Taking well-calculated financial risks is a key part of any business or investment strategy.
But for investors, failing to recognize potential liabilities until after a transaction is closed can have disastrous ramifications. At Spartan Investment Group, we believe that due diligence is the most important part of a deal. For many investments, it’s the point that determines whether you make or lose money. When we vet a new self-storage investment opportunity, our due diligence helps us to uncover improvements we need to make to get the most out of a property. It also exposes any legal or financial issues the seller must address before we close a deal.
Due diligence will look very different depending on whether you invest passively in commercial real estate or buy an investment property outright. In either scenario, designing a thorough and thoughtful process for evaluating risk will pay dividends.
Due Diligence for Active Investors
As a commercial real estate investor, there are two types of due diligence to consider: corporate due diligence and property due diligence. If you are an active investor looking to acquire and manage your own assets, investment property due diligence is your first line of defense against issues with the transaction.
At Spartan, the scope of our due diligence process ranges from mystery shopping competitors to meeting with the local planning and zoning department. We perform environmental site assessments and geotechnical studies. We also look at the physical and financial state of the property so we can understand what steps we need to take to transform an underperforming asset into a competitive business. Because risk mitigation and transparency are core priorities for Spartan, we make our property due diligence checklist publicly available.
Here are five priorities for vetting a real estate transaction as an active investor.
Have a Thorough Process
Make sure you have a due diligence process set up before you go out looking for deals. You will learn something new during each investment, but you need a solid rubric to evaluate opportunities against. After a deal closes, look back at what you missed, and use it to improve your process for next time.
Don’t Rush into Investing
When operating in a seller’s market, it can be easy to get swept up in a false sense of urgency. Don’t let sellers pressure you into cutting corners. However painful it may feel to pass on what looks like a fantastic deal, it’s far worse to lose money because you dropped the ball on due diligence. At Spartan, our 700+ point checklist helps us move through due diligence quickly and efficiently. That means we can protect ourselves while still being able to progress at a competitive pace.
Trust Nothing — and Verify Everything
Don’t base your investment on hopes, promises or assumptions — and don’t take anything at face value. Vet all the documentation your seller provides and ensure it is thorough, sound, and legitimate.
Having a consistent procedure you follow for every deal makes it easier to set expectations with brokers. Let them know what your due diligence looks like, what documentation you’ll need to get started and how long it will take. By sharing this information ahead of time, you can expedite the process and avoid surprises for the seller.
Invest with the Right People
At Spartan, we have a team of over 100 full-time employees and in-house experience that spans property management, syndication, acquisitions, development, and asset management. Still, we recognize the value of external expertise. Whether it’s a civil engineer or a lawyer, we invest in hiring the outside talent we need to move forward with confidence. Don’t be tempted to cut costs when it comes to bringing the right people into your deal. Due diligence is expensive — but it represents a fraction of the money you stand to lose if an investment goes badly.
If property due diligence feels like too much of a financial commitment, investing passively in commercial real estate syndication may be a better fit for you.
Due Diligence for Passive Investors
Passive investing is an excellent route for investors who want to reap the benefits of investing in commercial real estate but don’t have the desire or capacity to manage property. In this case, you’ll likely enter a deal as a limited partner. A sponsor or operator will handle the investment, oversee how funds are deployed and coordinate any construction or improvements. In return for providing some portion of the capital used to finance the deal, you may receive some cash flow and upside from the investment.
While you can assess individual offerings by looking at documents provided by the operator, like offering memorandums and pro formas, you won’t be responsible for property due diligence. Instead, your due diligence will focus on assessing the sponsor or operator. Below are Spartan’s top five tips for performing due diligence as a limited partner.
Focus On Communication
As a passive investor, you’ll rely on your sponsor to provide timely and consistent updates on asset performance. As a result, your sponsor’s approach to communication will play a key role in how good — or bad — your experience is. Ask to see examples of previous messages that your sponsor sent to investors. Review the samples and ask questions to ensure you are comfortable with how and when they communicate.
Ask Good Questions
If you’re considering investing with a new operator, an interview is your first chance to get to know them.
Develop a list of questions that help you understand their background, investment philosophy and approach to investor relations — particularly when faced with a challenge. Common investment questions include
- How many deals have you taken from start to finish?
- What do you like about this deal? What don’t you like?
- What does a worst-case scenario look like, and how are you prepared for this possibility?
In Spartan’s latest eBook, “How to Evaluate a Sponsor,” we break down 120 questions to ask a sponsor — from minimum investments to when you can expect your K-1 tax form.
Lead with Values
Your operator’s mission, vision and values will frame their work — and your relationship. Do some research into the companies you’re considering investing with and see how their priorities align with yours. How do they treat investors? Employees? Sellers? If their values resonate, you’re off to a promising start.
Talk to References
Referrals are a great way to get outside perspectives on your sponsor. To ensure you get as complete a picture as possible, speak to a range of clients. Ask the sponsor to refer someone who has invested in 75% or more of their deals — and someone who only invested in one. Try to speak to an investor who was involved in a challenging deal, too, so you can get their feedback on how the sponsor handled communicating through a crisis.
Don’t Get Hung Up on Fees
Fees are often a passive investor’s first priority when assessing an opportunity. But while low fees may seem attractive, they can be a red flag. If a sponsor doesn’t have the resources to steward the transaction forward, it’s likely to stall — and may even fall through. Rather than seeking out the cheapest deals, ask sponsors thoughtful questions about how fees will serve your investment.
Closing the Gap
At Spartan, everything we do focuses on mitigating risk for our investors and ensuring they have access to the best self-storage investment opportunities. Over the years, our rigorous due diligence checklist has grown to over 700 points. We only close on a deal once every box is ticked.
Due diligence isn’t about removing risk. It’s about assessing potential liabilities, so you can make informed decisions and identify the best opportunities for you. It reduces the gap between what a sponsor or seller tells you and the reality of an investment opportunity. It can be a lengthy, frustrating and expensive process. You may even lose deals along the way. But the narrower the gap, the stronger your process — and the lower the likelihood of a post-transaction surprise.
Ryan Gibson is CIO of Colorado-based Spartan Investment Group, a privately held real estate investment firm specializing in the self-storage industry. To connect with Ryan directly, email firstname.lastname@example.org. If you’re interested in learning more about how to evaluate a sponsor or operator, you can read Spartan’s new eBook on the topic.