Passive Investor Principles
What does it mean to be a passive Investor? From the management team’s perspective, a passive investor is an individual that is able to contribute to a deal in one or more ways. The most common element that a passive investor brings to the table is money; money that goes towards the initial investment of the deal. Passive investors can also move into a slightly more active role if they are able to provide any of the following: skills that complement the management team, high net worth, high liquidity, or credibility and mentorship for the management team.
From the passive investors perspective, you are mainly limited to providing capital for the acquisition of the property. As a passive investor you will share in the profits of the deal without having to share any of the day to day management decisions. While you do not have any responsibility in the day to day operations, you do have a responsibility to yourself to invest your money wisely. So, as a passive investor, at what point do you feel confident enough to invest in a deal? Unfortunately, there is no one size fits all answer. Investment decision and analysis is a complicated process that requires hours of due diligence. In order to build your confidence, consider these tips. A passive investor should maintain a checklist for each potential deal that comes to the table. They should be familiar with the market they are investing in and most importantly they should perform their due diligence on the management team.
You will want to build a checklist that allows you to easily evaluate the deal and determine whether the investment fits your risk profile. There are four basic elements that make up a real estate investment. Cash, Debt, Time, and Risk.
Cash represents the amount of money the investors will need to acquire the property. This includes the down payment, closing costs, loan costs, renovation expenses and required reserves for any unexpected expenses.
Debt represents the cost of financing the property. Consider the term, amortization schedule, interest rates, points, balloon payments and closing costs associated with financing the deal.
Time represents several factors such as the time it takes to stabilize a property, the payback period which measures the amount of time it takes an investor to recoup his or her initial investment. Time also represents the holding period of the property. The holding period of the property will always reflect the management team’s strategy.
Finally, risk represents many different aspects of the deal. Risk can factor the current management team and vacancy rate of the property. It can factor the class of property which carries an inherent level of risk. For example, class A properties will have a lower risk profile than class D properties. Risk also factors the market. The market that the property is located in is crucial to its long-term success.
As a passive investor you must thoroughly analyze the market in which you will be investing in. Consider the following three factors while analyzing the market; growth, new development, and employment.
Growth represents several different things, such as population growth, income growth, and job growth. You want to see a positive trend for all of these areas. It’s also important to look at new properties coming online and how they weigh against the absorption rate of that particular submarket. If the absorption rate for multi-family residences is low but the construction is high, this may indicate an overbuilt market.
Make sure to look at companies that are moving into or out of the market. Who are the major employers in the market? Avoid any one-horse towns. You don’t want your investment to depend on the success of a single employer. What kind of industries dominate the market? Ideally you would like to see lots of diversity in terms of industries. This will help you hedge against economic downturns that can affect major industries.
Having a strong understanding of these basic concepts will allow you to quickly analyze potential deals. This leads us to our final point. Who is the management team? The management team may be the most important factor you will want to consider when making your decision. All of the previous factors discussed should be covered by the management team in the offering memorandum. If you have a strong understanding of your risk profile and you have satisfied your checklist then you can be confident that the investment has a strong foundation. What brings the deal together and ultimately determines its success is the management team.
Consider the management teams experience. Is this their first deal or is it their tenth? Have their previous deals been successful and to what degree in terms of return? Speak to other passive investors that have previously invested with them. Most importantly, speak to the management team. Don’t be afraid to ask them tough questions, the management team should be happy to address any of your concerns. If you are satisfied with your personal due diligence and are confident in the management team, then you will be confident with your decision to passively invest in the deal.
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