Using Comparables to Perform Investment Due Diligence

For every real estate investment opportunity posted on the iFunding site, “comparables” in the form of a table or a Comparative Market Analysis is provided to support due diligence. This allows a potential investor to check estimates on the value of the property. What exactly is a CMA and how does an investor incorporate comparables into their investment research?

Comparables show the value of similar properties

Comparables provided an estimated range of value for a property. They accomplish this by listing the recent prices for properties with similar features. For homes, the comparison will include the number of bedrooms and bathrooms, total number of rooms, presence of a garage, year built, square footage, land acreage. Using nearby properties’ actual sale prices, a $/sq. foot figure will be calculated. Because there’s rarely a perfectly similar house just sold on the same street, often the comps will use houses sold in the last three to six months, within a few streets to a half-mile of the property being considered.

A Comparable Market Analysis, or “CMA,” is a form of comparables that is distributed in a relatively standard printed table format. It relies on a Multiple Listing Service (MLS), which is commercial database of property transactions, details and tax rolls, available only to licensed users such as brokers and appraisers. Once the user picks the filter criteria, the report is computer generated. Average selling prices, price per square foot and other statistics for similar properties are summarized.

Using comps

Especially with home development/refurbishment investments, potential investors may feel comfortable reading a comps report, because they have purchased their own home and went through the same thought process then. To put the comps reports in perspective, you then could combine a few points of information:

  • Look at the building layout information and photos of the existing property
  • Read several paragraphs explaining what the upcoming project will improve, fix or expand
  • Look up a photographic map of the neighborhood (such as you can get on maps.google.com)
  • Combine the above with property comps to see if you feel the value of the property is worth the planned acquisition price in the project. This gives you a baseline of what the asset is worth, even before improvements.
  • Then, read in the crowdfund listing about the project’s improvement plans and costs. If the plan includes an expansion of square footage or new rooms/bathrooms,  have a second look at the comps to see what that could be worth in selling price.

If you’re inclined, you can do your own quick comparable verification by using a web real estate service like www.zillow.com or www.trulia.com to filter on houses in the neighborhood and compare the project descriptions and listed sale price.

Whenever there is a rental investment opportunity, you’ll also want to see comparables with data about average number of living units, and monthly rent per unit and per square foot.

Cautions with comparables

CMAs typically are printed with standard caveats, such as “market conditions, and therefore forthcoming property sales prices, may vary” versus the comparables. The individual who generates the CMA based on similarity-search criteria also can have some impact on which property comparisons appear. Finally, prices for a similarly-featured property can change even a few streets away if the character of the neighborhood or access to nearby amenities is different.

Comparables are equally valuable for commercial property investments. In these cases, it’s important that the investor is willing to place confidence in the project sponsor about the nature of businesses that could occupy a property, the location (e.g., whether “street traffic” is heavy for a retail storefront), and the relative operating costs and efficiencies versus other buildings that may be older or more modern. For this reason, a crowdfund platform will help vet the project sponsor, to document their experience operating in a particular market and for a certain type of property or building.

In Summary

Comps and the CMA report are a helpful part of the due diligence process when investing in a property. Especially for single-family and smaller multi-family properties, the data presented should be straightforward to a potential investor to understand. Repeat experience reading comps can increase your confidence with real estate investing in general.

Comps should be combined with a review of other information on the opportunity, including the operating team’s experience, the improvement plans, financial projections, and investment operating documents. iFunding provide this information and more with each investment; just follow the information tabs within each listing.

Comparing Preferred Equity vs. Debt – for Real Estate Investors

One of the important decisions that investors make with real estate is whether to invest via equity or debt. This post describes key differences between these types of investments, and why iFunding has chosen to specialize in preferred equity financing, which we feel is the most attractive blend of returns and control for many investors.

What is preferred equity vs. debt investing?

First, definitions, which you can skip and go to the comparison, if you’re comfortable with preferred equity and debt investing:

Investing via equity in real estate means that you are a shareholder in a project. The project, be it a home refurbishment, a retail space, or office tower, generates profits through some combination of increase in price between purchase, improvement and sale, or via tenant rental income. You as the equity investor receive a share of the net profits after expenses, and the profits also are shared with the project developer/operator, and the promoter or crowdfunding platform. Many equity investments, including most of those from iFunding, include a “preferred equity” component: from any profits after project costs, the first cut is returned solely to the investors, not to the developer for their work. In the real estate investment sector, preferred equity often is set at 8-10% target return. After preferred equity profits are paid out, the remaining profits typically are shared at 30-50% going to the project’s operating partner, and the remaining amount to the investors (50-70%), with a modest fee going to the crowdfunding platform.

In addition, there are significant financial benefits to equity investing in that when property depreciates, investors can participate in the on-paper losses to offset other income they have. Also, longer-term profits may be taxed at long-term capital gains rates. We’ll cover these considerations in another post.

