Due Diligence for REIT Investments

Originally Posted September 2023
Edited May 2024

Since inception, our REITs have acquired investments with over $1 billion of underlying real estate value.^[1] No investment is without risk, but a successful due diligence process will identify the strengths and weaknesses of an investment and guide the underwriting process.

RM Adviser, the manager of RealtyMogul’s two REITs, sources the investments in which our REITs invest. We review hundreds of transactions each year for investment consideration into our REITs, and only those that meet our rigorous underwriting standards are eligible for REIT investment. One of the benefits of investing in our REITs is the robust diligence process that we perform on behalf of our REIT investors.

The underwriting process for these investments involves comprehensive financial, structural, operational, and legal due diligence of our borrowers and partners in order to optimize pricing and structuring and mitigate risk. Specifically, our process focuses on the following four aspects of a transaction: Property Diligence, Geographic Diligence, Real Estate Company Diligence, and Third-Party Reports.

In his book, The Most Important Thing (Marks, 2011), Howard Marks, one of the most successful investors of our generation, focuses on the qualitative and psychological aspects of investing, including an entire chapter on the distinction between first-level and second-level thinking and the importance of the latter. In that light, we’ve included below a sampling of the types of key questions and related diligence materials that we collect and some of the ways we go about analyzing such items.

Property Diligence

• When was the property built? If an older vintage, does the underwriting address any deferred maintenance?
  
  • First-level: Older properties will have components that break down; consequently, we should avoid this asset class.
  • Second-level: Older properties may warrant a higher expected return due to the increased risk of investment, and if we invest, we should capitalize funds upfront to address any deferred maintenance.
• Has our review of historical financial statements, rent rolls, and aged receivables corroborated our underwriting?
  
  • First-level: The financial statements look strong and should justify a higher purchase price.
  • Second-level: Why do the financials look strong? Are there any one-time revenue or expenses that are driving the strong performance and should subsequently be stripped out in our underwriting? What date was the aged receivables report run, and does our analysis account for prepaid renters and late payers?
• What sales comparables are in the immediate area that justify the investment’s purchase price?
  
  • First-level: The property purchase price is in line with the sales comps that the sponsor selected for their investment memorandum.
  • Second-level: Why were those particular sales comps selected by the sponsor? Are they all located in the same micro-market? When did the comps trade, and were there any macro events that occurred between the trade date and the contract date for our property?
• What rent comparables are in the immediate area that justify the underwritten rents?
  
  • First-level: The underwritten rents are in line with the rent comps that the sponsor selected for their investment memorandum.
  • Second-level: For multifamily properties, are the amenities within a unit truly the same (i.e. washer/dryers, 8’ or 9’ ceilings, countertops, cabinets, lighting packages, smart home technology)? Are the community amenities truly the same (i.e. pools, sport courts, security, outdoor lawns)? If variances between the subject property and the comps, have we accounted for such variances in our underwritten rents?

Geographic Diligence

• What are the business drivers surrounding the property and the avenues for economic growth?
  
  • First-level: The economic drivers and avenues of economic growth support the success of the business plan.
  • Second-level: Is the industry within the market/submarket one that has exhibited an ability to withstand any economic uncertainty throughout our hold? Are there growth drivers that give us confidence the property will succeed as underwritten? For office properties, does the anticipated economic growth support underwritten rents?
• What is the population and expected growth within a 1, 5, and 10-mile radius?
  
  • First-level: The population and expected growth is large enough to support the success of the business plan.
  • Second-level: For multifamily, is the population large enough to maintain demand at the property? Is the population projected to get older or younger? If so, how does that impact the property’s business plan? Is the property located next to or near a top 50 major MSA? If the growth is expected to be negative, is that in contrast with our business plan (business plan betting on the growth of a submarket with negative population growth)?
• What is the area median income and expected growth within a 1, 5, and 10-mile radius?
  
  • First-level: The area median income and expected growth is large enough to support the success of the business plan.
  • Second-level: For multifamily, does the area median income support underwritten rents after taking into account miscellaneous rent such as utility bills, parking fees, pet fees, etc.? Are there conflicts between area median income growth and anticipated business growth in the region? Is one or both lower than expected? If so, why?

Real Estate Company Diligence

• What is the real estate company’s track record, and does it support the investment that they are sponsoring?
  
  • First-level: The real estate company has vast experience and has exhibited the ability to successfully manage real estate throughout the life cycle.
  • Second-level: Does the real estate company specialize in this asset class? Has the real estate company operated assets that are similar in size and business plan to the opportunity they are sponsoring? For the properties the real estate company has sold, have the returns been at or ahead of pro forma? If not, is there a proper explanation for why not?
• Does the real estate company have the infrastructure to support this investment as well as those currently in their portfolio?
  
