Real Estate Gold: The 5 Essential Components for the Perfect Deal
Unlock the Secrets to Off-Market Success and Gain a Competitive Edge in Real Estate Investing
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1. The Nature of Off-Market (Preamble)
One unique aspect of my personal experience in the corporate world is that I’ve spent time sourcing and evaluating investments for real estate general partners and venture capital investors. While the functions are the same, these two worlds could not be more different culturally. One quick, tangible example: there was, and most of this is still true today, a time when if you didn’t wear a blazer to a real estate capital meeting they would not take you seriously; a tie would be even better. If you pitch a VC like Peter Thiel however, you might want to change garb. He famously wrote in his book “Zero to One” that a suit was “a huge red flag… because real technologists wear T-shirts and jeans. So we instituted a blanket rule: pass on any company whose founders dressed up for pitch meetings. There’s nothing wrong with a CEO who can sell, but if he actually looks like a salesman, he’s probably bad at sales and worse at tech.”
The darwinian “business survival” reason for this ethos might lie in the audience each striver was dressing to impress. Real estate developers often visit local government offices or banks to secure financing, while VC founders pitch to other successful technologists; it’s important to dress for the occasion. Bankers and politicians wear suits, technologists wear t-shirts. But it's also emblematic of the broader culture in each business, which extends to deal sourcing.
Much like the suits, most things in real estate are very buttoned up. A majority of deals are brought to market with a broker representing the asset, who builds a big 20-100 page “offering memorandum.” The pictures are high quality, the fonts are nice, and there’s very little white space. It’s “professional”. VCs also have “offering memorandums”, but they’re usually 10-page pitch decks built by the founders of the startups (or potential investments) themselves. They focus on content, not style, and there are no brokers involved. Nearly all deals in VC are “off-market” by nature, with a few exceptions. Having an inside track is still valuable, but it’s less of a differentiator. Finding an off-market deal in real estate can be crucial because it can set you apart from a pride of hungry lions eager to tear into their prey for the month.
2) A Deep Relationship
In our case, it was a local development firm with which we had a several years-long relationship. They had a ROFO (Right of First Offer) for a real estate asset they had no interest in owning. Instead of letting the opportunity pass, they transferred the ROFO to us. We’ve scratched their back, so they scratch ours, and the reciprocity continues. A ROFO is essentially a contractual agreement giving the holder the opportunity to make an offer on a property before the seller offers it to other potential buyers. ROFOs, and their counterpart ROFR (Right of First Refusal), are often where real estate deals start (or stop), especially off-market. Apart from a few other methods, like deep relationships with local brokers providing a “first look” before marketing a deal, or building a relationship with an owner and identifying the right moment for them to sell, ROFOs are one of the few true ways to get an “off-market” look at a deal. In this case, we had no prior relationship with the seller but, importantly, we had no potential conflicts with them either; something that was not true of other potential buyers we knew might be interested. To move quickly, it was important to enter negotiations with a strong offer at a precise valuation to quickly take the deal off the table before it was shopped to other buyers or put on the market.
3) A Lay-Up Underwriting
Perfect underwriting is almost impossible, but with the correct data and assumptions, you can get very close. The most critical part is accurately forecasting future rents. Long-term leases with specified contractual rents, such as on industrial and office properties, can make forecasts very accurate. For properties with annual leases or daily rentals, like multifamily assets or hotels, a thorough analysis of the market, supply and demand, competitive positioning, and customer purchasing power is needed. Our deal was more akin to this case, and the best forecasts in these cases happen when acquiring a “sister” property. It's like buying the second unit of a duplex or another suite in a retail center where you already have ownership. Rents, in 99% of cases, will be very similar to the property already being operated. Extremely well-informed cash flows and expense budgets give an investment team confidence in hitting their returns at the proposed purchase price. We had an almost perfect cash flow projection, with minor nuances, because we owned “sister” units. Therefore, we had a strong rent forecast; next, we ascribed the correct cap rate given our deep market knowledge (we also owned other assets nearby), and voila, we had an offer price that we were confident was “market,” with a slight discount because we had a chance to ink the agreement in a non-competitive process that would have driven the price higher.
4) Painless Diligence
Painless diligence is essential to any smooth deal, and off-market deals are no different. In this deal, our due diligence process was smooth due to several factors:
Comprehensive Physical Information: The seller had already provided detailed records of the property’s maintenance history and structural specifications to our developer buddy. This got us comfortable with the building’s physical condition with minimum hassle.
Environmental Diligence: We carried out Phase I ESAs swiftly with no RECs (Recognized Environmental Conditions) found.
Legal Diligence: A thorough title search confirmed clear ownership and identified no existing liens or encumbrances, all in order.
In summary: clean, clean, clean.
5) Cash On-Hand
The next step is paying for the asset (duh). Depending on your background in real estate, the idea of “capitalizing” a deal might vary. Many smaller investors raise capital for deals on a one-off basis in Joint Ventures (JVs), where the deal’s completion depends on the investor’s ability to raise capital. More pedigreed private equity investors have “discretionary funds,” capital raised ahead of time on a particular thesis. The institutions providing that capital have enough trust and faith in their “general partner” (or “GP”) sponsor, the private equity firm, that they will go hands-off. The investor is free to do deals according to their own best discretion, hence the name. Even in this scenario many “discretionary” funds require frequent reporting and, in many cases, have caveats or instances where the private equity fund has to run a deal past its capital providers. Lastly, there's “balance sheet” equity. This can be a personal or, in the case of our story here, a company balance sheet. The money is just sitting there, in an account, losing its time value. It can be put to work and the only person or entity needed to make that decision is the owner of the balance sheet. During a time of high interest rates with scarce loans and 3rd-party equity, such as today, it can be difficult to raise capital for deals one-off. Having cash on the balance sheet for compelling off-market deals can be a huge competitive advantage. We had the cash just sitting there. Financing? Check.
Conclusion: Done Deal
That’s it! Wire the funds over, the title company facilitates the transfer of the deed, and the property was added to our portfolio. One quarter later and we found that we had nailed our underwriting forecasts as well. I know this all sounds very simple but it’s important to remember that this once-in-a-blue-moon home run is not how most real estate transactions are done. Most move slowly, with many moving parts; and without going down each rabbit hole where a typical real estate deal can die, it’s hard to grasp just how seamless this particular transaction was. Such is the value of off-market deals, and the associated value in what makes them possible. Extremely deep and recent market knowledge, alongside the cultivation of close relationships with market players.
Great post, with lots of insights on how deals are made.
Raising the capital and sourcing deals are very time consuming tasks.