Investors’ approach to analyzing investments is often spotty and unprotected by experience and disinterested vision. This often leads to unnecessary investment risk and, if included, could make good investments that much more attractive to qualified investors. This article attempts to design a plan that provides this disinterested vision and a proactive approach to risk management.
We believe prudent investors should distance themselves a bit from the project. Banks attempt to accomplish this by using appraisals, property status reports, environmental studies, surveys, and by collecting other information on directors. This is not an ineffective approach, but the approach does not consider the investment in the context of the plan and the overall financial strength of the proposed investment. The investor must remain connected to the investment context, but make an unemotional decision based on merits and problems.
Conceptually, achieving this goal requires the following actions:
- You need to collect the information from the standard reports. From this, the investor needs to extract: 1) property taxes, 2) immediate improvements and 3) improvements for the next 5 years, and 4) any other actions that require funded work. In addition, the investor should look for structural problems such as lack of central air conditioning, aluminum wiring, lead paint, or other items that may require financial planning on the project. Ideally, the investor should estimate the cost of these items.
- The investor should review the planned improvements planned by the manager or for the project. You need to measure the cost of these items to verify their accuracy.
- Financing terms and conditions must be clearly defined prior to investment. Terms must be secure at closing. They must allow for timely refinancing if the exit does not proceed. The potential requirement for additional capital should be understood in the event that the assumptions fail.
- Operating income and expenses should be compared to local projects. Expectations should be judged on their reasonableness and likelihood. Occupancy must be verifiable for similar projects with similar traffic.
- Plans and accounting and cash management capabilities must be proven, they must provide critical accruals, especially payroll taxes, property taxes, insurance, and reasonable capital reserves.
- Reserve accounts must be fully funded at closing for capital reserves, taxes, and insurance. Also, reservations for leaving and finishing are prudent. In addition, an initial post-closing operating reserve must be budgeted and itemized. Finally, a contingency reserve is prudent.
- Finally, a review of the operating agreement must confirm that the assets cannot be sold from the investment without reasonable approval from the investors and that the investor has an adequate stake in the event that additional funds and support are required.
Investors are likely advised to use resources to answer these questions prior to closing as part of their due diligence and influence the manager to add them to the project if they are not provided or forfeited the investment.