One of the best things about passive investing is that you aren’t the one doing the day-to-day work. When you invest passively, you find big, trust a worthy surgical team, and then get monthly or quarterly checks. Sounds pretty good, doesn’t it?
But there is a downside.
Since you are not the one actively managing your funds, errors can occur.
Your control of the business is in the front end before you invest. Think of it like a high school: the best thing you can do to be successful is your homework.
Failure to do your homework leads to the two most common mistakes that investors make in my opinion.
- Failure to adequately review the operator (or deal sponsor).
- Failing to adequately examine the deal.
Review of the operator
There are many reasons to check out the operator (or the deal sponsor running the deal), but the biggest one is also the most obvious.
You want to be able to trust them!
The operators take care of your investment every day. You are trying to increase the workload, close deals and work on the business plan.
Understand their background
These are the people whose success leads to yours. So you want to know a few things about her
- Who are you? You’re looking for a track record with consistent returns.
- In which plant area do you work?
- Who else is involved in the deal?
- What is your reputation like?
Just think about the type of person you would like to do business with and let that guide you.
You can also do background checks. Remember, your money is at stake so be as thorough as necessary. I know a few people who do background checks on every single partner in a business. Do what feels right.
Increase Your Investment
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Use your network of co-investors
People know each other, and word gets around quickly when they have had good or bad experiences. Talk to people who have used this operator before. What was your experience?
One of the best questions is about operator communication. How was the communication when the deal went well? How about if it didn’t go well?
There are groups out there who stop communicating with passive investors. For me, this is one of the worst things that can happen to a passive investor.
A lack of communication can lead to all sorts of problems. Think about it. If a problem arises and the operator doesn’t let you know, how would that affect your investment?
Know their experience and strategy
Focus on what types of deals this operator has done.
What types of deals are there? What is the operator’s investment track record?
Great operators should be able to share stories about businesses that have done well and their specific returns. They should also allow you to speak to current investors and ask what it was like to invest with this group.
Use your network again! Talk to your friends and find out what they can help you with.
If you can see a positive history in the operator’s portfolio, you can feel a little more confident about managing your investment.
There are so many different passive investing strategies out there. The type or class of shares in which you invest, how you generate profits, and the level of investor commitment required can vary from business to business.
What Makes a Great Operator?
My experience has taught me that the best operators are specialized. Your plans are specific and clear, and you can follow their plans.
You cannot be everything to everyone. You cannot enter into basic development and value-added contracts and work with office space and apartment buildings and work across the country.
That’s way too much to keep track of! Just thinking about it is a lot.
An example of a good, simple deal looks like this: “We operate in the southwest in secondary markets. We’re looking for X% of the returns. We’re looking at B and C class or working class properties. We pursue a value-add strategy. We’re trying to increase rents by $ 100 or $ 200 per unit. “
And it’s even better if you can refer to a history of your investments.
How would you feel if an operator could show you five, 10, or even 20 deals using the same strategy? Pretty good, I guess!
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Review of the deal
Just as important as reviewing the operator is reviewing the business.
In this process, the first and foremost question is whether the operating group is conservative about the deal.
There is a lot to report about conservative underwriting. Let’s try to keep it simple: They want the deal to be on the Conservative’s side.
Make sure the deal doesn’t just try to show off with large hypothetical numbers. Some offers look good, but on closer inspection you see that the operators just make the numbers look good.
You want to make sure that the deal incorporates a healthy margin of error in its growth projections. Housing, for example, is a reliable investment plan, but in various markets one cannot always rely on accurate and organic rent increases from year to year.
When it comes to seeing how conservative a business is, my favorite number is rental growth. So much can be said about a deal with that number alone.
Let’s say a particular deal is in a market where organic rent increases are 3% per year. Looks good, doesn’t it?
But many operators will think that if the rent has increased this way in the past, it will stay constant at 3%.
But since you’re conservative, don’t rely on this number to be consistent. Perhaps there have been fewer rent increases in a few years. Or maybe the market appreciation is stagnating.
By planning such slumps in rental growth, the conservative operator can better survive such situations. This contributes to the security of your investment.
This also shows you that the operator is staying active and not just relying on experience.
Cap rate on exit
The cap rate is the rate of return, the extra income that you bring home from your investment each month.
Think of it like a tree. If your investment capital is the root and trunk of the tree, the leaves are the cap rate. We all want more greenery, but sometimes a bigger tree will blow fewer leaves.
When you sell your investment, you want fewer leaves on the tree, which means you are getting as much green as possible out of the investment.
When working out a deal, you don’t want to assume that you can sell your investment at a cheaper cap rate. If you can, good for you! However, the conservative operator plans to sell at a higher, inconvenient capitalization rate than the initial investment. This also enables a healthy error rate.
That way, you won’t have to rely on the cheaper cap income even if business isn’t doing as well as you would have liked.
It also gives you, the investor, peace of mind that the operators are not misrepresenting the numbers so that the business looks better than it is.
This one is easy. You want to make sure the deal has a rainy day fund and a small cash reserve in case something shows up.
What if you run out of cash? What if the renovations or improvements don’t go as planned? A simple check on whether or not the deal has extra reserve can show you the quality of the deal.
Make sure you understand the deal
I’m a student of Warren Buffett, and he puts it best: “Never invest in a business you can’t understand.”
You want to make sure that you understand the deal and are comfortable with everything that comes with it. If you don’t understand, don’t invest!
Be ready to check out some offers. Find the provider and offer that suits your temperament and goals.
By taking the time to review the operator and the deal, you are two steps ahead of anyone who made the mistake of blindly jumping in.
Investing successfully means understanding what you are doing and keep learning!