12 Ways To Add Unnecessary Risk To a Deal

July 6, 2021
12 Ways To Add Unnecessary Risk To a Deal
Unnecessary Risk To A Deal

Since we started our podcast, and most recently, RealCrowd University, our goal has always been to steer investors towards a profitable investment decision. Not just providing access to great deals, but discussing the right mindset, how to develop a plan, and how to measure risk. That’s why we bring in experts like Paul Kaseburg of MG Capital Groups to discuss subjects like “how to evaluate sponsors”, “how to analyze deals”, and “how to read a PPM.” But we still see many investors fall into the same traps that puts their money at risk. So we brought Paul back to discuss the 12 ways investors are adding unnecessary risk to a deal.

12. Putting the deal before the strategy

Investors should have a game plan in place before going out to search for deals and sponsors. This is to avoid being swayed by inflated numbers and flash marketing. It’s fine to look at IRRs, but your personal investment strategy is much more important.. Before analyzing deals, answer the following questions:

  • How much money do I want invested in this sector of real estate?
  • Do I want to be in equity or debt or some sort of structured product like preferred equity or mezzanine debt?
  • What product types do I want?
  • What locations are forecasted to perform?
  • Will it be entitled land or is it going to be core?

“Since the eventual goal is to have a diversified of a portfolio of real estate, you need to look at many deals, and speak to a variety of sponsors to increase your chances of success,” Paul says.

11. Underestimating your risk tolerance

"Once you pull the trigger on a deal, you are stuck with it for as long as it takes for that sponsor to decide it’s time to sell," Paul says. Your tolerance for risk is dependent on your entire investment portfolio so your financial advisor is best suited to give you advice on that front. The average real estate deal is anywhere between 5-10 years. Do you have the capacity to have your money locked up for that long? "This all comes down to understanding your tolerance for risk because in a downturn, you need staying power to get you out of a risky place," Paul says. Real estate is hard to predict. "There’s so many variables and so much uncertainty," Paul says. “So if a sponsor decides to hold another couple years, that’s really out of your control as a limited partner and you need to be prepared to hold longer if necessary."

10. Listening to the "guru" party

Everyone has an interest. "Whether they’re an intermediary, an advisor, a deal maker, or some kind of a sponsor, ask 'how they make money and what their relationship is to you?' And whether that relationship is fiduciary or not," Paul says.The reality is that the financial management industry is too broad to offer one-size-fits-all solutions. Each expert has a narrow context, so Paul is weary of anyone who claims to have all the answers. "It’s best to avoid a deal you're not comfortable with because there will always be more deals in the world run by sponsors who meet your comfort level," Pay says. "Your responsibility to ask the right questions and theirs is to clearly communicate what they’re trying to do with the deal."​

9. Going for quantity instead of quality

“To find the highest quality deals, you need to look at a lot of them,” Paul says. There’s no way around it. And as you look at them, ask yourself:

  • Is this a good sponsor?
  • Is this good real estate?
  • Does this track record fit with the sponsors?
  • Can they execute on the strategy that they’re planning to do?
  • Do the fees make sense?

“Over the long-term, fill your portfolio with the best-in-class across many categories, those with sponsors and strategies that makes sense,” Paul says. For each deal you look at, pay close attention to the following 2 documents:

  • The Executive Summary goes through the basics of the deal like the real estate maps, business plan, basic financials, sponsor information, and track record. "That’s your first cut to see what’s going on with a deal, particularly on the sponsor," Paul says.
  • The PPM is super boring but it has everything you need. "This discloses everything good or bad about a deal to investors. It helps investors understand all the risks in a deal and potential kind of pitfalls of that deal, as well as the opportunity," Paul says.

8. Participating in a deal that takes regulatory shortcuts

RealCrowd operates under Reg D Rule 506(c) which was part of the Jobs Act that allowed for public advertisements of private real estate deals. With that comes additional accreditation requirements, including asking investors to go through a qualification process.But it turns out, not all crowdfunding platforms follow the strict rules imposed by the SEC. Investors often say, "In other places, I can just check a box and I’m good to go?" But that can be a dangerous— getting involved with a platform that takes regulatory shortcuts. So far, the market’s been strong and everyone is turning a profit. But what happens when the markets turn? “That’s when issues come up,” Paul says. “When the real estate doesn’t perform as expected, and you have investors asking for redemption.” Whatever platform you choose to invest with, always ask what exemptions are being relied on? How is this regulatory compliance assured? What are my risks if I’m investing in a deal on this platform and it isn’t done correctly? Those are all valid questions to avoid unnecessary risk.

7. Focused on returns over experienced sponsors

It’s often the case that less experienced sponsors tend to be more aggressive with their assumptions. This is to incentivize investors with higher returns on paper. “It's just a matter of turning ON the right dials because for an investor, it's hard to understand the entire financial model," Paul says.Unfortunately, a common practice within the industry is to focus purely on return. Investors have been conditioned to want high cash flow, without any consideration for the risks being taken to get it. "You know it’s easy to evaluate an IRR, but it’s really hard to quantify risk." — Paul Kaseburg"Everyone just assumes you can forecast 10 years worth of IRR to the thousandth place and no one really thinks that’s humorous," Paul says. "First think about the risk then think about IRR."To see through hyped-up marketing, Paul suggests measuring assumptions as follows:

  • What are the payroll assumptions?
  • What are the turnover assumptions?
  • What are the assumptions for the growth rate of utility expense over time?

