One of the best things about passive investing is that you are not the one doing the day-to-day work. When you invest passively, you find a great deal, trust a worthy operations team, and then you receive monthly or quarterly checks. Sounds pretty great, huh?
But there is a flip side.
Since you are not the one that is actively managing your funds, there is room for error.
Your control in the deal is in the front end before you invest. Think of it like high school: The best thing you can do to succeed is your homework.
If you don’t do your homework, it leads to the two most common mistakes that I see investors make.
- Not appropriately vetting the operator (or deal sponsor).
- Not appropriately vetting the deal.
Vetting the operator
There are many reasons to vet the operator (or deal sponsor running the deal), but the biggest one is also the most obvious.
You want to be able to trust them!
The operators are the ones handling your investment day in, day out. They are trying to increase occupancy, doing deals, and working on the business plan.
Understand their background
These are the people whose success leads to yours. So you want to know a few things about them,
- Who are they? You are looking for a track record of consistent returns.
- What area of investing do they work in?
- Who else is involved in the deal?
- What is their reputation?
Just think about the kind of person you would love to be in business with, and let that be your guide.
You can also do background checks. Remember, it is your money on the line, so be as thorough as you need to be. I know a few people that do background checks on every single partner on a deal. Do what feels right.
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Utilize your network of fellow investors
People know each other, and if they have had a good or bad experience, the word gets around pretty quickly. Talk to people who have used this operator before. What was their experience?
One of the best things to ask is about the operator’s communication. What was the communication when the deal went well? How about when it didn’t go well?
There are groups out there that stop communicating with passive investors. To me, that is one of the worst things that can happen as a passive investor.
A lack of communication can lead to all sorts of problems. Think about it. If a problem arose and the operator didn’t tell you, how would that affect your investment?
Know their experience and strategy
Focus on what kinds of deals this operator has done.
What are the types of deals they do? What is the track record of the operator’s investments?
Great operators should be able to share stories of deals that turned out well and their specific returns. They should also allow you to speak with current investors and ask about how it has been to invest with this group.
Again, use your network! Talk to your friends and see what they can help you find out.
If you can see a positive history in the operator’s portfolio, then you can feel a little safer with them managing your investment.
There are so many different strategies out there for passive investing. The type or class of unit you invest in, how to create profit, and the level of involvement needed from the investor can all vary from deal to deal.
What makes a great operator?
My experience has taught me that the best operators are specialized. Their plans are specific and clear, and you can follow what they plan to do.
You can’t be all things to everyone. You can’t effectively do ground-up development and value-add deals and work with office space and work with multifamily and work all over the country.
That is way too much to keep track of! Just thinking about it is a lot.
An example of a good, simple deal goes like this: “We work in the Southwest in secondary markets. We look for X% of returns. We’re looking at B and C class or working-class properties. We do a value-add strategy. We’re trying to raise rents by $100 or $200 per unit.”
And even better is when they can point to a history of their investments.
How would you feel if an operator could show you five, 10, or even 20 deals where they used the same strategy? Pretty darn good, I can assume!
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Vetting the deal
Just as important as vetting the operator is vetting the deal.
In this process, the first and biggest question to ask is whether the operating group is conservative in approaching the deal.
There is a lot to cover about conservative underwriting. Let’s try to keep it simple: You want the deal to err on the side of being conservative.
Make sure that the deal is not just trying to show off great hypothetical numbers. Some deals look good, but on a closer look, you realize the operators just made the numbers look good.
You want to make sure that the deal considers a healthy margin of error in its growth projections. Housing, for example, is a reliable investment plan, but within different markets, you can’t always rely on exact and organic rent increases year to year.
When it comes to seeing how conservative a deal is, my favorite number to look at is the rent growth. You can tell so much about a deal from just this number.
Let’s say a specific deal is in a market where the organic rent increases are 3% per year. Looks good, right?
But a lot of operators will think that if this is how rent increased in the past, then it will stay at 3% consistently.
But being conservative, you don’t rely on that number being consistent. Maybe some years there has been less rent increase. Or maybe the market appreciation has become stagnant.
By planning for such dips in rent growth, the conservative operator can better ride out these kinds of situations. This helps keep your investment safe.
This also shows you that the operator is keeping active and not relying solely on experience.
Cap rate at exit
The cap rate is the rate of return, the extra income you are bringing home each month that has accrued from your investment.
Think about it like a tree. If your investment capital is the root and trunk of the tree, the leaves are the cap rate. We all want more green, but sometimes a bigger tree puts out fewer leaves.
When selling off your investment, you’d want to have fewer leaves on the tree, meaning you got as much green out of the investment as possible.
When scoping out a deal, you don’t want to assume that you will be able to sell off your investment at a more favorable cap rate. If you can, good on you! But the conservative operator will have it planned out to sell at a higher, unfavorable cap rate than the investment was initially at. Again, this allows for a healthy margin of error.
By doing this, even if the deal doesn’t do as well as you would have liked, you aren’t relying on that income from the more favorable cap rate.
It also gives you, the investor, the confidence that the operators are not misrepresenting the numbers to make the deal look better than it is.
This one is simple. You want to make sure the deal has a rainy day fund and a little cash reserve if something comes up.
What if they run out of liquid cash? What if the renovations or improvements don’t go as planned? A simple check on whether or not the deal has an extra reserve in place can show you the quality of the deal.
Make sure you understand the deal
I am a student of Warren Buffett, and he puts it the best: “Never invest in a business you cannot understand.”
You want to make sure you understand the deal and feel comfortable with everything involved. If you don’t understand, don’t invest in it!
Be willing to look around at a few deals. Find the operator and the deal that match your temperament and your goals.
By taking the time to vet the operator and the deal, you are already two steps ahead of everyone that has made the mistake of jumping in blind.
To invest successfully is to understand what you are doing and keep learning!