There are several structural reasons why we may decline certain offerings and not have some offerings that others may provide. We carefully consider concerns about the sponsors previous performance or management background disclosures. We scrutinize financial projections that rely on financial engineering or aggressive assumptions that could harm future cash flows. We assess offering load and expenses to ensure they add value and are reasonable. We also identify hidden initial or deferred taxable 1031 exchange boot and analyze loan provisions that may be detrimental.

An alarming development within the industry is that some newer, less experienced, and smaller alternative real estate sponsors are selling their real estate offerings directly to the public. This practice circumvents federal securities laws by either an intrastate offering or an issuer or sponsor that is not a member of FINRA and not subject to federal securities laws designed to protect and safeguard the investor. The direct selling by the issuing sponsor of the offering should be viewed with extreme alarm and caution as it exempts the offering from the other levels of independent due diligence.

Without an extensive and diagnostic due diligence process the property is not visited, financial assumptions are not tested, loan covenants are not reviewed, and potentially misleading statements are not examined. Without independent, trained, and experienced professionals performing due diligence on the offering materials, the sponsor is able to financially engineer higher than attainable cash flows, obscure hidden taxable exchange boot at closing, and use unreachable assumption for an exit strategy that will return less than the investor’s original capital. At the property level, construction quality is not inspected, unit conditions are not examined, tenants are not interviewed about their true lease renewal intentions, rent rolls and the trailing 12-month rents are not verified, and property financial statements are not audited. Most alarmingly, there are no background checks on the principles and management of the sponsor and the comprehensive performance track record (performing and underperforming) is nt attested and disclosed.

Over a 5-to-7-year hold period, the offering property may face significant economic and environmental challenges. Over this lengthy period, the property being offered needs to perform well with consistent and reliable monthly cash flows and attain a profitable exit sale for the investors. A traveler would not want to board a plane for a 10 hour trans-Atlantic flight if they knew that the person operating the plane was an unlicensed pilot who has not gone through a preflight checklist testing for the mechanical viability of a fully functioning plane. Of course not, and neither should an investor enter an alternative real estate investment for the better part of a decade without all four levels of due diligence independently and prudently performed on the offering and the property.

The Broker-Dealer’s Sponsor-Level Review

On an annual basis, the broker-dealer offering alternative real estate investments needs to perform the following sponsor-level examinations as part of their review:

  • Examination of the sponsor’s financial statements and financial position. In most cases audited financial statements are required and analyzed to determine the depth of financial resources and liquidity.
  • Examination of the sponsor’s organizational capabilities, including depth of real estate expertise, customer service capacity, and operational manpower.
  • Review of the track record of the sponsor both for full cycle and current operating properties with respect to estimated projections and actual performance.
  • Background checks on the principals of the sponsor, including the search for the existence of criminal records, bankruptcy, or judgments, as well as their track record in the field of syndicated real estate.

The Broker-Dealer’s Property-Level Review

As a sponsor brings various alternative real estate investment offerings to the market throughout the year, the broker-dealer performs a due diligence review of each offering. The review separates into an examination of the actual property and the examination of the offering documents. The analysis of the properties themselves from a real estate perspective includes, but is not limited to, the following:

  • Property tours (site visits).
  • Tenant interviews.
  • Lease agreements.
  • Loan covenants and recourse carve-outs.
  • Appraisal assessments.
  • Environmental issues.
  • The adequacy of tenant improvement, loan, and other reserves.
  • The national and local markets with third-party real estate data firms.

The property-level data is compared to the information provided within the offering documents for reasonability as compared to historical data and the overall market in which the property is located. The quantitative metrics compared include (but are not limited to) acquisition cap rates, occupancy, expense ratios, capital improvement plans, value add components of the business plan, the anticipated investment hold period, the anticipated exit cap rate, and the absolute disposition price.

The fee structure charged by the sponsor is analyzed and compared to other sponsors, as well as third party vendors that perform similar services. The areas of compensation that focuses on interest are the acquisition fees and costs, asset management fees, property management fees, master lease profit margins, and disposition fees.

The offering documents are analyzed for appropriate disclosure of the key terms of the legal and operative documents for the investment including the trust agreement, the master lease, asset or property management agreements, loan agreements, and the tax opinion letter. The operative and legal documents are reviewed by the investor for completeness, consistency, and a reasonable structure for investment and gives the sponsor the ability to operate the property effectively.

Investment Committee Vote

After a potential offering has gone through the due diligence process, the due diligence analyst presents their findings, together with the third-party due diligence report, to an investment committee for further review and potential approval. The members of the committee should have multiple years of commercial real estate experience and an aptitude for the marketplace. An offering is presented to the investor for consideration once it has gone through examination by internal and external parties, is found to be a sound offering, and is approved by the investment committee.  It is not uncommon for a broker-dealer to reject approximately 30 percent of the offerings presented. The reasons for a rejection are varied and can relate to the property itself, the sponsor, the financing, or the market. It is important to note that this final level of due diligence is after the sponsor, the lender, and the legal counsel have approved the offering, meaning that the offerings declined may become available to investors through other broker-dealers.