Knowing your investment position is essential in real estate

Luck plays a more significant role in our lives than we like to admit. The world is not the predictable and understandable place we think it is. We place too much confidence in intuition and underestimate the role of chance. How do we become luckier? Become better at analyzing oncoming risks?

In the real estate world, it makes sense to know where you stand as an investor. If challenging times begin — tightening loan standards, higher unemployment, tenants with cash flow problems, declining real estate values, slowing business conditions — your business affiliations are critical.

First, think of the term partner in a broad sense. The way I use it, the term means any party you interact with in the deal or are exposed to financially. This general concept includes your co-investors, the lender financing the deal, the project management company you use or the income sources your project depends on to succeed.

If you invest your money with other people, determine your ongoing obligations to the investment entity. The money you invested in the deal is gone. Now figure out your future obligations to the entity. If the entity is a limited liability company or a limited partnership, figure out the requirements for the contribution of new money. You must understand what happens if you do not contribute the new funds. You should also understand what happens if you make new capital contributions and your co-investors do not.

Are your co-investors solvent? Answering this question is tricky and requires people skills. Ideally, the investors prepare and share new financial statements listing existing and contingent liabilities they owe. If the co-investors are partners in other deals, you need to understand the status of those deals. If there are interest rate hedges in other deals, find out if they are underwater, as this kind of contingent liability can get large quickly.

Do not stop with your co-investors. Your lender partner requires (at least) a two-fold analysis. Determine your maximum exposure if you guarantee even a portion of the entity’s debt. Understand what happens if you pay your share of the guaranteed debt and others do not. Also, consider your lender’s shape, such as other problematic real estate loans. Try to find out if the lender has issues with regulatory authorities. Typically, the most recent call reports filed with the Federal Financial Institutions Examination Council can help here. At this point, judge whether the lender will renew the loan when it matures and on what terms. Finally, the lender can always sell the loan to a third party. Now is the time to ensure the lender contacts you before taking such an action.

If you have a management company, make sure the management team has experience in challenging real estate markets. Have the manager prepare six- and 12-month cash flow projections. If there are projected deficits, start thinking about how to fund them.

The project revenue sources (yes, these are partners, too) — tenants or potential purchasers — are harder to gauge. An awareness of local business conditions helps, but don’t let current conditions fool you. Even if things look strong, determine if the project is overly reliant on one tenant category. If so, determine ways to limit that exposure or what to do if that category gets in trouble.

None of this makes you luckier, but it will help you make better decisions. If you are fortunate, your partners do the same analysis. The bottom line, stay alert.

Alan Lewis is a retired transaction lawyer in Bentonville and the managing member of 207 Consultants LLC. The opinions expressed are those of the author.