January 30, 2022
Joe Fairless

JF2707: 3 Red Flags When Evaluating Operators as a Passive Investor ft. Dan Handford


 

What qualities should you look for in a potential operator? What if they don’t have a lot of commercial real estate experience? Does the size of their team matter? In this episode, Dan Handford answers these questions and more by sharing three red flags that passive investors should be aware of when evaluating operators. 

Dan Handford | Real Estate Background

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TRANSCRIPTION

Joe Fairless: Best Ever listeners, how are you doing? Welcome to The Best Real Estate Investing Advice Ever Show. I’m Joe Fairless. This is the world’s longest-running daily real estate investing podcast where we only talk about the best advice ever, we don’t get into any fluffy stuff. With us today, Dan Hanford. How are you doing, Dan?

Dan Hanford: Doing great, Joe. How are you?

Joe Fairless: I am well, and looking forward to our conversation. This is round three with Dan. If you want to hear his Best Ever advice – well, you can simply click a link in the show notes, or you can go to Episode 1609. That’s where we talk about his Best Ever advice, and talk about more of his background. And if you want to hear about team building, you can go to Episode 2027. The title is Strong Team of Three, with Dan Hanford. So if you’ve got two other partners, or if you’re considering having two other partners, then that will be a beneficial episode for you to listen to. Today, we are talking to you, passive investors, or aspiring passive investors, because Dan has three red flags that we’re going to talk about when evaluating operators as a passive investor.

A little bit about Dan – he’s the managing partner with passiveinvesting.com. They are a national passive equity real estate investment firm based in the Carolinas. They’re experienced, they’ve got properties valued at over $820 million, which consists of at least 3,700 units. You can learn more about the company at, surprise, surprise, passiveinvesting.com.

With that being said, Dan, let’s talk about red flags as LPs. Both you and I are both LPS, as well as GPs. I’ll speak for myself now – I’m an LP on nearly 100 deals. I’m obviously a GP, but I’m also an LP. So I love learning from others’ experiences as LPs, so this will be an enjoyable conversation for me also. I know you’re an LP on deals. First off, anything that you want to mention before we get into the specifics of the three red flags that we’re going to go over?

Dan Hanford: Yeah. Like you said earlier and just a minute ago, we’re both LPs in various projects. I’m not at 100 or just under 100 just yet; I’m only about 60 to 65 I think right now is where my number is. But I’m getting there, I’m getting there, Joe. But I do this for the same reason that you do it. Yes, the returns are nice, you want to see the cash flow, you want to see the bump in the end when we sell. But one of the real main reasons why I like to do it is to be able to kind of see how other people do things. Oddly enough, there have been some things that I’ve seen people do that I’m like “Oh, yeah. It’s a great idea.” There have been probably more things that people do and I go “Yeah, I want to make sure I don’t do that.” So there have been experiences on both sides of it, being an LP in other people’s projects. It helps me kind of build up my investor relations process and management for our passiveinvesting.com team.

But before we dive into these three red flags we’re going to talk about today, we really need to kind of define what a red flag is. Because sometimes people think of a red flag as just like, “Oh, let’s just stop and think about it.” But it’s really not; that would be a yellow flag in my book, where we’ll pause and go, “Okay, at least I know that there. But then I need to maybe just think about a little bit further as to whether or not you want to move forward.” A red flag truly is a big red stop sign, is really what it should be. If one of these three red flags is present, you shouldn’t do the deal; you shouldn’t put your money as an LP with an operator that has one of these red flags present.

Now, the red flags that I’ve come up with that we’re going to talk about today are my experiences, with my wife and I, investing our own cash as an LP in other people’s projects, and also from just learning from other people about what we want to put in place for us. So this might not be something that is exact for everybody out there, but it’ll give you a good starting point for being able to start at your own type of a red flag list where if you see some of these certain things present 0 you just stop doing any more research and you just move on to the next investment. Because there are plenty of other operators out there and plenty of other investments that are out there that you can put your money into at this point in time.

Joe Fairless: Okay. Thank you for teeing that up. Now let’s talk about the first one.