There's a million things you can dig into to compare and contrast different deals. And although Paul admits you don’t always have all the information you need to do that, you can still reverse engineer as much as possible with the financials that are provided.

6. Focus on fees over the quality of sponsors

"It doesn’t help to have low fees on a deal that doesn’t make money," Paul says. "And while you would expect higher fees for higher quality sponsors, that’s not always the case."“Investors pay sponsors to go out, find great deals, and leverage every tool at their disposal to make a profit on for all parties involved,” Paul says. The more experience a sponsor has, the more they can leverage existing relationships, whether it’s with brokers to avoid overpaying for a property or contractors to minimize the cost of construction. That’s why there’s no sense paying smaller, obscure sponsors exorbitantly high fees.

5. Adding additional entities or aggregator vehicles to a deal

One of the reasons RealCrowd follows a direct model is so that investors deal directly with sponsors, unlike indirect platforms that act as an intermediary entity, where investors must communicate with the platform, not the sponsor. This adds fees and complicates the relationship. Simple is always better.. And this includes how the capital is structured. “This is how you end up in unusual situations and structures, and get misaligned interests between all the people who are involved with the deal,” Paul says. The same goes for investments where deals are packaged together into notes or other forms of aggregator vehicles. Really, any legal entity that gets in between a sponsor and investor adds unnecessary risk to a deal.

4. Lack of diversification

The cylical nature of real estate cannot be avoided. At some point, the downturn happens. The best defense, Paul says, is to “avoid being overly exposed to any one asset class or location that’s going to come back to haunt you.”“A big employer might leave or the price of oil could go down and that can either change your entire portfolio or it can impact one or two deals in your portfolio,” Paul says. And there’s really no excuse now, with the rise of crowdfunding platforms like RealCrowd that makes deals much more accessible.There used to be a very real barrier to building a diversified portfolio. Now you can get into deals for $10K-$25K and build a really well diversified portfolio across different markets, product-types, and sponsors. “But don’t forget the quality-vs-quantity conversation we had earlier,” Pauls says. “On the one hand you want to make sure you’re doing quality deals with quality sponsors and on the other you want to have enough diversity in your portfolio that you’re not overexposed. Find your middle ground.”

3. Failing to diversify time

Paul was one of the first to introduce the concept of vintage on our podcast. This is the concept of spreading investment capital out over time."This is to help manage risk," Paul says. "You don’t want all that concentration in one year for sure. But it’s a whole lot easier when you have that market tailwind than a market headwind to do well, so I think diversifying your investment over time is important," he says. Another strategy is to rollover on the exit too, asking whether all assets should be sold or whether a 1031 exchange is required. “Investors should look at managing their ongoing portfolio over the next 30 years as opposed to trying to find the highest underwritten IRR over the next three years,” Pauls says.

2. Too much leverage

Paul cautions that over levering deals can create unnecessary cash-flow problems to the point where you start having conversations with the lender about how to manage the property. "You want to be able to hold a good deal long enough that the market is going to make up for a lot of short-term ills,” Paul says. Always think, "What can go wrong before I can’t make my debt-service payments? During his own due diligence, Paul runs a simple stress test for each multi-family where he considers how much revenue he can afford losing before he hits a cash-flow break-even point.“For retail or office, this means considering if a major tenant leaves, can I pay my bills and what’s my exposure here? And what are the chances that they’re going to leave?” Paul says. Thinking through these scenarios will help you understand critical problems before they happen.

​​1. Failing to read the PPM​​​​​​​

If you do nothing else, read the PPM. Because anything “bad” about a deal, it will be found in the PPM. “Private real estate is an illiquid and inefficient market that makes it exciting and interesting, but it’s going to require work to do properly," Paul says.This is how Paul goes through a PPM:

  • First, and I realize this is not environmentally friendly, I print the whole thing out.
  • Next, I sit down somewhere where I won’t be disturbed, go through it from beginning to end, writing down questions and comments with a red pen.
  • It takes some focus so you don’t want to do it five minutes here and five minutes there, and risk getting distracted.

It seems simple to do, but what’s important is developing a practice that works for you. The PPM is hefty and written by lawyers, so it will test your patience.. Paul goes through it all at once but you may prefer to dedicate 1-2 hours per day consistently.Once you have your cliff notes, take it to the sponsor to go through all your concerns together. Remember, sponsors want to know that investors understand what they’re signing up for, including all the risks and opportunities. ​*********That’s 12 ways you can add risk to a deal. In describing each, we hope you’ve walked away confident that you can now avoid these traps. If we had to summarize this list into one important takeaway it’s this: knowledge is power.There are no tricks, shortcuts, or secrets to learn. Everything you need to succeed is available for free. Train yourself to spot the amazing opportunities less hard-working folks don’t see.*********Tyler Stewart is VP of Investor Relations at RealCrowd. All opinions expressed by Tyler and interviewees are solely their own opinions and do not reflect the opinion of RealCrowd. This article is for informational purposes only and should not be relied upon as a basis for investment decisions.

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