Looking at a Real Estate Deal

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A client recently asked me to look at an investment proposal he was considering. He isn’t familiar with real estate deals, so his basic questions were:

  • Is it a good project?
  • Is it a good deal?
  • What are the risk factors?
  • Please explain the deal structure. Is it a common structure for similar deals?

Here are some thoughts on how to evaluate this sort of a deal:

This Project

In this case the project involved purchasing land in a Southern California town, building a senior living facility, and operating it for a period before selling it. They were looking for a $10 million investment.

Land acquisition, permits and other pre-construction were to take 7 months, construction 12 months and lease-up (the time it takes to lease all units) another 12 months. The proposal was to hold and operate the facility for 10 years, but vaguely suggested the possibility of selling at the end of the lease-up period.

Is This Your Kind of Deal?

This is a passive deal in which the investor has no control over the property or decision process. Are you ok with that? And are you willing to let someone hold your money for 13 years?

This isn’t to suggest that it’s a bad deal. A lot of people have made good money on investments like this. You just have to be sure it fits your needs and expectations.

Who is the Sponsor?

The sponsor is the person or organization that conceived of the project, put together the plan, and is now looking for equity financing. This is a long-term strictly passive investment, so you need to have full confidence in the sponsor. His (or her, or their) experience, reputation and integrity are critical to the project’s outcome. Questions to ask include:

  • Has the sponsor completed similar projects in the area? This is especially important in Southern California, where local governments can make you jump through hoops before they approve a project.
    • Does he have experience with land entitlements in the region? How about his experience with the local municipality?
    • Does he have experience with construction management and budgets? Has he selected reputable engineers and contractors?
    • What is his expertise in operating senior living facilities, or whatever else the project may involve? Does he have a reputable management company on board?
  • How much is the sponsor investing? Do you want to be a limited partner when the person controlling the project doesn’t have anything at risk?
  • If the sponsor has previous successful experience, why isn’t he using previous investors?

Risk Factors

The first big risk has already been discussed. You’re letting somebody control your money for 13 years. First, is the sponsor trustworthy? Next, the longer your money is outside your control, the more chance there is that something will go wrong. That’s a main reason why long term projects need to have a significantly higher return than short term projects.

That whopper of a consideration aside, here are some specifics:

  • General business risk. Is this the right project in the right place at the right time? The sponsor should have comprehensive, convincing information to help you make this decision. Senior living facilities sound like a pretty good bet these days, but is it the right time and place? Clearly, you should do your own due diligence.
  • What happens if cash flow projections are bad, or something unexpected happens, and more funding is required? Are you required to invest more? Will you have to give up a big part of your return to attract a new investor who knows you can’t complete the project?
  • Land entitlements (permits, approvals, etc.) require expertise and knowledge of the local government process, and VERY often take a lot longer than expected, running up costs and dragging down financial returns. The fewer permits required, the more likely the project will move ahead on schedule. That will make the land more expensive, though, because someone else took the entitlement risk.
  • In my experience, the land development phase almost always goes over budget. Is there enough contingency? Again, the less land development required, the better chance of staying on plan. But it will also make the land more expensive.
  • Assumptions used in projecting revenues and costs.
    • Are the unit rental rates in the projections achievable? This particular proposal used a 3% annual increase in rental rates over the entire 10 year operating period. This sounds aggressive to me, but maybe the sponsor has data from other projects to support it.
    • Expense assumptions need to be examined closely, too. Having done hundreds of budgets and projections in my career, I can promise that expenses are always projected on a “best case” basis.
  • Are there holes or errors in the cash flow projections? Something I noticed in this specific proposal is that there were no operating costs budgeted for the 12 month lease-up period. I also didn’t see the sponsor’s fees deducted from the cash flow projections.

Is it a Good Project?

Over and above your due diligence regarding the risk factors, attention turns to the financial returns. How you view the proposal is important:

  • This project is really two separate projects – 1) acquisition, construction and lease-up of a senior living facility, and 2) investment in an operating facility. These are very different projects with very different risks and expected returns, so they need to be analyzed separately.

This proposal did not separate the two phases, but when I applied the sponsor’s valuation assumptions (a 7% cap rate) at the end of the construction and lease-up phase, there was no profit whatsoever, even though this is the phase with the greatest risk. Did the sponsor even bother to check whether he was overpaying for the land? Any suggestion of selling at a profit at that point has flown out the window.

  • It is common for investment proposals to show project returns on a leveraged basis, maybe even applying tax assumptions that may or may not fit your situation. Not unreasonable, because the project is probably using debt financing, and this would be the actual return on your equity investment.

The problem is that it makes it difficult to compare the quality of this project against other similar projects. The only way to compare one project with another is to take out the variables, and show the pretax unleveraged return. Of course, this proposal did nothing of the kind.

  • This project seemed to be projecting a 23% annual after-tax return to the investor, but the financial analysis didn’t feel reliable. Anyway, that’s a heck of a return, and you would really want to ask if it’s too good to be true.

The Deal Structure

Once the investment is made, then the deal is all about who takes out cash – when and how much. This deal was fairly typical.