Dan Hanford: The very first one – the red flag itself is an operator that has no successful background in business. It doesn’t necessarily mean all the managing partners that are part of it. Like, if you have two or three managing partners, all of them have to have some sort of successful background in business. That’s not necessarily true, but at least one of them on the team should have a successful background in business. I’m not just talking about a background in business, because you and I both know people, Joe, that have had a background in business, but it wasn’t very successful. They had a good background in business and running it into the ground. We don’t necessarily want to be operating with somebody like that, we want to make sure we’re investing with somebody that has run a business successfully. Because in any business, there are going to be challenges, and how you handle and overcome those challenges is how you can prove to your investors – whether this is the very first syndication that you’re trying to do or if it’s your 10th one, you want to make sure that your investors know that you know how to run a business. At the end of the day, we are buying apartments, but we’re buying, at the end of the day, a business that just so happens to have real estate associated with it. Because you still have to know how to manage people, you still have to know how to put systems, procedures, and processes in place, and that really comes from having that successful background in business.

Joe Fairless: So I want to make sure I’m understanding something, because there’s a distinction here that is important. So are you saying a successful background in business, or are you saying a successful background running a business?

Dan Hanford: I would say that it could be either-or. However, the end business – there has to have been some form of leadership role. It couldn’t have just been a technician or a worker or whatever, and you were the one doing all the work, but you didn’t really make any leadership or management decisions. So if you’re in business and you have a leadership position where you had to make difficult decisions, you had to lead a team one way or another, and you made those difficult decisions – that’s really the critical thinking that I think is important for a syndication business, it’s having that ability to lead. Whether you were a leader in the business or whether you owned the business. Obviously, being the owner of the business, there’s a lot more on you than just being the leader or a management role, if you will. But I would say either one of those would be a good, solid background for somebody when you’re investing with them.

Break: [00:07:04][00:08:43]

Joe Fairless: And the successful part – I think there are two groups of people as it relates to what we just made the distinction on – either they were in a business or they are running a business. Let’s just talk about, first, successful in a business. It’s not their business, but they’re successful in a business.

The one thing I can think of is looking them up on LinkedIn and saying, “Okay, they were at this company for X amount of time and they got promotions, clearly”, at least according to LinkedIn, whether that’s true or not. But I would think typically, that’s true because you’d have other people in the company who can call BS on that if it’s not true. Any other way for people who were W2 employees, but are now presenting this syndication to me as an LP – how do I determine how successful they were? How do I qualify that, or even quantify how they were as W2 employees?

Dan Hanford: Yeah. Well, I will say that it is challenging to actually figure out exactly whether or not they were successful in that role. One of the best ways you’re going to find out is just to ask the person. And yes, they could lie to you, but to me, most people if you ask them, they’re going to tell you what they did. You can usually just tell by what they did, what role they were in, as to whether they were successful or not; were they seen successful, or were they seeing successive promotions? If there are successive promotions, you know they were probably doing something right. If they got promoted and then just kind of stayed in that same position for many, many years, and maybe didn’t get or see a lot of success, maybe they moved up the ladder a little bit, maybe they didn’t see as much.

So it is a little bit harder to really quantify the success, if you will, for somebody who’s working in the business. Even if you kind of just kind of go straight into somebody who owns her own business, what’s the success of that? Obviously, again, asking them and saying, “Hey, how can you describe to me how you ran that business? How successful was it?” They should be able to talk to you about numbers and could be challenges that they had. That’s maybe something you can do too, is ask, “What kind of challenges have you had in business and how did you overcome them? Did you just kind of roll up in the fetal position and suck your thumb and cry? Or did you really kind of tackle it head-on?”

If you wanted to take it a step further, obviously, you could ask for references. But one of the things that I have always found with references is that no one’s going to give you somebody named that is going to talk bad about them. That, to me, is even not as beneficial as just asking somebody, “Hey, what kind of success have you had? Did you grow your company from x to x in two years, or five years, or 10 years, or whatever it was? What kind of challenges did you have along the way?” But I will say it, it is a little bit harder to quantify that success.

Joe Fairless: And what would be a reason why someone who was successful running a business would leave that business and do a different type of business model, like doing a syndication?

