All across the state, but particularly in north Texas, real estate opportunities are available for astute investors with the right tools. Our blog series examines three elements that we believe are common to every successful real estate investment.
In today’s blog post, we examine the second of these three critical elements – Aligned Capital.
Most people have heard the expression, “It takes money to make money.” What exactly does this mean? While we can earn income from working at a job for someone else, or even ourselves, the true meaning of “investment” is the use of money or capital to gain profitable returns as interest, income or appreciation in value. Applying this concept to real estate investing, one must have sources of capital, both debt and equity, 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 for a real estate investment to be successful:
As part of the business plan for a real estate investment, the sponsor must clearly project and identify the expected term of the investment. The term for such an investment can range from a few months in the case of a single-family fix and flip to thirty years or more for a large income-producing asset. The important concept is that each capital provider must have the proper expectation for when their capital will be returned.
Let’s begin with debt. If a rehab project is expected to take six months, the sponsor should seek a lender who is willing to offer debt for a term of twelve months or more. This would allow the sponsor enough time to complete the rehab, prepare the property for sale and have several months for marketing to prospective buyers. Depending on the type of lender, the sponsor should be aware of any pre-payment penalties in the event a sale takes place before the loan matures as well as the availability of extension options in the case of unexpected delays. If the objective is a long-term “hold for income and appreciation” strategy, the sponsor must find a lender who is willing to make a long-term loan.
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 as well as the eventual 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 a result, it is imperative for the sponsor to develop a realistic business plan and an appropriate term that includes some flexibility for the inevitable unforeseen circumstances.
The most successful real estate transactions are those in which each party involved makes money. This includes lenders, equity investors and sponsors. 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 as additional security in the event a project does not proceed as expected. While a lender can, in many cases, also make money from foreclosing and selling a property in the event of a default, most legitimate lenders are content to receive the negotiated rate of interest and fees and be paid off at maturity. 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. The distribution of any available cash flow from a project should be clearly defined in the governing document that establishes the relationship between the sponsor and his or her investors. The priority of distributions is commonly known as 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 known as “residual” profits. The residual can be split between the sponsor and investors using any ratio agreed upon by the sponsor and investors. The key alignment concept for equity capital is to ensure that the sponsor does not receive any material profit participation before the equity investors. While some nominal fees to cover overhead during a project may be acceptable, the sponsor should not be in a position to make material profits until the equity investors have received a return of their capital. Ignoring this concept can make it difficult to raise capital, or worse, create a situation in which the sponsor has profited and the equity investor have lost money if an investment fails. A sponsor that employs a structure without alignment of equity capital will not maximize the probability of long-term success.
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.
Using the concept of aligned capital will provide any sponsor the best chance to complete any real estate transaction successfully.
Next Blog post: Business Plan Execution – Learn the key elements of designing and successfully executing your real estate business plan.