Seven Questions to Ask Before Investing in a Private Real Estate Deal or Fund

In an earlier blog post I discussed how to evaluate private real estate investments, including the challenge of comparing different opportunities to each other. Common real estate performance measures reviewed were debt service coverage ratio (DSCR), cap rates, yield on cost, internal rate of return (IRR), and equity multiple.

While all these metrics are useful, some can be misleading when analyzing investments side by side, and it’s perilous to make an investment decision based solely on one or two popular metrics.

But there’s more to investing in real estate than the property itself. You’re investing in people, too. So, kick the tires of the sponsors behind the commercial or multifamily real estate deals or funds you are considering. In other words, get to know who you’d be doing business with.

How do you do that? A good place to start is by asking these seven questions:

What's the sponsor's track record?

It sounds simple enough, and it is. But it’s amazing how many firms squirm when you ask them to detail their performance on a deal-by-deal basis. That’s what you want to see, if only to verify that the sponsor is disclosing the poor or middling performers as well as the winners. (There’s no shame, by the way, in necessarily having some poor performers.)

How consistent is their overall performance?

Following on the above, general consistency is arguably as important or more than occasional misses. Look at the sponsor’s overall track record over time. For most people, overall performance is most important, especially if you’re investing in a diversified fund that holds multiple properties.

Do they hit their targeted underwriting goals?

Before making investments, sponsors analyze them, determine how they intend to make money, and essentially develop a business plan for each asset or portfolio. Asking sponsors how well they’ve done at underwriting reveals how thoughtful, thorough, and accurate the sponsor was in their planning versus their actual performance. It also reveals the role of luck (good or bad) and how extenuating circumstances may have affected their projected versus actual performance.

How do they react when their underwriting assumptions don’t pan out?

In other words, are they able to pivot to a “Plan B” to turn the property into a performer or otherwise exit the deal in a way that minimizes losses?

How well do they communicate with investors?

You can gauge this by assessing the frequency and the transparency of a sponsor’s investor communications, their willingness to be available and answer your questions, and by speaking with other people who have done business with them.

How likely are they to make it through the next few years and take care of you?

This can be a tough question, but what you’re really trying to gauge is how prudent (or not) a firm is in its investment decision-making and operations. In contrast, if they’re a highflier making high-risk bets, the odds are higher they won’t survive a crisis or downturn.

How much of their own money are they investing alongside yours?

The sponsor should always have skin in the game, plain and simple. Make sure the “House” is invested alongside you in any deal or fund.

Long story short, no person or firm is perfect — that should not be the standard. But you see where I’m going here.

Who you do business with is as important as the fundamentals of the deals you are investing in. As you seek to build a diversified investment portfolio with alternative assets including income-producing real estate, you should be comfortable with the sponsors who are the stewards of your money.