Dan Hanford: Well, I look at my own background in business – I still have them today; I have a group of nonsurgical orthopedic medical clinics that my wife and I started from scratch. They’re 100% debt-free, they cash-flow very nicely, we’ve built those clinics up, and we have a great solid team of about 40 employees that run that for us now. We actually have built that business to the point where it’s 95% passive at this point. So we don’t go into the clinics every day and we don’t do everything. But we wanted to keep more of what we earned, so we stepped out of that business, and went into the real estate space.

That’s kind of how passiveinvesting.com got started, when we merged, Danny Randazzo and Brendan Abbott, all three of us came together and started passiveinvesting.com, to be able to help other people that maybe have a successful business and they don’t really want to get out and do something different; they want to stay in it, and we can kind of help them invest their hard-earned money to be able to increase their return and grow their wealth.

Joe Fairless: What’s the second red flag?

Dan Hanford: The second red flag that I would bring up today is about managing partners. The red flag itself is anybody who has only one managing partner. The reason why I always say more than one managing partner… Obviously, I think the preference is at least two, but ideally, three. Obviously, because I’m…

Joe Fairless: Why is that ideally three?

Dan Hanford: I say three because, for our group, it’s great, we have three managing partners and we have all these three different lanes… I would say at least two, but of course, with our group, we have three; I think it’s a great number. But I’d say at least two unrelated people, meaning that you couldn’t be a husband and wife. Because they could possibly go on a trip to Mexico one day and fall off a cliff and you never hear from them again. So really kind of where we came up with this was not from our own experience. It was with somebody else that we knew, who had an experience where they invested $200,000 of their own money in an investment, and they actually convinced one of their friends to bring in and invest $200,000 in that deal with an operator. Within about six months, the operator disappeared, and they can’t call him, they can’t text him; they tried to go to his house, they tried to go to the property management company, nothing.

The property management didn’t have any communication with the person and they just couldn’t find him. And of course, how do they get access to their return or their money or their properties like that? They had to go through this long court process to try to get access to their funds. For one, they had one of the things that’s in the operating agreement is that they had to arbitrate before they go to court. Well, how do you arbitrate with somebody you can’t find?

So to avoid all of these issues, I’d say at least two managing partners that are unrelated. That way, if for some reason somebody has a problem, you can always get access to somebody else. Obviously, as the team grows, it obviously makes the investors feel even more comfortable, because… I know your team has grown quite a bit. We just hired on the 30th team member that works full-time for us. So even if all three of the managing partners went out, there are 27 other people that they can reach out to, to try to find somebody. But with this particular group, it was a new syndicator, he was pretty much the only one running the ship, and he wouldn’t ghost on them. To this day, they still haven’t found him. It’s been quite a battle for them. I think they’re still going through this process to try to get access to it. So that would be the second red flag is really only one managing partner.

Joe Fairless: What’s the downside to having three managing partners?

Dan Hanford: [laughs] Well, I’d say right now, I don’t really have any downsides. I think one of the downsides that could come about when you have three managing partners is if you have managing partners that do not have complementary skill sets. This also is kind of the same thing when you have any more than just one. If you have two, three, four, five, right? I think four and five is getting to be too many; more than five is always way too many, there are too many cooks in the kitchen. But even with two or three, you can partner with somebody that does not compliment your own skill sets and it could cause conflict.

The tendency for us as humans is we like to hang out with people that like the same things as us. You go to a conference, you meet somebody that likes to do underwriting, and you start talking geeky underwriting stuff, and you guys just hit it off, “Let’s partner together.” The problem is that down the road, you start to butt heads about how you want to do underwriting. Then you realize, “Wait, we need to have somebody that does investor relations. We need to have somebody that’s doing the marketing. We need to have somebody that’s doing the asset management,” all these different additional pieces of the puzzle. That’s a lot of times why partnerships… Not even just in real estate and in this stuff, but just in business, in general, where partners get together and they don’t have complementary skill sets.

So when you’re trying to find that other partner to partner with, try to find somebody that does not like to do the same things that you do. If you’d like to do underwriting, find somebody who likes to do on-site due diligence, asset management, broker relations, and investor management. So I would say the biggest downside for any type of partnership, whether it’s two, or three, or four, or five, is having partners that do not have those complementary skill sets.

