Key Questions To Ask When Performing Due Diligence On Your Deal Sponsorship Team

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Not every deal is worth your investment. Before making any decisions, it's important to establish a baseline for both effective decision-making and mitigating loss of investment capital. Here are eight great questions to ask a deal sponsorship team when performing due diligence on the investment opportunity.

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1. How experienced is the property management company? How many units do they currently manage? Are those properties comparable to this investment opportunity?

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A property manager is one of the most important partners in successfully executing the investment strategy. The property manager should be experienced in that particular market and their portfolio of experience should match the asset type associated with the investment property. For example, a property manager with class "A" expertise is not likely to be successful with class "C" properties. Ensure your sponsor has hired a property manager who manages comparable properties in the area.

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2. Have you or your team surveyed and visited the comps? Why are you confident that this property is comparable or better?

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Upon performing due diligence on a multifamily investment opportunity, your sponsor should not only perform a rent survey that supports their decision-making on rent projections, but should also "shop" the comparable properties (comps) in order to get a detailed view on their competition in the market. This allows the sponsorship team to have a visual conception of what their property should look like. Furthermore, the comps should be a like-kind asset to the investment opportunity. A class "A" property built in 2010 is unlikely to be comparable to a class "C" property built in 1978.

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3. What is your number-one concern with the property?

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Every investment opportunity has its downsides and risks. Your sponsorship team should be transparent when identifying all concerns and potential issues in an investment opportunity. If a sponsorship team is not able to identify at least one concern, it may be a red flag.

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4. Are you investing your own capital in this deal? If so, how much?
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This is one of the most important questions any investor should ask and know the answer to when presented with an investment opportunity by a sponsor. It is important to have a sponsorship team that has some "skin in the game," to ensure an alignment of interest among all parties. Sponsors with skin in the game will be more motivated to perform well in their roles and responsibilities, as they, too, are tied financially to the investment.

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5. Will there be an acquisition fee? Will there be an asset management fee?
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An acquisition fee is common in most real estate syndication or deal structures where large amounts of capital are pooled toward an investment opportunity. The acquisition fee simply compensates the sponsorship team for their expertise, network, and hard work of identifying and closing on the property. Typically, an acquisition fee is between 1-3% depending on the deal size.

An asset management fee is commonly charged by the sponsorship team for the ongoing management of the investment opportunity and executing the investment strategy. Typically, an asset management fee is between 1-3% of the total income collected.

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6. Does this investment opportunity offer a preferred rate of return or equity split only?

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An investment offering a preferred rate of return (PREF) is structured in such a way that the equity investors (or limited partners) are the first to receive profit distributions at a certain percentage point, before the general partners are paid their asset management fee, profits, etc., on distributions. This is a method to ensure an alignment of interest among all parties.

An investment offering can also offer an equity-split-only structure on distributions. Both structures have their own pros and cons, but an investor needs to understand the implications of either choice and how it affects their investment returns.

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7. How did you come up with your property taxes in the pro-forma?
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Property taxes are likely the largest expense on a multifamily investment property. Absorbing unforeseen increases in real estate taxes can be detrimental to any investment, thus impacting return projections. Your sponsorship team should have discussed with the local municipality and the tax assessment office on exactly how the new purchase will likely increase their property tax liability over time. Property taxes can be a serious oversight if not factored into the pro forma correctly.

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8. Does the insurance policy cover the loss of rental income and the full cost to rebuild in case of a fire?
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Acquiring a large asset requires purchasing the proper insurance coverage to protect the investment from a loss as a result of weather damage, fire damage, accidents, and natural disasters. A multifamily sponsorship team should always have coverage for loss of rental income and cost reimbursement in the case of a fire at the property. A detailed understanding of these coverage options provides additional security on the investment opportunity, and provides operators additional protection over their capital investment if the property is unable to operate.

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Summary:

It is critical that adequate due diligence is performed on every sponsorship team. These questions provide a framework that works for any real estate syndication. Always follow a detailed process on qualifying deals.

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Author: Yannik Cudjoe-Virgil

Yannik formed Merlynn Acquisitions in 2017. He has experience in portfolio asset management, real estate investing, investment analysis and financial modeling.