  • First-level: The real estate company has the individuals in place to support the current and proposed portfolio.
  • Second-level: Does the real estate company have a staff that is large enough to actively manage the proposed opportunity as well as the remainder of their portfolio during the regular course of business and if unexpected situations were to arise? Does the staff have relevant experience to allow them to be successful in their role?
• What industry references do we have from those who have invested with the real estate company previously?
  
  • First-level: The industry references corroborate that the real estate company represents themselves as advertised throughout the investment life cycle.
  • Second-level: Does the industry reference point anything out that is contrary to what has been represented? How timely was the real estate company in getting information and reports out?
• How are the business terms of the deal structured?
  
  • First-level: The business terms provide adequate protection for the business plan, property type, and real estate company sponsoring the transaction.
  • Second-level: Is there adequate protection/compensation for the key risks identified as part of the transaction? If contributing majority equity, does the REIT have approval rights over major decisions, including the sale or refinance of the property and/or the ability to remove the manager?

Third-Party Reports

• What capital improvements do we need to underwrite that were identified in the Property Condition Assessment (PCA)?
  
  • First-level: The real estate company sponsoring the transaction has incorporated items called out in the PCA.
  • Second-level: Does the PCA identify previously unexpected conditions at the property (i.e., building foundation issues, roof repairs, ADA compliance issues)? Are the findings from the PCA accurately reflected in the underwriting? If not, is there a clear rationale for why not? Does the PCA corroborate the underwritten replacement reserves? How much, if any, additional contingency needs to be added to the capital budget?
• Is the property management company reputable?
  
  • First-level: The property management company exhibits an ability to manage the property in accordance with the business plan.
  • Second-level: Does the property management company manage properties in the surrounding market/submarket? If so, how many units or square feet? Throughout the acquisition process, has the property management company showcased an expertise of the market/submarket as well as the property type? Is the property management company aligned with the business plan?
    

While any one of these items may not be a deal killer, we focus on the compounding effects of different risks as they relate to the real estate investment, paying particular attention to the question, “How much needs to go right in order for this deal to succeed?” The question that follows is, “Are we getting the appropriate return to take this investment risk?”

As manager of the REITs, RM Adviser aims to provide first-class investment and real estate management services to the REITs – performing high-quality diligence on the real estate sponsors and real estate investments is fundamental to that end. We leverage our highly experienced team of real estate and finance professionals and their collective experience in originating, underwriting, and servicing billions of dollars in real estate-related assets over the course of their careers. Much of investing is about managing risk, both at the property level and in the context of a portfolio. We believe wholeheartedly in employing a robust diligence process to identify risk and underwrite it properly in order to make sound investment decisions.

Disclosures

RealtyMogul Income REIT is managed by RM Adviser, LLC, an SEC registered investment adviser and a wholly-owned subsidiary of Realty Mogul, Co.

RealtyMogul Apartment Growth REIT is managed by RM Adviser, LLC, an SEC registered investment adviser and a wholly-owned subsidiary of Realty Mogul, Co.

Investing in the REIT’s common shares is speculative and involves substantial risks. The payment of distributions is not guaranteed and may fluctuate. Review the “Risk Factors” section of the REIT’s offering circular for a discussion of risks that should be considered before you invest. You should not invest unless you can sustain the risk of total loss of capital. Past performance is not necessarily indicative of future results. For additional information on risks and disclosures, visit https://www.realtymogul.com/investment-disclosure.

[1] Aggregate value of properties owned by the RealtyMogul Income REIT (“Income REIT”) and RealtyMogul Growth REIT (“Growth REIT”) based on the most recent internal valuations as of the end of the fiscal quarter upon which our most recently announced NAV per share is based pursuant to our valuation policies; provided; however, the value of the properties underlying investments acquired since the most recent NAV per share was announced are based on the most recent purchase prices. The aggregate value of the properties underlying loans made by the Income REIT is based on independent appraisals dated within six months of the original acquisition dates by the Manager, Realty Mogul, Co. or Realty Mogul Commercial Capital, Co., as applicable. The aggregate value of any preferred equity investments made by the Growth REIT is based on the most recent purchase price of the asset. As with any methodology used to estimate value, the methodology employed by our affiliates’ internal accountants or asset managers is based upon a number of estimates and assumptions about future events that may not be accurate or complete. For more information, see the section of the Income REIT Offering Circular captioned “Description of Our Common Shares – Valuation Policies” and the section of the Growth REIT Offering Circular captioned “Description of Our Common Stock – Valuation Policies.”