  • Sponsor fees –
    • The sponsor typically takes an up-front fee based on funds under management. In this situation, it was 1.0%, probably about enough to recoup the sponsor’s start-up costs.
    • He also typically also takes a percentage of the selling price when the project is sold, 1.0% in this case. This is his bonus.
    • The sponsor will also take a fee for the duration of the project, often measured as a percentage of assets. It seems reasonable that the sponsor have some cash flow. In this case it was 2.5%, or $250,000 a year.
  • The “waterfall” – This is a detailed agreement outlining where and when free cash flow is distributed among the investors and sponsor.
    • This particular agreement was unclear as to how the monthly cash flow would be distributed, but it would generally be based on a percentage formula, and the investors’ share divided according to their relative investment.
    • There is often a “preferred return” when the project is sold. That is, the investor gets his entire investment back, plus an amount that brings him up to an agreed rate of return (7.0% in this case) before the sponsor gets to share in the profits.
    • After the investor gets his preferred return, then the remaining cash flow is shared according to any simple or complicated formula agreed to in the partnership agreement.

The great thing about deals is that they are negotiable, or you can walk away. You don’t have to accept any terms you can’t live with.

Are You Getting a Good Deal?

A good deal is in the eye of the beholder…

  • Is the projected return better than your other investment opportunities, given the risk factors involved?
  • Are you getting as good a return as you would on a similar project?
  • Are you satisfied that the sponsor is being rewarded reasonably?
  • Are you satisfied that you are getting as good a deal as other investors in the project?

My Recommendation

You’re probably not surprised that I recommended against this particular deal. I did recommend, though, that my client keep an eye out for other deals to educate himself. You never know when the right deal might present itself.

 

 

 

 

 

 

 

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Profit Improvement – Allocation of Resources

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

Allocation of Resources

Where a company chooses to invest its resources has an important effect on its profitability and ROI. This can be managed at the time of the initial investment, but ongoing investment needs to be reviewed with a critical eye.

Profit maximization – A land developer and builder was very disciplined in its due diligence on land acquisitions. Land development is a surprisingly complex process involving massive investment, and is subject to a seemingly endless list of restrictions and costly requirements from all levels of government. So choosing between land investment opportunities is a painstaking process, but often subject to emotional responses. We built a linear programming model to maximize the profitability of our land use plans based on our budgets and timing, as well as the attendant marketing and government constraints. This removed much of the emotion from the land acquisition process.

Unprofitable operations – A homebuilder was focused on entry-level housing, and suffered from tight margins and the need for economies of scale and tight discipline in that sector of the business. At the same time, its land entitlement and development business was generating high margins and even higher returns on investment. With 80% of the company’s overhead, but only a small percentage of profits coming from homebuilding, we weighed the investment required to operate a full-scale builder in a higher price category against the potential return, and decided to walk away from the business entirely. Overhead was drastically reduced, and capital was redirected to the more profitable business of land development.

More profit with lower investment – A retailer was famous for the department stores it had operated for many years. Over time, though, these stores had lost ground to competitors, and capital investment had been cut back in proportion to declining profits. The company also operated a number of successful specialty store formats. A time of reckoning came, and the company realized it could make management changes and invest heavily in its department stores, possibly reaching the level of success, for example, of Target Stores. After an intense review, though, they recognized that specialty stores had a higher potential return, a relatively lower investment, lower risk and correspondingly low barriers to entry in niche specialty markets. Relying on its depth of experience, the company closed its famous department stores, and reallocated its funds and energies toward rapid growth in specialty retailing. It became one of the top-performing companies on the New York Stock Exchange.

Drawing on strengths – Another homebuilder operated in a single market, selling low margin homes during a downturn in the housing market. Recognizing its strength in efficient, low cost construction, it started looking for new opportunities. We focused on selling houses at full margin for rental by investment partnerships, expanding regionally into new markets through joint ventures, construction for hire of military housing and multifamily construction.

Does your CFO lead your management team in constant evaluation of your resource allocation process?

Profit Improvement – Cost Reduction

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

COST REDUCTION

Reducing costs can be as simple as finding a new supplier, but sometimes a more detailed analysis or a global approach can be effective.

Looking at the details – A retailer’s payroll is typically its largest expense. At one company, the standing order was to maintain payroll at 10% of sales. This worked consistently, but when we started to look at customer traffic patterns, we saw that staffing was not being increased at peak times, or decreased during the slow hours of the morning or evening. A new staff planning system improved customer service and brought payroll under the 10% target.

Statistical analysis – A homebuilder had a problem with windows leaking during rainstorms. Nobody really knew why, but replacement was costly, and it was a serious customer satisfaction problem. We formed a Six Sigma task force to gather and analyze the data. We broke down the data by community, by subcontractor, by supervisor, by manufacturer and installer until a pattern became evident. After a few changes, leaking window problems were reduced by 60%.

Centralization – At another retailer, repairs and maintenance expenses were the responsibility of the local management, and no amount of threats or encouragement could stop costs from increasing. We centralized the function in the corporate office, and made low cost arrangements with regional contractors, reducing costs by over 30%.

Glaring opportunities – A land developer always paid for up-front infrastructure costs – roads, sewer, etc. – on its development projects. This had a huge impact on cash flow and ROI. I learned that most cities are willing to finance these costs with municipal bonds. It wasn’t a secret, but the company never took advantage of the opportunity. I set about becoming something of an expert on the subject, and initiated over $100 million of cost savings that went straight to the bottom line when the developed properties were sold.

Planning – At a homebuilder, we carefully reviewed the cost of every house, and construction (or even purchase of the land) would not be approved until we were certain that projected profits met our investment return guidelines. Marketing would sometimes change design specifications, but the purchasing managers were often the ones who would drop the cost per square foot by changing a material or redesigning a minor architectural detail. This was sometimes a painful process, but the result was a low cost, high value product.

Does your CFO encourage your management team to look at cost reduction in a comprehensive way?