August 18, 2017
,Especially in North Texas, real estate opportunities are available for investors around the state with the right tools. Our blog series examines three elements that we believe are common to every successful real estate investment.
- Buying Right
- Aligned Capital
- Business Plan Execution
In today’s blog post, we examine the second of these three critical elements – Aligned Capital.
Aligned Capital
Most people have heard the expression, “It takes money to make money.” What exactly does this mean? Investment is the use of money or capital to gain profitable returns as interest, income, or appreciation in value. In real estate investing, one must have sources of capital through both debt and equity. This is in order to purchase, rehabilitate, reposition, and operate real property in the hope of creating value. Here are three areas where the interests of the sponsor, investors and lenders must be in alignment to be successful:
Term
As part of the business plan, the sponsor must clearly project and identify the investment term. The term for such an investment can vary. It ranges from a few months for a single-family fix-and-flip to thirty years or more for a large income-producing asset. The crucial piece is that each capital provider must have the proper expectation for when they will see ROI.
As an example, you expect a rehab project to take six months. The sponsor should seek a lender who will offer debt for a term of twelve months or more. This will allow for the sponsor to have enough time for all aspects of the flipping process. They need to complete the rehab and prepare the property while having several months for marketing to prospective buyers. Depending on the type of lender, the sponsor should also be aware of any pre-payment penalties. This is important in the event a sale takes place before the loan matures. Additionally, ask about the availability of extension options in the case of delays that spring up.
The same concept applies to equity. The persons or entity providing equity capital should have an expectation for how long it will take to receive income from an investment. They also need to have an idea of when to expect the return of capital and residual profits. The sponsor must be careful to find investors who have proper expectations for when these cash flows will occur. As such, it’s imperative for the sponsor to develop a realistic business plan and an appropriate term for flexibility.
Cost
The most successful real estate transactions are those in which each party involved makes money. This concept highlights the importance of using realistic assumptions for each area of underwriting. A lender will generally make its money through interest paid on any debt used. The lender will also have a lien on the property. A business plan must incorporate sufficient working capital to service any debt during the life of the investment to minimize the possibility of default.
Equity investors take more risk than lenders, and thus their investment return objectives are generally going to be higher. You should clearly define the distribution of any available cash flow from a project in the governing document that establishes the relationship between the sponsor and his or her investors. The priority of distributions is the “waterfall.” Equity investors typically receive one or more types of return on their capital. If the sponsor is offering a “preferred return” to investors, this is typically the first priority item followed by the return of the investors’ capital. Any amounts remaining are “residual” profits. The sponsor and investors can split the residual.
The key alignment concept for equity capital is to ensure that the sponsor does not receive any material profit participation before the equity investors. Ignoring this concept can make it difficult to raise capital. Worse, it can create a situation where the sponsor profits and the equity investor loses money if an investment fails.
Leverage
The concept of leverage can be both powerful and risky. In the case of real estate investments, leverage is typically defined as the amount of lower cost debt used in the capital structure relative to the amount of higher cost equity. While it can be tempting to try to maximize the amount of leverage in a transaction in an attempt to maximize returns for equity investors and sponsors, it’s important to recognize the risks associated with higher leverage. Specifically, higher leverage will result in higher debt service payments that must be met in order to keep a project going. As a result, more working capital is needed. In addition, higher leverage reduces flexibility for any reductions in expected property value or the option to refinance if projects run into delays.
Sponsors should seek to structure real estate transactions utilizing the proper balance of debt and equity capital in order to align the capital structure for the best chances of success. Such balance should be dictated by the type of transaction and the risk associated with the business plan. Purchasing and holding a stable income-producing asset can often justify higher leverage as long as the necessary debt coverage metrics are in place. Conversely, a ground up development project, in which the number of uncertain elements is higher, generally would call for lower leverage.
About Bay Mountain Capital
Bay Mountain Capital has been in business for more than a decade, closing over 2,250 loans. We specialize in financing all types of residential and commercial property investments throughout Texas, Tennessee, Oklahoma, and Georgia. Using a common sense and value-added approach, we strive to incorporate these principles into our underwriting and closing processes.
As a direct lender, Bay Mountain Capital can close a loan within one day after receiving a complete file and clear title. The process generally takes two weeks for a residential loan, but can we can accelerate this where circumstances require it.
We are primarily an asset-based lender, which means that qualification requirements are limited. Our rates, fees, and terms are among the most competitive in the industry.
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