If you listened to episode JF120 of the Passive Investing Show, John had special guest Adam Adams in for a great interview session. During this time of discussion, Adam dropped a few value bombs for Passive Investors to take seriously: Vetting your opportunities.
If you are a seasoned investor, you may already know the importance of vetting your sponsor. Adams emphasized the criticality of vetting two other important pieces to any investment decision: vetting the market and the deal. Even as passive investors, recognizing that you trust the sponsor with whom you are working, it is advisable that you take an active approach to understanding and buying into both market and deal in which you are considering investing
Vet the market
I agree that right after vetting the sponsor, vetting the market is next in line of critical evaluation. Two important considerations that John and Adam outlined in the interview was population and job diversity:
Population
Adam asserts that population is a very key determinant in the deals he accepts. His personal investing criteria keeps him away from MSA’s with populations less than than 100,000 people. He argues that there is risk in these areas that can destroy your investment prospects. For example, if the key employer in the area goes out of business or has a massive layoff, it can greatly affect life in the area and housing occupancies.
This concern with low population areas segues seamlessly to the second consideration all passive investors should consider: job diversity.
Job diversity
Job diversity is essential in any market under evaluation. Like population, from a risk perspective, if one industry or employer suffers from loss or downsizing, the balance allows for sustainment of many jobs in other industries or from many employers. Adam’s criteria are that for any market to be attractive to him, no more than 20% of jobs should be within one industry.
These above considerations are precisely why I am attracted to the Jacksonville, Florida market, which is a great example of a market that would pass the above criteria: the city itself has over 900,000 people and the wide variety jobs range from anywhere from military to education to banking and finance.
After vetting the market, next comes the deal itself.
Vet the deal
Many investors see deals and do not know how to properly vet them. Remember, even if you are good with numbers, the key metrics are only as good as the assumptions used to input them. What do I mean?
Savvy deal makers know how to color a great deal, and certain assumptions can be made to make average (or risky) deals appear to be a great deal when this is not the case. Adam stressed the importance of conservative underwriting.
Let’s consider two examples: rent growth and reversion cap.
Rent Growth
Rent projections are fundamental to the deal. In the numbers, some sponsors will assume positive annual rent growth, and to this you should be attentive. There are two common areas to watch: projecting too high rent growth in the first year and projecting consistent year over year rent growth in the holding period high.
Adams pleads his case to PI listeners: “Just because comps say they are 20% below market, how do we know that we can raise all rents by this amount in the first year? Vet the deal better.”
Reversion cap
Another important assumption in the deal to watch out for is the reversion cap rate, or the cap rate at which the syndicator estimates property will be sold. In Adam’s example, if you bought the property at a 5% cap rate, and the cap rates in the area are now at 7%, it is prudent to be conservative. Rather than assume a reversion cap rate of 5% – the same at which you bought – the conservative approach is to use a higher cap rate that is, perhaps, two basis points per year higher, which is 8% in this example.
As you vet the deal against your return goals, pay attention to the realism of rent growth and reversion cap. It is always best to be conservative here, because the assumptions on which these targets are made greatly influences the IRR on which the deal is marketed and from which your investment decisions are made.
Remember
As PI listeners and subscribers, you already know the importance of knowing your investment criteria. Take it one step further by thoroughly vetting more than just your sponsor, but the market and deal itself. Just because you are a passive investor does not mean you are not actively involved in your own investment decision making process. Be attentive to both the market and the deal and ensure that you have fully vetted them before moving forward with the next investment decision.
If you have considered investing with a private equity investment firm, please create your investor profile with The Fortes Company at www.investwithfortes.com.
Guest writer Rodney Robinson of https://rodneyrobinsonii.com/
Disclaimer: The views and opinions expressed in this blog are provided for informational purposes only, and should not be interpreted as an offer to buy or sell any investment or course of action.