Due Diligence. As either a beginning or seasoned real estate investor, if you are in the game long enough, you will likely be approached by other investors. These folks will be looking for partners to supply needed credit, capital, experience, contacts and more. Although you may be flattered, you have to remember it is business. The world of business runs on profits and losses. In order to make sure that your participation in a deal is in the black, it’s important to conduct thorough due diligence on the project or offering.
Let’s discuss doing your due diligence on somebody else’s offering, be it a securities offering or just a joint venture:
1. Ask for References (and maybe a credit report) depending on the amount of money being contributed. Ask for proof of funds if needed. Who are the other investors?
2. Know Who’s Handling the Project. If it’s someone else besides your initial contact, you want to meet those other people as well. Make sure you know who is handling the accounting and the funds.
3. Do they have Experience? It is vitally important that the principals have experience, especially with the type of project you are considering investing in.
4. Review the Numbers. What’s coming in? What are the costs? What’s going out? What are the potential profits? Are the numbers conservative? Do they account for a worst- case scenario if things don’t go as planned?
5. Is it an Appropriate Investment for your Portfolio? Does it make sense for you? If you are older, a long-term, risky investment doesn’t make sense. Is it taking money away that you can’t afford to be without in order to properly run your current business with positive cash flow?
6. Understand the Exit Strategy. Ask if there is more than one exit strategy and specifically what it is. Once again, what is the worst-case?
7. Don’t be Pressured. Sometimes a project can be very time sensitive. That being said, it is vitally important that you take time to do your own due diligence. If there isn’t enough time to do that properly, just remember; there will always be other opportunities.
1. Cash on Cash Return. This is the return on your investment that you make as the investor. A good Pro Forma will have that information.
What you’re looking for is your annual cash flow divided by the total cash you put into the project. Whatever you get as annual cash flow from the deal divided by what you invested is your cash on cash return. A good number to shoot for4 is at least 7% or 8%, which is good; 10% or 12% is superb. It could be more, but it will likely be much riskier.
2. Total Yield (aka your IRR or Internal Rate of Return). Basically, this is your annual cash flow for the life of the investment divided by the sales proceeds. This is your total yield or internal rate of return. This is a rough calculation. You should really calculate your net present values of each year of cash flows for an accurate number, but the above gives you a very good approximation. Once again, most Pro Formas will have this information. It’s up to you to verify it.
For example, you invest $100,000 and earn $10,000 per year for five years. That’s obviously 10% per year. When you sell the deal, you get your money back plus $50,000 at the closing of the sale. Add that $50,000 to the five years of cash flow, which is a total of $100,000. Divide this $100,000 by five years, which means you got an average of $20,000 per year cash flow. If you invested $100,000 to start with, then your average annual return is 20%.
3. Plans B and C (if something goes wrong) This is an area where the experience and reputation of your potential partner (s) are very important. If something goes wrong, what are the options?
4. The Risk to Your Money. It’s great to get 8% a year, but if something goes wrong and you lose all your capital, that’s not good.
5. Your Liability. Can you be sued in the deal? In a general partnership or JV, absolutely; you can be sued! Make sure you are structured in the deal properly so that you’re not personally liable. This is where an experienced mentor and/or attorney experienced in real estate and asset protection can be worth their weight in gold.
Many investors lose out by either never doing a deal with others that can make them some great passive income or they get involved in a deal where they don’t do their own due diligence and they lose money. Remember, in the world of business, no matter how many others are involved, your buck stops with you!
Attorney William ("Bill") Bronchick, host of Legalwiz.com, has authored six best-selling books and is sought nationwide for his 25+ years of real estate and legal knowledge. He has been interviewed by numerous media outlets, such as CNBC, TIME Magazine, USA Today, Investor Business Daily, Forbes, and the LA Times, to name a few. William Bronchick is the co-founder and past President of the Colorado Association of Real Estate Investors and the Executive Director and founder of the College of American Real Estate Investors. Click on the "About" link above for more information on William Bronchick.