Family Offices Need Real Estate Due Diligence That’s Real

Forbes

Direct investing by family offices in real estate is something that you hear about a lot. But the question that hardly ever comes up is, “Are we really investing in a solid real estate deal?”

Of course, this is not true for all families, especially if real estate is the industry in which they created their wealth. But for families whose money was made in steel, fashion or chemicals, for instance, who then exited after years of building a business and then selling it, the due diligence hurdle often is a high one.

If you were to ask a non-real estate family to examine a deal in their own field, they could size up the opportunity in a matter of minutes. But if they were trying to dig into the nuts and bolts of investing in a hedge fund, private equity deal or real estate deal, they would likely have trouble understanding the intricacies of the deal. I’ve experienced this on a number of occasions with other family offices. Working for a single-family office myself over the last four years and knowing close to 600 family offices directly, I get calls often from other family office leaders and family members who seek my opinion on various real estate transactions.

So, if being able to do proper due diligence is an issue, then why are these families doing direct deals without carefully exploring the financial implications? According to a report by iCapital, one key reason for this is the desire to avoid fees associated with gaining exposure to private equity real estate through third-party funds. But, can wanting to avoid these fees end up costing the family offices more money in the long run because they do not really understand what they are investing in?

Earlier, I mentioned I had seen this type of situation unfold in front of me. The story goes like this: I was provided an investment opportunity for a multifamily property in the Denver market. The chief investment officer who is also a family member from the out-of-town family office who shared the deal with me was seeking to invest between $1 million and $3 million in the deal and wanted to know whether any other families wanted to “club” together for a bigger investment. I looked at the deal and, within five minutes, was putting the final touches on an email outlining a few points that the family member wasn’t aware of. Among those points:

• Denver had two years of multifamily inventory coming to market.

• The owner of the multifamily property was planning to take eight months to rehab the property. This would mean this multifamily property would be coming online when other properties would most likely be lowering rents and providing concessions to attract tenants. In turn, this would harm the financial projections for the property.

• The operator was new and had no track record.

• The operator was putting little skin in the game for this investment.

All of those points made it glaringly obvious that this was not the opportunity that it appeared to be on the surface.

Rather than investing in this property, the ideal play would have been to wait a year or two and then start acquiring properties that could be purchased at a discount. That discount would have been available because of the overbuilding — overbuilding that would have tripped up some inexperienced operators who then would be seeking an exit.

How To Inspect Potential Real Estate Deals

There are a number of things that you should look for when evaluating a potential real estate investment to avoid a potential disaster, the most important factor being the investment manager.

It’s easy to focus on quantitative aspects when reviewing potential investments. Even the best real estate deal can’t overcome the damage that a bad operator can cause. You will be better off by setting aside the pro forma returns and budgets and focusing on the people. Screening the mangers are your primary concern — the assets are secondary.

Now that you are focused on the manager, what should you look for and what should the due diligence consist of?

1. Look at the company’s investment strategy and infrastructure. It’s better if you can meet in person to see its operations, but if you can’t, then be sure to get a sense of size and scope of the team.

2. Seek references by asking around — better yet, ask the company for a list of references. If the manager is reluctant to share this, consider it a red flag and perhaps you should retreat.

3. Examine the manager’s track record. They should be able to pride you with a list of properties purchased including location, purchase and sales dates and net LP returns. Be sure to look at when these returns happened. As my old office patriarch used to say, all boats rise in a rising tide.

4. Find out if the manager has been through a down cycle before. How they reacted and performed during a down cycle can give you tremendous insight into the group.

5. Does the manager invest in a consistent product type and have the necessary experience in that asset class?

6. Look at the executive team. Is it an experienced team with expertise in their respective areas? Has the team worked together for a long time or has their been turnover? This has potential conflicts due to the fees and compensation structure.

In an industry where single family offices are generalists in the various types of investments, the trend of bringing professionals into family offices with expertise in their respective fields, such as real estate, is only going to increase. I believe this trend will gain traction as more family offices see the results of their prior investments in direct real estate deals.

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