Since regulatory changes permitted general solicitation of investors for real estate projects, developers have started pitching investment opportunities online, attracting the interest of both the knowledgeable investor, as well as of those with little experience in the industry.
Many of these opportunities are legitimate—others are a bit riskier. If you’re looking to invest in commercial real estate, how can you decipher the good developers from the great? Some you may want to run from altogether, but how can you tell?
There are several tried and true way to evaluate a real estate developer. Based on our collective years of experience, here’s how to go about it.
5 Questions to Ask Before Investing With a Developer
1. Does the developer have multi-cycle experience?
People will advise you to consider a developer’s experience, but experience alone is insufficient evidence of how the developer will perform long-term. A developer who has an incredible track record over a five-year timeframe during only the upward period of a cycle might collapse when the next recession hits.
That’s why it’s critically important to consider whether the developer has multi-cycle experience. Look for a development partner that has weathered at least one downturn and made it through to the other side.
Ask probing questions about their experience during the last downturn:
- Did they have any projects in process when the recession hit?
- How’d they manage to complete the project? (Or did they? For example, maybe they sold it or surrendered to the lender.)
- What is their game plan in the event that the lending market tightens up?
How a developer answers these questions will give you confidence as to whether you should be investing with them.
2. What does the developer see as the risks for this investment opportunity?
Every project has risks, and a developer who tells you otherwise is misleading you. Instead, look for a developer who is unafraid to discuss the risks of a project and address them head on.
For instance, maybe the project is located in an untested market—or in a market where the target rents for this project have never actually been achieved elsewhere, but the developer has good reason to believe this project will achieve them (and explains why).
Or maybe it’s a 20-unit apartment building with a restaurant contemplated for the ground floor, and there’s no prospective tenant lined up for the restaurant space. Therefore, the restaurant space may be a loss-leader for some time.
Whatever the case may be, it’s important that the developer talks candidly about potential risks and how they plan to mitigate those risks.
3. What does the developer charge for fees?
Many real estate developers charge initial fees for various components of assembling a project—from acquisition fees, to finance fees, to development or assets under management (AUM) fees. The total of these fees can vary widely, from 2 percent of total development costs to upwards of 10 percent, depending on the size and complexity of the project.
It is important to look at the developer’s aggregate fees going into a project and compare with the co-invest that the developer has in the deal—the equity they personally invest. For instance, if the developer has a 10 percent co-invest in the deal but is charging a total of 10 percent upfront fees, then they aren’t really putting any of their own money at risk.
Take a look at the “promote” the developer is taking from the deal, as well. A promote is essentially an extra (disproportionate) share of the returns, taken by the developer (as the project sponsor) as a bonus to motivate them to exceed the expected returns on the investment (versus those returns being shared with the equity investors).
The most common promotes industry-wide range between 10 to 20 percent, whereby the developer will take that as their incentive fee before investors split the remainder.
You want to look for a development partner who is motivated by their profit share—you want them to do well and be driven to maximize returns for you. But you also want one who is willing to share in the risk of a deal. In short, be sure that there’s what’s called an “alignment of interest” between you and the developer in terms of the shared risks and rewards before committing to any investment.
4. Who else is on the developer’s team?
Be wary of investing with solo entrepreneurs. No matter how impressive that developer may be, those who operate independently put projects at risk in the event something were to happen to that individual. As unlikely as it may be, that solo developer could get hit by a bus or become incapacitated in a ski accident—you just never know.
Instead, look for who else the developer has on their team. Look at this on two fronts: the first is the management team. Look for at least two partners on the developer’s management team. Gauge how well they work together and who is responsible for what.
If something were to happen to one, can the other pick up where the other left off? Who’s the team behind them, and is there a succession plan in place if the partners decide to move on or retire?
Look at the other “team” members, too—those outside of the organization but who are still critical to the project’s success. Who have they brought on as their architect, general contractor, and property manager? Who is their accountant, attorney, and lender?
Do these people seem credible? Unlike stocks, which you can cash out of at any time, investing in a real estate deal is a long-term commitment. It’s important to know who you’re getting into business with before investing in a deal.
5. What is the developer’s approach to debt?
Debt is a killer. During the last financial downturn it wasn’t the real estate that went bad, per se, it was the way that developers had layered excessive debt onto their projects. Federally regulated lending institutions had little flexibility then, as they have now, in managing borrowers who missed payments on debt.
There was little or no room for negotiation. As the economy slumped, rents declined across all sectors, vacancies increased, and NOI dropped below debt service levels, creating distress. This was particularly true of land investments where there is no possibility of income from rent and only expenses like insurance and property taxes.
Land should only ever be purchased all cash and checking a developer’s perspective on how much leverage they place on assets during every phase of a project’s life cycle will inform you how likely they are to weather the next downturn.
The real estate market experiences tremendous run ups and calamitous collapses during its natural economic cycle. Often times during the upswing periods, inexperienced professionals will enter the market to try and take a bite out of the apple, too.
This creates a crowded industry where novice investors are at risk of investing with developers who don’t fully understand what they’re doing. Mitigate that risk by asking these questions as part of your due diligence process when evaluating real estate developers.
What would you add to this list? Questions about the above?
Let’s discuss in the comment section below.