Investing via debt means that a loan is provided to the project operator. The investors receive a fixed rate of return. The payback of the loan is usually guaranteed against the property asset itself. That is, this is a mortgage similar to what you’d have on your own home. Instead of directly listing the investor as a lender, however, in crowdfunding the invested money is pooled in an entity such as an LLC and this entity lends the money to the project operator.

How to decide on preferred equity vs. debt investing?

  • Returns: Typical returns on equity investment in real estate can range from 18% to 40%, annualized, or more. Typical interest rates on debt, or lending, currently range from 8% to 13%, annualized, in the crowdfunding business.
  • Principal: With equity, investors participate in the profit or loss on the project, much like stock you hold can go up or down in value. The investor would want to be comfortable with this dynamic. Real estate debt is generally considered somewhat safer, as it behaves similarly to high-yield corporate debt. Principal is intended to be repaid regardless of project profits, but there are situations in which a borrower may default and foreclosure proceedings occur over the assets.
  • Investment duration and payment frequency: Equity investments and debt both are available with short term returns, such as house refurbishments completed in a few months, and on longer term holds, usually commercial property spent with rental and upgrade potential. Profits returned on equity investments often tend to be paid out quarterly or annually and with a significant lump sum at the end (sale) of the project. Interest on debt usually is paid quarterly or monthly, sometimes annually, in the crowdfunding world, again with a lump sum return of capital at the end of the loan.

Questions to Ask Crowdfunders

While equity and debt are relatively straightforward to understand, there are nuances, especially in the crowdfunding world, that you’ll want to ask your fundraising platform about:

If equity:

  • How much oversight and control does the crowdfunding platform have over each project? If the project is sidetracked for any reason, what ability does the crowdfunding platform have to identify the issue and direct it’s resolution? At iFunding, our company serves as the manager of the entity overseeing the project. iFunding holds title over the property in nearly every case, so the property itself is part of the guaranty underlying investors’ principal.
  • Is the investment individually structured for protection? investors should prefer that the property title and their funds are held in a corporate entity set up solely for the purposes of the one project. That is, any financial issues with other projects or with the crowdfunding company itself should not affect the ownership, liens on, or reliability of a particular investment. iFunding structures its offerings this way, through “single purpose entities,” which continue as viable, legally-protected entities regardless of the status of other investments or the company itself. iFunding does not create a more complicated structure, with the property/project in one LLC, and the financing in another LLC that invests in the first. Other crowdfunding sites have taken this two-tier approach, however unwinding them or otherwise following the property ownership and lien structure (should that be required on a difficult project) can be more complex .
  • What’s the term of the investment? Equity investment durations can range from a few months to several years on the crowdfunding sites. Different durations will interest different investors. Be aware that longer term investments, such as larger commercial properties, can both be more stable, in that existing properties have a demonstrated operating track record of occupancy and cash flow. However, investments that are committed for years are more subject to macro-economic trends which can cause ongoing returns and final value to fluctuate.

If debt:

  • Do the investors have a true guaranty on the property? In some cases, crowdfunders actually give investors a promissory note, which says that the crowdfunding company promises to pay the investor — as long as the project operator first pays the crowdfunding company. It’s the crowdfunding company only that has a guaranty. The investors don’t have direct control over the assets should investor repayments stop and the property needs to be foreclosed. But, how aggressively will the crowdfunding site pursue foreclosure and return of investor’s money?
  • What happens if the crowdfunding company is no longer available to make payments, is unable to make timely payments, or closes itself? Have the site explain their backup processing plan if they are no longer in business, and confirm whether the switchover to the backup plan is automatic, or depends on the crowdfunder being involved to take action. In these two preceding situations, the security of debt investing may be less than in traditional real estate lending, where the investors have direct property title or borrower guaranty.
  • Your ultimate return on real estate debt also depends on how long the interest accrues. If a project, like a home refurbishment, is completed and sold ahead of schedule, a loan that you thought would yield interest for a year may only provide interest for a few months. If so, you’re actual return after taking the time to research and invest in the project (and cost of a wire of funds), may be just a few percent. At a minimum, ask the crowdfunding site whether pre-payment (early loan completion) premiums are paid by the real estate operator and passed back to the investors in this case. Also, calculate your likely absolute return as well as an annualized rate.

The Case for iFunding and Preferred Equity

Experts recommend that sound investing involve diversification of your portfolio, both across asset classes such stocks, bonds and real estate, and within a class, that is, different property types, locations, investment durations, and equity vs. debt structure. So there’s certainly room, and benefit, to hold a variety of investment types and hold both equity and debt. iFunding offers both but specializes in preferred equity.

Our investors tell us that, the more comfortable they become with real estate, the more they appreciate the combination of potential returns and control that iFunding can offer through preferred equity deals. We offer a range of property types across the nation, with many being shorter-term, smaller budget equity investments. A “preferred equity” component means that the first distribution of profits goes to the investors, putting individuals like yourself on par with what financial institutions traditionally have received in equity investment terms. Finally, we believe we lead the industry in oversight of project and frequency/detail of reporting on project activity, increase the quality of project and investment results and increasing your comfort about investment status.

