How To Vet A Crowdfunded Development Opportunity

This is from one of my blog posts for iFunding that I thought I'd reproduce here for BP's benefit ;-)

As an investor you should be concerned that the project you’re participating in has a sponsor with adequate knowledge of the development process. Development activities vary considerably in different areas of the country, which makes your job of doing diligence on the opportunity much more challenging. Given the typical investment on most of the crowdfunding portals an exhaustive diligence process is difficult because the expense would crowd out any profits you could generate.

So what should one look for in a successful developer? How can one verify that they add value and will be a good steward for investor capital? How can one really develop trust via an online portal?

To be completely frank these are difficult questions to answer and an exhaustive analysis is unlikely for most investments. Below are some of the things I would consider if you’re looking to invest in development projects online via a portal:

·Proper Contracts – What many passive investors fail to understand is that proper buy-side contracts are crucial to designing out risk. People that invest in real estate opportunities frequently have some experience with buying existing building or land that is already properly entitled or has an existing improvement. Purchasing land for development is a far different animal given the uncertainty associated with entitlements. This is especially true in locales with large backlogs of permits with beefy waiting times because sellers of infill land or projects for redevelopment often treat the sale like a residential house sale. They want 7 or 10-day options and short closing periods typical of residential house sales. They also want short closing of 30 days or something similar to this. Some of the better developers can react this quickly, but it often presents a lot of challenges with city bureaucracy that doesn’t care that the market is dictating quick closings. You should examine buy-side contracts closely if you’re investing in a project where the developer is raising funds during the contract period

·Budgets – Budgets are always challenging because they attempt to assign some predictable expenses to real world projects that are inherently unpredictable. Development can yield projects with underground springs that were not discovered during soils analysis pre-closing or other challenging items that could not have been predicted until the project was in flight. A careful accounting for a contingency factor should be budgeted and bank budgets should have enough room to account for the uncertainty associated with material or labor cost variances. In a hot market these costs can rise and certain systemic risks like inflation can cause material prices to rise appreciably. One should ask questions about budget items and make sure that the developer and/or his contractors have a history of bringing projects in on budget

·Experience – How many projects has the developer developed in the subject area? How often have they worked with the team of professionals that will be executing the project you’re considering investing in? Just like with a professional sports team the individuals can be fantastic and fail miserably collectively. We take care to only pair one new team member with others in a new project to help isolate the source of problems. One would do well to quiz the developer about their experience with the team they select for a given project and how they’ve worked collectively. The most important members of this team are generally the property broker, banker, civil engineer, architect, and surveyor. All of these team members provide critical needs for the project and any one of them being a weak link can cause major problems for new development projects. We have literally interviewed hundreds of professionals to select team members for each of these functions over the last several years. Finding top-notch team members is hard work. Finding talented individuals that work well as a team is even harder

·Alignment – Deal structure matters! Investors should take care to make sure that developers primarily make money by adding value for the investors. Small fees to cover overhead are necessary for cash flow reasons in many cases, but the best projects for investors are generally ones where the developer has to deliver value to the investors before they participate in the profits. This is generally done with a preferred return and some split structure thereafter. Fees should be carefully examined; especially if they’re higher than industry averages. Fees higher than normal create misalignment and can cause promoters to take on projects solely to generate fees instead of providing value for the project’s investors

·Internal Controls – How does money move in the project and who has access to it when? There is a different golden rule in business that says, “He that has the gold makes the rules.” Small contracts are difficult and costly to enforce. Thus one wants to carefully examine who will have access to funds and how they’re handled throughout the project. A classical source of issues for both lenders and promoters is to allow contractors to handle funds for items before the work is done. Some contractors are great at building houses, but horrible at managing a business or handling funds in general. Care should be taken to make sure that work is paid in arrears to avoid money handling risks

The list of items above is certainly non-exhaustive, but it should be a good start for things to look for. In general I would look for these items:

1.Buy-side contracts are structured properly to hedge development risk for the project

2.Budgets appear professional and include all project fees and not just the sticks and bricks for the project

3.The developer has a track record of doing the type of project they’re raising funds for and are not practicing with your money

4.There is alignment in the deal structure so that the developer primarily makes money by making the investor’s money work harder

5.Internal controls and handling of cash are structure to minimize risk; especially risk of contractors handling funds prior to the completion of work

Hopefully this is helpful information in your quest to find the best risk-adjusted home for your investments. Happy investing!