BPI Episode #13: Red Flags in Deal Presentations

Welcome to Building Passive Income, the podcast for professionals, entrepreneurs and investors who want to build wealth, diversify beyond Wall street, and create financial freedom through passive commercial real estate investing. Your host is Wayne Courageous iii, a seasoned investor and founder of CREI Partners, a leading commercial real estate investment company. He spent nearly two decades navigating and educating others on the commercial real estate, from multifamily to storage to retail. Each episode is under 15 minutes, intentionally short, easy to understand, and packed with insights that help you grow your income and protect your capital without becoming a landlord or sacrificing your time. If you're ready to learn fast and invest smarter, you're in the right place. Let's get started.

Welcome back to Building Passive Income. I'm your host, Wayne Courageous. I am excited for another episode here where we're going to continue diving into passive investing in hopes to make it bite size, where you're able to enjoy the learning but also be able to take some actionable steps and some lessons learned as we move forward. So today we're going to be talking about real red flags and deal presentations. So some of the red flags that we're going to go through are just opportunities for you to be like, hey, step back and ask questions. And if it doesn't feel right, don't worry about moving forward, just go to the next deal, right? And sometimes people feel like, hey, there's only one deal, there's the only opportunity they have to invest. And when they start going through the due diligence, which we've talked about previously, where passive investors, their hardest part, their biggest part of investing in real estate is evaluating the sponsor, evaluating the deal. But as you start evaluating, those red flags may pop up. And so we're going to go through some of those today. Yesterday we talked about questions to ask before you invest. And so as you're going through those questions and you're starting to look through the webinar or listen to the opportunity, see if there's some of these red flags. One, and we've talked about this previously, is unrealistic assumptions on rent growth or expenses. Previously we spoke about how this, when you invest in real estate, it's a physical asset. So it's like a business. You have your income, your expenses, and get you to your net operating income, which then pays, of course, your debt service and then hopefully those distributions to you as the investor. But if you're looking at the business plan and they're seeming like they're being extremely aggressive on assumptions on the rent growth, that may be one of Those red flags to make the deal work, typically 2 to 3%. I still see an underwritings and I think that's, that's fine because you got to think a lot of the residents that may be living there are not currently paying market rent. So say you know, rents $1,000 and they're you know, getting a 3% rent bump, then they're getting a $30 rent bump and say the market say $1100 and you know they're paying a thousand, they get 10, 30 new renewal, so that's their new rate. You know, they're still below market so that's still doable. But understanding like what, what are the rental assumptions and, and then what are the expenses, the growth. So if they're not expecting any expense growth, obviously that's a huge red flag because we all know inflation and cost of doing year over year. But just getting comfortable that there is enough expense growth. In particular if you're investing in Texas, maybe in Florida, some of these states where property taxes is the main driver for state funding since you know, income tax, there's no income tax in Texas as an example. So when you look at real estate taxes, typically what you'll see in Texas is the taxes is going to be based on purchase price. Even though it's a non disclosure state, somehow they have find ways to do it or they'll go out on a high, they know it's sold so they'll go and give an appraisal valuation at you know, a certain price and the sponsor has to go in and protest to get those taxes down. Either way, typically you want to see 100% of purchase price times the mill rate. So they've, they're assuming that they're going to have taxes at least year one on the full purchase price, that they are purchasing the asset. In prior years and a little more aggressive underwriting, I've seen 80, 90% of purchase price. And in our underwriting at CIO Partners, we always do 100, 100% of purchase price. We're always staying conservative. So that's one of the things you want to look at. The other thing is insurance. Property insurance, especially along the coastal regions has continued to grow. It's not growing doubling as it has previously, like it was insane a couple years ago. It's definitely more capacity has come back to the markets and things have gotten a lot better on that front. But you still want to see that hey, there is a good budget for insurance year over year. And so typically for us, I mean we're between 7 and 10% year over year versus maybe 2 to 3% of expense growth on the other category line items. So looking at assumptions, rent growth, just making sure you feel comfortable. As I mentioned, you're very sophisticated already. Digging in on this podcast, learning about real estate investing in general. Many of you already have your own businesses or you've gone and done some type of business classes and all. Again, none of this is where I say rocket science. It's more just understanding like income minus expenses. And does the story seem right? The other thing we want to look at and that could cause a red flag is understanding the actual business business plan. Like how detailed is the business plan? Does it look like it's been really thought out? Are there pictures to back it up? Are there market studies? Are there rental comp growths in the area where you can see what other apartments as an example are renting for on a per square foot basis? So looking at that detail the business plan, just making sure you feel comfortable that the sponsor has done proper due diligence. They've had plumbing, electrical, roofing, foundation, they've done a lease audit, they've gone through all the leases to confirm that all the leases have been executed. It's a crazy to think but like we've toured properties where we received a rent roll and that rent roll, as we were walking through units, had units showing as occupied when the actual unit was vacant or even worse, like we would have units occupied, but there's no lease that's been signed. Which is just mind blowing how you can manage a property that way. But you know that it is what it is and you have to do your due diligence, you have to make sure your sponsors doing those due diligence. So checking the detail plan and making sure that they have done their due diligence and you feel comfortable that they've gone through all these different trades as I had just