Read a step-by-step explanation of the iFunding investment process here.

How To Vet A Crowdfunded Development Opportunity

As an investor you should be concerned that the project you’re participating in has a sponsor with adequate knowledge of the development process. Development activities vary considerably in different areas of the country, which makes your job of doing diligence on the opportunity much more challenging. Given the typical investment on most of the crowdfunding portals an exhaustive diligence process is difficult because the expense would crowd out any profits you could generate.

So what should one look for in a successful developer? How can one verify that they add value and will be a good steward for investor capital? How can one really develop trust via an online portal?

To be completely frank these are difficult questions to answer and an exhaustive analysis is unlikely for most investments. Below are some of the things I would consider if you’re looking to invest in development projects online via a portal:

  • Proper Contracts – What many passive investors fail to understand is that proper buy-side contracts are crucial to designing out risk.  People that invest in real estate opportunities frequently have some experience with buying existing building or land that is already properly entitled or has an existing improvement. Purchasing land for development is a far different animal given the uncertainty associated with entitlements.  This is especially true in locales with large backlogs of permits with beefy waiting times because sellers of infill land or projects for redevelopment often treat the sale like a residential house sale. They want 7 or 10-day options and short closing periods typical of residential house sales. They also want short closing of 30 days or something similar to this. Some of the better developers can react this quickly, but it often presents a lot of challenges with city bureaucracy that doesn’t care that the market is dictating quick closings. You should examine buy-side contracts closely if you’re investing in a project where the developer is raising funds during the contract period.
  • Budgets – Budgets are always challenging because they attempt to assign some predictable expenses to real world projects that are inherently unpredictable. Development can yield projects with underground springs that were not discovered during soils analysis pre-closing or other challenging items that could not have been predicted until the project was in flight. A careful accounting for a contingency factor should be budgeted and bank budgets should have enough room to account for the uncertainty associated with material or labor cost variances. In a hot market these costs can rise and certain systemic risks like inflation can cause material prices to rise appreciably. One should ask questions about budget items and make sure that the developer and/or his contractors have a history of bringing projects in on budget.
  • Experience – How many projects has the developer developed in the subject area? How often have they worked with the team of professionals that will be executing the project you’re considering investing in? Just like with a professional sports team the individuals can be fantastic and fail miserably collectively. We take care to only pair one new team member with others in a new project to help isolate the source of problems.   One would do well to quiz the developer about their experience with the team they select for a given project and how they’ve worked collectively. The most important members of this team are generally the property broker, banker, civil engineer, architect, and surveyor. All of these team members provide critical needs for the project and any one of them being a weak link can cause major problems for new development projects. We have literally interviewed hundreds of professionals to select team members for each of these functions over the last several years. Finding top-notch team members is hard work. Finding talented individuals that work well as a team is even harder.
  • Alignment – Deal structure matters! Investors should take care to make sure that developers primarily make money by adding value for the investors.  Small fees to cover overhead are necessary for cash flow reasons in many cases, but the best projects for investors are generally ones where the developer has to deliver value to the investors before they participate in the profits. This is generally done with a preferred return and some split structure thereafter. Fees should be carefully examined; especially if they’re higher than industry averages. Fees higher than normal create misalignment and can cause promoters to take on projects solely to generate fees instead of providing value for the project’s investors.
  • Internal Controls – How does money move in the project and who has access to it when? There is a different golden rule in business that says, “He that has the gold makes the rules.” Small contracts are difficult and costly to enforce. Thus one wants to carefully examine who will have access to funds and how they’re handled throughout the project. A classical source of issues for both lenders and promoters is to allow contractors to handle funds for items before the work is done. Some contractors are great at building houses, but horrible at managing a business or handling funds in general. Care should be taken to make sure that work is paid in arrears to avoid money handling risks.

 

The list of items above is certainly non-exhaustive, but it should be a good start for things to look for.  In general I would look for these items:

  1. Buy-side contracts are structured properly to hedge development risk for the project
  2. Budgets appear professional and include all project fees and not just the sticks and bricks for the project
  3. The developer has a track record of doing the type of project they’re raising funds for and are not practicing with your money
  4. There is alignment in the deal structure so that the developer primarily makes money by making the investor’s money work harder
  5. Internal controls and handling of cash are structure to minimize risk; especially risk of contractors handling funds prior to the completion of work

Hopefully this is helpful information in your quest to find the best risk-adjusted home for your investments. Happy investing!

This article is a guest post from Bryan Hancock, head of the Acquisitions Department for Bullseye Capital’s Real Property Opportunity Fund.The information contained in this article is not to be construed as constituting tax, legal, accounting, financial or investment advice.