“Never invest in a business you cannot understand.” – Warren Buffett
One of the best things about passive investing is that you are not the one doing the day to day work. Maybe this has been your chance to work on your golf swing!
But there is a flipside.
Since you are not the one that is actively managing your funds, there is room for error.
Your control in the deal is in the front end before you invest. Think of it as high school! The best thing that you can do to succeed is your homework.
If you don’t do your homework, it leads to the two most common mistakes that I see investors make.
Not vetting the operator and not vetting the deal.
Vetting the Operator
There are many reasons to vet the operator, but the biggest one is also the most obvious.
You want to be able to trust them!
The operators are the ones handling your investment day in, day out. They are trying to increase occupancy, doing deals, and working on the business plan.
Knowing that these are the people whose success results in your investment gain, you would want to know a few things, right?
Who are they?
What area of focus of investing do they work in? Who else is involved in the deal? What is this person’s reputation?
Just think about the kind of person you would love to be in business with, and let that be your guide.
You can also do background checks. No shame!
Remember, it is your money on the line. So be as thorough as you need to be. I know a few people that do background checks on every single partner on a deal. Do what feels right.
There is also your network of fellow investors!
People know each other, and if they have had a good or bad experience the word gets around pretty quick.
What is their experience?
Hyperfocus on what kinds of deals this operator has made.
What are the varieties of deals they make? What is the track record of the operator’s investments?
Again, use your network! Talk to your friends and see what they can help you find out.
If you can see a positive history in the operator’s portfolio, then you can feel a little safer with them managing your investment.
What is their investment strategy?
There are so many different kinds of strategies out there for passive investing. The type or class of unit you invest in, the ways to create profit, and the level of involvement needed from the investor can all vary from deal to deal.
I won’t get too far into the weeds quite yet. I promise!
What my experience has taught me, is that the best operators are specialized. Their plans are specific and clear, and you can follow what they plan to do.
You can’t be all things to everyone. You can’t effectively do ground-up development, and value add deals, and work with office space, and work with multifamily, and work all over the country.
That is way too much to keep track of! Just thinking about it is a lot.
An example of a good, simple deal goes like this:
We work in the Southwest USA in secondary markets. We look for X% of returns. We’re looking at B and C class or working-class properties. We do a value add strategy. We’re trying to raise rents by $100 or $200 per unit.
And even better is when they can point to a history of their investments.
How would you feel if an operator could show you 5, 10, or even 20 deals they use the same strategy? Pretty darn good, I can assume!
Speak to previous investors.
Talk to people who have used this operator before. What was their experience?
One of the best things to ask is about the operator’s communication.
What was the communication when the deal went well? How about when it didn’t go well?
There are groups out there that stop communicating with the passive investors. To me, that is one of the worst things that can happen as a passive investor.
A lack of communication can lead to all sorts of problems. Think about it, if a problem arose and the operator didn’t tell you, how would that affect your investment?
Vetting the Deal
Just as important as vetting the operator is vetting the deal.
In this process, the first and biggest question to ask is whether the group or the person being conservative.
There is a lot to cover about conservative underwriting. Let’s try to keep it simple!
You want the deal to err on the side of being conservative.
Make sure that the deal is not just trying to show off great numbers. Some deals look good, but on a closer look, you realize the operators just made the numbers look good.
You want to make sure that the deal takes into account a healthy margin of error in its growth projections. Housing, for example, is a reliable investment plan, but within different markets, you can’t always rely on exact and organic rent increases year to year.
When it comes to seeing how conservative a deal is, my favorite number to look at is the rent growth.
You can tell so much about a deal from just this number!
Let’s say a specific deal is in a market where the organic rent increases are 3% per year.
Looks good right?
But a lot of operators will think if this is how rent increased in the past, then it will stay that 3% consistently.
But being conservative, you don’t rely on that number being consistent. Maybe some years there has been less rent increase. Or maybe the market appreciation has become stagnant.
By planning for such dips in rent growth, the conservative operator can better ride out these kinds of situations. This helps keep your investment safe.
This also shows you that the operator is keeping active and not relying solely on experience.
Cap Rate at Exit
The cap rate is the rate of return, the extra income you are bringing home each month that has accrued from your investment.
But If you think about it, the cap rate is like your money tree.
If your investment capital is the root and trunk of the tree, the leaves are the cap rate. We all want more green, but sometimes a bigger tree puts out fewer leaves.
When selling off your investment then, you’d want to have fewer leaves on the tree. Meaning, you got as much green out of the investment as possible
When scoping out a deal, you don’t want to assume that you will be able to sell off your investment at a more favorable cap rate.
If you can, good on you!
The conservative operator will have it planned out to sell at a higher, unfavorable cap rate than the investment was initially at. Again, this allows for a healthy margin of error.
By doing this, even if the deal doesn’t do as well as you would have liked, you aren’t relying on that income from the more favorable cap rate.
It also gives you, the investor, the confidence that the operators are not misrepresenting the numbers to make the deal look better than it is.
This one is simple. No, really!
You want to make sure the deal has a rainy day fund, a little cash reserve in case something comes up.
What if they run out of liquid cash? What if the renovations or improvements don’t go as planned?
A simple check on whether or not the deal has an extra reserve in place can show you the quality of the deal.
Make sure you understand the deal.
I am a student of Warren Buffett, and he puts it the best.
“Never invest in a business you cannot understand.”
– Warren Buffett
Really great, right?
You want to make sure you understand the deal and that you feel comfortable with everything involved. If you don’t understand, don’t invest in it!
Be willing to look around at a few deals. Find the operator and the deal that matches your temperament and your goals.
By taking the time to vet the operator and the deal, you are already two steps ahead of everyone that has made the mistake of jumping in blind.
To invest successfully is to understand what you are doing and to keep learning!
If you are interested in learning even more, we have a special report about investing. It compares the stock market to real estate, and it also includes how the pandemic affects your investment future.
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