate it will or may go during that time frame?  Look at the worst case scenario- what if that apartment market is peaking now and will be at the bottom of the cycle in two years?  Can the property survive 50% occupancy and 15% rent drops?  Then at the five year mark- what if there are no buyers in five years and the loan on the property needs to be renewed- can the property survive an interest rate hike of 5%?

All good stuff.  Thanks. 

tralfamadorian

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Re: Invited to invest in development project- what questions to ask?
« Reply #6 on: March 25, 2017, 11:33:34 AM »
All good stuff.  Thanks.

NP.  Let us know how it goes!

NorCal

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Re: Invited to invest in development project- what questions to ask?
« Reply #7 on: April 13, 2017, 08:09:59 PM »
I've spent some time reviewing the prospectus, operating agreement, and had a due diligence call with the developer.  I also re-built their cash flow projections with some more conservative assumptions.

Overall, I feel pretty good about the deal.  There are certainly risks, but the risk/reward profile seems reasonable.  Using my more conservative assumptions, I see a reasonable possibility of an 8% ROE*.  More optimistic assumptions could yield up to a 17%-20% ROE*. 

Summary:
-This is the second round of financing for this project.  The first round was used to acquire land and get all entitlements approved.
-Construction will take ~2 years.  The project will be refinanced from a construction loan to more traditional financing.  Market conditions will determine whether they sell the property or hold it.  I would have no say in this as a minority investor.
-*The refinancing would include a distribution of contributed equity back to investors.  The "E" in the ROE calculation above would be based on a lower equity amount than the initial capital being put at risk.
-Based on my cash flow model, the 8% ROE is based on today's market rents and a 10% vacancy rate (the local market is currently at ~5.5% vacancy).  Assuming lower vacancy, and some inflation in rents gets to the ~17-20% ROE.  The project completely blows up if rents decline by more than ~10%
-I'm considering putting 2.5% of my investable portfolio into this project.

Pro's:
-This is their third comparable project.  It is slightly larger than the other two, but not by much.  The first project did well (I don't have specific numbers, but I personally know several investors that are happy).  The second project is still underway.  They admittedly have had a big boost from Mr. Market over the last few years.
-A number of investors in the project are the same investors that backed the first two projects.  My wife also knows several of the investors as people who have made good livings in real estate investing.
-My checks into current market rents and vacancy assumptions didn't turn up any discrepancies with their financial model.  There were a few areas I wanted to be more conservative, but I didn't think the assumptions were actually out-of-line.

Con's:
-The project is in a new city for this developer
-The property does sit near some train tracks.  There is another property with comparable rents on the same tracks. 
-The project is in a part of town that is showing signs of gentrification, but isn't there yet.  While it's reasonable to think the neighborhood could improve, there's a non-zero probability that the neighborhood could revert in a downturn.