Joe Fairless: And number three…

Dan Hanford: I would say number three is when you look at distributions as “return of capital” versus “return on capital”. The actual red flag would be distributions as “return of capital”. It’s one of those things where you really have to watch carefully on a lot of the PPMs, because it’s literally one letter different, on versus off. For us — not just for us, but in general, it’s better to have “return on capital” with distributions versus “return of capital”. The main reason why is because if you think about your preferred returns, the preferred returns are based off of the unreturned capital contributions, which is, if you’ve put in $100,000 and you’re getting your preferred return off that 100,000, if you have a, let’s just say, a 7%, preferred return, so you’re given $7,000 the first year, if it’s a “return of capital”, now that unreturned capital contribution balance goes from 100,000 to 93,000. So now your preferred return is actually based off of a lower amount, so over time, your preferred return actually goes down. So it certainly benefits the operator but it does not benefit the LP.

Now the operator will many times try to convince the LPs that it’s actually better for you from a tax perspective. Because from a tax perspective, if it’s returning of your capital, then you’re not going to pay more taxes on it, because we’re just giving you back the capital that you put in. But the thing is, it doesn’t really advantage me, because I’m going to be balancing out in the end when we sell anyway. And along the way, I’m getting negative paper losses, like K1s with negative passive losses with depreciation. That’s going to offset my return on capital distributions anyway. So both ways have similar tax advantages and they’re going to both balance out in the end anyway.

So really, the return of capital for distributions is really only benefiting the operator. From an LPs perspective, you have to look very carefully at that, because a lot of times that’s just another way for operators to kind of –I don’t want to say sneak in if you will– a juicing of their own returns by having distribution classified as return of capital.

Joe Fairless: Where would that be located?

Dan Hanford: The best way to do this… I’ll just kind of share with you real quick how I review deals. The first thing I do is I get the PPM and I just search the PPM for distributions. There’s usually two, sometimes three, what they call distribution waterfalls. There’s the cash flow waterfall for what happens to all the cash that comes in during the whole period, and then there’s going to be a – when you sell the property or when you do a refinance, what happens to that cash. So I go there and I look exactly what’s going to happen. Okay, first, this is going to happen; second, this is going to happen. Usually, inside of that language will actually state that the distributions will be classified as “return of capital” or “return on capital”, so you can kind of determine how they’re actually going to classify your distributions so that you know exactly how they’re going to classify those distributions.

Break: [00:20:04][00:23:01]

Joe Fairless: Anything else that we haven’t talked about as it relates to these three red flags that you think we should before we wrap up?

Dan Hanford: I think we pretty much hit it on these three red flags. The biggest thing I would say is these are red flags that I’ve come up with from my wife and I going in and investing with other people. These are three things that you can go study and figure out for yourself how you want to do things. But these are three red flags for us in our family, like if these are present, we’re not going to invest. You just have to take these, study them. I would suggest that everyone who’s listening come up with their own red flags so that when they’re looking at investments, they know what these red flags are. Also, as your family grows, if you have children or whatever, start to teach them some of these different things and walk them through them so that they can fully understand it along the way as well. I’m kind of doing the same thing with my daughter, she actually is investing in a couple of our assets through me. She’s not an accredited investor yet, but she’s investing through me. I’m teaching her how she can invest and get some of these types of returns with these investments I have for a minimum investment of $1,000. Once she gets $1,000, she can invest. She’s got two of them so far and she’s working on her third one.

Joe Fairless: How old is she?

Dan Hanford: She’s 11.

Joe Fairless: How can the Best Ever listeners learn more about what you’re doing?

Dan Hanford: Sure. You can go to our website I mentioned earlier, passiveinvesting.com, or if you want to link with me, you can go to linkwithdan.com, just go straight over to my LinkedIn profile.

Joe Fairless: Dan, thanks for being on the show. Thanks for sharing these three red flags or stop signs, as you mentioned, and talking through them each in detail. Hope you have a Best Ever day and talk to you again soon.

Dan Hanford: Thanks.

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