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November 10, 2011

Due Diligence 101 – Analyzing the Sizzle Versus the Steak

Most folks don’t want to spend the time and energy to learn how their watch was made so long as they can live comfortably knowing that it’s telling them the right time. This I can completely understand, especially in a…

Due Diligence 101 – Analyzing the Sizzle Versus the Steak

Most folks don’t want to spend the time and energy to learn how their watch was made so long as they can live comfortably knowing that it’s telling them the right time. This I can completely understand, especially in a world today where you don’t even need to wear a watch because most of us can simply check the time on our cell phone.

What I can’t understand is why so many investors take that same attitude of blanket acceptance toward investment opportunities without asking the most basic fundamental question, “how exactly is that going to work?”

I wrote a piece two months ago about how most adults have a tendency to lose much of their childlike wonder as they age and  tend to simply accept the world around them at face value. We hear and see things every day from all manners of sources (friends, co-workers, the internet, television, ect), some credible and some not so, and yet we neglect to ask the basic questions to help sort through the sizzle to validate that there is some steak to back it up.

Since that article was published, I’ve received numerous calls from clients in the hopes that I would lift the proverbial veil and shed some light on basic tactics I use to break down an investment opportunity to gauge the appropriateness of the offering’s claims.  While I can’t in one article explain all of the structural and economic elements I review to corroborate a given investment’s claims, I will provide a great starting point for investors looking to build a solid first line of defense for their portfolios.

It’s not Rocket Science… Look at the fees first!

When considering an investment in a program that provides an offering memorandum, there is typically a section called “Use of Proceeds” that outlines where just about every one of your nickels and dimes will be allocated. It will detail the up-front cost of structuring the deal, any commission payable to your investment advisor, the amount of funds allocated toward reserves (if any), and any acquisition and financing fees that may apply. By reviewing this section, you can determine how much of your original dollar actually “makes it into the ground.”

The “in the ground” figure is an extremely important factor when determining whether a syndicator can achieve their stated return goals. Every offering is going to have a different % of your capital that is utilized to acquire the underlying investments. Please note that just because one investment comes with a higher up-front cost than another, does not mean that the “more expensive” investment offering is necessarily inferior. There are a number of reasons why a given investment could experience higher up-front costs than another… they key is to review the “Use of Proceeds” and ask your advisor or the syndicator for an explanation of their fee structure.

Fees, Fees, and more Fees

I fully recognize that I’m not going to blow many minds by recommending investors analyze the fee schedule before investing but I need to highlight it here because those fees can add up. You should note any ongoing fees like asset management and property management and also back end fees like sales commissions, profit sharing arrangements, and disposition fees.

Many companies market themselves as firms that “put the investor first,”  but the proof is generally in the pudding… or in this case, the Fee Schedule.

The Sizzle versus the Steak

Now that you understand how much of you money is going to be put into the ground and how many bites out of the revenue apple are going to be taken before you get your taste, it’s time to look at marketing assumptions versus economic realities. If your real estate syndicator says they can consistently acquire class A office buildings in major metros at capitalization rates of 10%+ or an energy company says they sell their natural gas for a 20% premium about the current spot price, you better ask them to prove it. Make sure that the general economic assumptions being used to establish the return estimates are grounded in reality, rather than some wholesaler’s pipe dream.  The best way to test this is to simply ask around. Check with other companies in a similar business segment to see what assumptions they use to structure their investments.

Now let’s put these tools to work

Here is a quick example using a real estate investment to help illustrate the impact of some of the issues I touched on above. In the example, XYZ Financial has set out to raise funds from investors in order to acquire an apartment building for $1 million at a capitalization rate of 8% using all cash.  XYZ makes a claim that they intend to pay investors a 7% distribution. Let’s take a closer look at the costs of the deal to see if XYZ can make good on these claims.

“In the Ground” Calculation

Use of ProceedsXYZ Financial
General & Admin. Expenses3%
Sales Commissions7%
Marketing Expense1%
Acquisition Fee1%
% of Capital “In the Ground”88%

You’ll see that for every $1 XYZ Financial raises from investors, $0.88 is actually making it “into the ground” to buy the property.

Property Purchase Price$1,000,000.00
Up-Front Costs$136,363.64
Total Cost $1,136,363.64

XYZ must raise a total of $1,136,363.64 from investors in order to acquire the building given that 12% of every dollar raised (or $136,363.64 total) is spent elsewhere.

Purchase Price$1,000,000.00
Net Operating Income$80,000.00
Unloaded Yield8.00%
Loaded Purchase Price$1,136,363.64
Loaded Yield7.04%

 

This illustrates how an asset acquired with an 8% property level yield may only be able to actually distribute about 7% net to investors because of the load. This net cash flow may be even less due to ongoing management fees as well.

Before you invest, do yourself a service and take the time to understand the business plan for the investment. Ask yourself these two questions: “Given what I know about the up front load and the ongoing fees, can this investment provide an acceptable return relative to the underlying risks? Second, can this investment perform if circumstances don’t play out in the most ideal of manners?” If you are content with the answers to those two questions, you’ll likely have a far better shot at success and you’ll probably sleep a lot better at night.

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