Doing Financial Research On Properties
By Kevin Williams
Why invest in real estate at all? After all, we could put our money into bonds and collect the interest. Unfortunately, the value of a dollar decreases over time. If a solid piece of real estate is our investment vehicle, its value will increase during its holding period while at the same time providing income. Real estate’s down side includes the fact that it requires a considerable upfront investment, a constant positive cash flow and usually, it cannot be quickly sold. On the other hand, about 90% of America’s millionaires made their fortunes in real estate, and 1031 exchanges allow for a deferral of taxes, so let’s look at some legal and financial aspects of these offerings.
Non-construction offerings, the most common, usually range from three to twenty years. This may include revitalizing a building while it is being used for income. Raw land with an offering time of three years or less usually means that the site will be going through the entitlement process wherein the required permits and reviews are completed by officials before construction begins. Consider what your ideal time limits would be for your investment because typically there may be little market for the long-term investments once they have closed. If need be, the sponsor would typically first offer the property to the investors in that same property, then to their other investors and finally, the selling agent may offer it to their clients, so it would not be a speedy process if the property had to be sold.
Let’s use as an example a hotel that needs refurbishing and has a (capital) cost of $16,345,000. If the cap (capitalization) rate looks at how quickly the property will pay for itself, then we can adjust the other factors involved to find our desired return. Net cash flow / Purchase price = Cap rate. With a purchase price of $16,345,000, the net cash flow has to be about $1,144,150 annually to get near a 7% capitalization rate. Investors, however, like to keep their cash equivalents, so, just as in buying a home, they may use a mortgage or leverage when partaking in an offering.
If an offering has 35 or less participants, it need not go through the SEC’s registration process, so that is the most common offering provided. For a 35-member offering, each investor would have to take on a minimum in leverage and supply equity (cash) totaling $467,000. The PPM (private placement memorandum) may also specify how the leverage and equity are to be split. The PPM also usually states a minimum purchase amount for each investor, but let’s stay with the $467,000 mentioned above. It then gives a dollar amount for the equity and debt. For instance, it might require $210,150 in equity and $256,850 in debt (leverage), which translates to 45% equity and 55% leverage as a minimum investment. Leverage gives the investor a larger slice of the pie with a smaller infusion of equity. Sometimes a single investor is limited to an amount 10 times the individual subscription amount. However, the fewer the investors, the less time and personnel the offering company has to allocate to the endeavor. About 6 months ago, a sponsor put out an offering with a 10% return, and one quick investor supplied the entire $12 million total for the 3-year period before any other broker-dealers could get PPM out to their clients. The sponsors could offer that return on New York property and they also liked having to deal with only one client. Some investors take larger slices if they feel the offer is a good one, or if their 1031 exchange amount is larger than the minimum, so having all 35 allocations go to 35 different investors is rare. Also, while the investor may keep to the 45-to-55 percent ratio, as long as they meet the minimum requirement, they can invest the amount they want. At the end, this may leave an amount less than the minimum. Therefore, there is usually a statement that says the offering company, in its own discretion, may accept an offer less than the minimum.
Our next step is to look at whether the operations will provide the advertised cash flow. For the startup, a Sources and Uses of Funds statement, found in the PPM document, should be present to show funds received from the loan and the investors (sources), and its deployment (uses). Uses may include reserves for ongoing operations – an important hedge against the unknown. The first Sources and Uses statement is about the startup, that is, the leverage and equity supplied by investors. There may be a projected Sources and Uses statement that shows the final year when everyone is cashed out. There should also be Cash Flow Projections for each year of the investment with cash-on-cash returns as a percent and reserves at the end of each year. The Debt Coverage Ratio is used as a criterion for further lending, should that be necessary. It is the annual net cash flow divided by the annual debt service. If the ratio is 2, then it has 2 times more net cash than the required debt repayment or leverage, and therefore can comfortably cover its mortgage payments. If there is or are pages about assumptions, it may seem very conservative, almost to a point that seems as if business will never be better than at the start of the operation. This conservative outlook is championed by auditors so as to keep everyone’s expectations within reality.
Be sure to look at the terms of the loan. Can it be prepaid, and if so, when? An inabililty to prepay the loan and/or a defeasance that works against prepayment might adversely affect the tenants in common’s ability to sell the property, if need be. If there will be a mezzanine loan (short term) or a refinancing, is the interest rate reasonable? Review all the fees and compare them to the other offerings. Don’t be afraid to ask about anything that isn’t clear. The offering companies have specialists who put the deals together and are ready for questions. Formatting your questions in an e-mail will give you time to first review it for clarity and omissions. There is often a section on how a 1031 exchange will work with the IRS code, accompanied by denials that it will work for everyone (or anyone). UBTI and the Alternative Minimum Tax may also be covered. Once you have submitted all your questions and received answers from the sponsors, be sure to show it to your tax or investment advisor. They sometimes have a different take on the situation.
Companies, more and more, are setting up a Special Purpose Entity as a Delaware LLC for each buyer, whether or not the buyer has a trust or other protective vehicle they planned to use in the title. Spouses are considered to be a single member for this purpose. This is referred to as “a single member limited liability company intended to be bankruptcy remote (“SPE”)”. Its purpose is to securitize a commercial mortgage and at the same time keep the investment and investor out of anyone else’s bankruptcy. To do that, it has to meet certain requirements which are not usually in a trust or other personal document. For more information you can bring up “SPE” on Google to get a more complete definition, or request a copy from us to be e-mailed or U.S. mailed to you. The offering company may pay for the initial setup or roll the cost into the buyer’s upfront fees. The buyer usually pays the annual Delaware fee thereafter (about $125), and the bill is usually mailed to the investor from the State of Delaware. This is an additional layer of protection for the investor and therefore the offering company.
Some investment firms include in their PPMs a list of all their offerings in the past with their dates and financial data as part of the list. If this is not provided in the PPM, be sure to ask for it from your agent or broker-dealer. The offering company is a stranger to you and as a careful investor this is one more step in allocating your funds wisely.
Kevin A. Williams, President of North Global Securities, is currently the Managing Director of North Wealth Management Company, LLC. He has allocated his talents to the institutional investment services arena for over 15 years. Kevin earned a Bachelor’s Degree in Economics and also holds the following securities registrations: FINRA series 6, 7, 24, 63 & 65 industry certifications and is licensed by the California Department of Insurance.
Kevin can be contacted at North 1031 Exchange, 4667 MacArthur Boulevard, Suite 220, Newport Beach, CA 92660. Toll Free: 866-700-1031 or Kevin@north1031.com