Investor General’s Warning: The contents of this article may stunt your growth. Side effects include sleeping well at night, the ability to look at yourself in the mirror in the morning, and longevity in business.
Raising money isn’t easy. Why make it harder than it needs to be? Because your long term success depends on it, that’s why. You might have heard me tell part of this story on the BiggerPockets podcast. Recently I was conducting an investor presentation for a multi-family office. No, not an office in an apartment complex, but a financial advisor that makes investment allocations for ultra-high net worth families.
I commented to the advisor that raising capital is one of the most difficult parts of what I do. He said to me, “do you know why that is? It’s because you don’t overpromise.” It’s such a simple comment, but so very, very important. Let’s explore why.
How to Raise Capital by Keeping It Real
Over ten years ago when I decided to leave part time real estate investing behind and go full time, I put a small investment fund together with a couple dozen investors. After all these years, these investors are still with me. I believe that a major reason for this is that I didn’t oversell the opportunity. I like to under promise, and over deliver. When you have capital partners, you will have to talk to them on a regular basis to update them on current events and performance. If the investment is doing better than you promised, your investors will think you’re a hero. If it does worse than you promised, you’re a bum. No one wants to be a bum.
When I started my first fund, I explained it to my investors this way: “The unlikely worst case scenario is you could lose money, my goal is to earn you a 10% return, and if all goes well you’ll do slightly better than that.” You notice that nowhere in this explanation did I promise any specific rate of return. I knew all along that the returns would probably be closer to the 12 to 15% range, but what if I told them that and only produced 10%? They’d be disappointed and would probably have left to invest somewhere else. Instead, I told them the risks, I told them my goals, now it was up to them to decide if the risk was worth the reward.
The end result was my investors in this one particular fund averaged 18% annually over the last ten years, despite some pretty wild market cycles during that time. Not a bad return, and definitely above what they were told to expect. When they compare their actual results to what they were expecting, do you think they were thrilled or upset? In your deal, the way that question will be answered is entirely within your control. For example, if I had promised 30% returns, they’d have pulled their money out a long time ago. The difference was simply managing their expectations. Sure, it is easier to recruit an investor with the promise of high returns. But it is very difficult to retain an investor unless you achieve the benchmarks that you set for the deal at the outset.
Resist the Temptation when Raising Capital
Some new—and seasoned—real estate investors are tempted to overstate the potential of their deal so they can raise capital. Resist the temptation. Here are just a few tips on producing conservative projections for a typical buy/hold deal:
- Overestimate the vacancy rate. If the average for the property type and age class in the same area is 6%, use 7% in your projections (or even 8%).
- Overestimate the exit cap rate. If properties are selling at a 7% cap rate, why not use 7.5% for your exit valuation? If interest rates rise, cap rates are likely to rise also, better to be safe than sorry.
- Pad the expenses. Put a little extra in each expense category, you may or may not spend what you project, but better to have a cushion.
- Underestimate rent growth. Projections aren’t always right. If the market reports forecast 5% rent growth, and you forecast 3%, your investment will outperform if the market reports turn out to be right.
If you follow this advice, you might think that it will be harder to find investors for your deal because the returns will be too low. If that’s the case, maybe this isn’t the right deal. Remember that it is more profitable to invest in good deals than just any deal (Tweet This Quote!)
If you want to keep your investors for the long term, start by recruiting the right investors. Attract the ones that expect a return aligned with the opportunity. If you promise 30% returns, you might have an easier time raising capital (if you’re even believable), but when that deal only delivers 20%, your investors will be dissatisfied and you’ll have to raise money all over again. If you use very conservative projections for performance, your investors will be very happy when the return you deliver exceeds their expectations. They’ll invest with you again and again (and maybe even tell a friend), and that means less time spent raising capital on the next deal.
Do you raise capital? Do you over or under promise? Let me know in the comments below.
Photo: Adhi Rachdian