mentioned, but also done the due diligence on walking each unit and doing a lease audit. Other things to look for red flags is that the sponsor is not disclosing the fees. Sponsors take a lot of risk finding deals, taking time. I know, me personally, you know, between the earnest money and you know, the due diligence cost, I mean a lot of those expenses are paid up front before even closing. And then of course, you know, we've got a team of people at CRI Partners and we all have families, so we all have to support ourselves too. Sponsor fees is a way to keep the lights on and ensure that the sponsor is focused on the Asset and not worrying about, you know, their own expenses. So between acquisition fees, asset management fees, these are all very normal fees. However, are they being fully disclose and are they market? Right. And so we'll talk about that in more detail on another podcast. But typically just for the sense of this pod, this podcast episode, you know, typically you would see between a 2 to 3% on an acquisition fee on the purchase price and you would also typically see a 2% of asset management on gross rental income. So if you're seeing 4 or 5% acquisition fee or 3, 5, 6% or on asset management fees, you definitely want to ask some more questions and get a second opinion of those things. And again, if it's a red flag and you're not comfortable, it's okay to walk because there's going to be other opportunities. But sponsor fees are definitely normal. We have blogs on those and other podcasts episodes as well on it. But just know you want full transparency and if you get that full transparency in the beginning, then you're going to feel more confident like hey, you've got a straight shooter. And so as you go through the investment cycle, you know, you feel like they're being as transparent as possible and there's really nothing they should be hiding if they're not doing market type fees, other guaranteed returns. There's no such thing. If you have a sponsor saying hey, it's guaranteed, you're going to, we're going to knock it out of the park. Or they just seem overly aggressive. Like we all want to close a deal and to close a deal we want to, you know, have gone through the due diligence and been very excited based on the findings. Like hey, we, we really did find this diamond in a rough, which is great. But if anyone's telling you like, hey, this is guaranteed, there's not a really a lot of thought on downside, then it may be a red flag. We do a sensitivity analysis and so it shows like different returns based on different rental projections and exit cap rate. And so we feel we can get comfortable and our investors get comfortable on the different potential internal rate of return as an example, the rate of return. But you know, you just want to make sure that you know, you're not getting sponsors who are just like overly aggressive on guaranteed returns. I'm also seeing lately about bitcoin getting into the real estate market. I mean there's all different risk and everyone has different risk tolerance. Just be, be mindful of those returns and just the security and the safety of what you're investing in other things to consider, red flags is no track record and they don't have any other reference type experience. Now, we all start somewhere. And as I mentioned on a previous podcast, if you're working with someone who's new, that's okay as long as they have other team members or people to offset that experience. Right. And so understanding what their track record is, if they don't have a track record, who on the team does? Who's really the jockey on the horse that's running, running the show? And so those are things you definitely want to ask. What's the track record? If they've been investing over the last few years and they're not transparent, at least one deal that's caused them to age 20, 30 years, then they're probably not being very truthful because we've all had ups and downs in real estate and it's being transparent. Lessons learned. What, what are things that they're doing to have not lost investor capital or if they did lose investor capital, what was the reasoning? What was, you know, what was the process which in that occurred? Did the sponsors put in more money? Just understanding what their track record is? Hey, it's okay to have a black eye here once in a while. Not everyone's going to hit home runs every single time. But getting that sense of transparency on the track record and understanding who the team is important goes back to transparency. This is a relationship, this is a business. But you are trusting the jockey, the sponsor, to deliver on the project. And so having that full transparency, if you feel in any case that you're asking questions and they're not being transparent, they're not giving you the full financials, et cetera, then it may be something just be like, hey, I'm a pass on this one, you know, keep me posted on the next one and maybe look for another deal. I would also say, you know, just the last thing on red flags on this, on the show is just if you're getting like overly polished pitch with no clear downside, I keep going. There's ups and downs. There's always the risk part of the risk, or the risks are typically defined and outlined in a private placement memorandum. But you have to understand what, what those types of risks are. And if they're not communicating those risk up front, then those are some red flags. You know, that's something like, okay, this sponsor may not have been thinking about all the good, bad and ugly of this investment. And you know, for us, like, we look at the risk and we look at, you know, the bad and ugly. But that allows us to strategize and work through make sure we have enough reserves. Or maybe we're getting additional pricing during due diligence on fixing, you know, a repair component or looking at like where rental comps are and where our projections are, etc. So you always want to look at what what the risk downside and there always will be. So what is the sponsor doing to overcome those and so hopefully this podcast gave a little bit more insight on some red flags. I always encourage people to check out our free Passive Investor coaching program@ passiveinvestorcoaching.com it's several hours of bite sized type communications where I just really try to educate. I mean it's a big passion of mine just making sure you as the listener investors, whether you're investing in our deal or other deals, that you feel confident that you're asking the right questions and you're sophisticated enough to make a decision if this investment is worth for you. Check us out tomorrow on our next podcast. If you haven't checked out our prior podcast, please do. They're short 15 minutes or less and hopefully they'll add a lot of value to your journey. Looking forward to continuing the momentum of this podcast. Please like share and we'll be getting ready for our next episode tomorrow. Hope everyone's doing well.

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