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How to Structure Syndicated Investor Deals: What Investors Are Looking For

by Michael Blank on January 15, 2014 · 26 comments

  
Structure Syndicated Investor Deals

I appreciate all of your comments and questions to previous articles because it gives me fodder for articles that you’ll hopefully find helpful.

One of the questions last week was about how to structure deals with private investors.

This is a complex topic, and one that I can address a little bit over time. This week, I’d like to focus first on what investors are looking for in an investment. By this, I mean what kind of returns are they looking for. Once we understand that, we can talk about how we can structure our investments to try to satisfy our investors’ requirements (we’ll leave that for a later article!)

For this discussion, I’m going to assume you’re looking for investors for a larger buy and hold deal like an apartment building or other commercial project.

What Do Investors Look for in a Commercial Real Estate Investment?

The first thing you need to address is the risk level of the investment. Investors first and foremast care about not losing their money. Brandon talked about this in some detail in his article “The One Simple Thing Required to Raise Unlimited Money From Private Investors“.

Once they’re comfortable with the perceived level of risk of the deal itself and you as the principal, you can address some of the other aspects of the deal, which are the (1) projected returns and (2) how to structure the deal.

In this article, I’ll focus on (1) the projected returns, and next week we’ll talk about (2) different ways to structure the deal.

Here are the three questions investors will have for you about the deal:

  • When will I get my money back?
  • What will the overall return be?
  • How much will I get paid throughout the year?

Let’s talk about each in turn.

When Will the Investor Get His Money Back?

Investors want to know how long you plan on keeping their money, or when they will receive their principal back. They will want to know what precisely your plan is for returning their principal. The answer to this question normally involves a liquidation event, either an outright sale of the asset or a cash out re-finance.

I insist on a minimum 5 year commitment before entertaining a repayment of the principal, longer is even better. Unless you’re doing a gut-rehab or re-position project where you’re adding significant value in a short period of time, 5 years is a reasonable amount of time to build good value for all involved.

If an investor insists on a shorter time frame, you need to move on. Keep in touch with the investor when you find a more suitable project.

What is the Overall Return?

Investors want to know what their return will be over the life of the investment. The overall return is a combination of cash flow distributions, paying down the loan, and appreciation of the property as realized by a sale or cash-out refinance. You add all three “profit centers” together, and you can project the overall return.

You can take the overall return over, say, 5 years, and divide by 5 to get the average annual return.

I always consider this the most useful and easily understood way to articulate overall return. You can calculate the Internal Rate or Return (IRR) which is the more “sophisticated” way to calculate the return of any investment over time, and your more “sophisticated” investors may actually use this as a criteria.

However, I’ve found that my investors (who range from completely non-sophisticated to fairly sophisticated) respond better to the average annual return – it’s just easier to understand.

What Kind of Return are Investors Looking For?

This depends on the current market environment, i.e. what are CD rates and the stock market doing. With a somewhat flat and uncertain stock market and negligible interest rates, I have found that investors are very interested in overall rates of return of 8% – 15%.

I used to think I needed to show returns of 20% plus, but those kind of deals were extremely hard to find. Not only that, my investors actually got suspicious at the very high return. “Wow, that’s a pretty big return, so, it’s a pretty risky investment, huh?”.

For both of those reasons, look for overall returns of around 12%.

How Much Will the Investors Get Paid During the Year?

While most investors care about the overall return, they also enjoy being paid during the investment, which I will refer to as “distributions”. The return from distributions is usually measured in terms of the “cash-on-cash return”, which is the percentage of distributions per year divided by the capital invested.

I have found that investors are typically happy with a 3%-8% cash on cash return.

Let’s say you take $100,000 from two investors to buy an apartment building. If you projected a 5% cash on cash return, you are saying that you plan to distribute $5,000 per year out of cash flow to your investors.

That number is after all expenses are paid out (including debt service) and must also take into consideration any distributions to you.

Preferred Rates of Return

Sometimes you can offer to investors a “preferred rate of return”, which means you agree to pay out a certain minimum before you get paid anything. Investors of course prefer this, but it is not as good for you.

For our previous example, if you agree to a 5% preferred rate of return, it would mean you pay out the first $5,000 to the investors. Anything that is left over is split according to how much equity each investor has.

Normally, the higher the preferred rate of return for the investors, the less equity I give them.

One option is no preferred rate of return, but the investors get 80% of the building. Option two is that the investors get a 5% preferred return but only get 30% equity.

I generally don’t want to give a preferred return but investors prefer it. You need to test these options with your investors to see what you need to do to get the deal done.

Be Conservative in Your Projections!

I can’t emphasize this point enough. It is far better to under-promise and over-deliver than have to explain to your investors why you missed your (originally aggressive) projections.

Conclusion

After you address your investor’s fear factor (i.e. making them comfortable with the risk of the investment), then you need to confidently address their “greed factor”, i.e. how much money they can make.  Show your investors a solid real estate deal with reasonable returns and a conservative business plan, and you will attract capital to do as many deals you want.

Thanks for reading! Let me hear your thoughts below!
Photo Credit: Jims_photos

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{ 26 comments… read them below or add one }

Gerald Harris January 15, 2014 at 9:11 am

Great Article Michael!
I was listening in on a real estate investment call last night and they were addressing this very issue. Investors want to know that you bring a certain amount of value to the table and are comfortable and confident about they investment opportunity that you will present to them. Another point was made to the fact of how do you go about finding these cash investors? Word of mouth is best. Taking out an ad in a local newspaper or posting an ad on craigslist was not the preferred way of attracting cash buyers. However knowing someone within your sphere of influence (Doctor, Lawyer, IRA account holders etc……) was best.

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Michael Blank January 16, 2014 at 6:54 am

I agree, word of mouth works best to find investors!

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Jorge Caicedo January 15, 2014 at 10:22 am

GREAT ARTICLE!

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Kyle Zaylor January 15, 2014 at 12:51 pm

Great piece, Michael!

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Michael Blank January 16, 2014 at 6:55 am

Thanks for reading!

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hudson January 15, 2014 at 4:13 pm

My question is when you purchase a property with investor $ and take on a mortgage, against whom is the loan taken out?–you, the investors, everyone? So do they have to go through the application process along with you?
My mortgage officer tells me that one can only take a mortgage out with a max of 4 people on the note. And that the loan to value (LTV) ratio must not exceed 43%, so as you buy more properties, the more difficult it will be to get another investor mortgage… I have 2 properties in my name and she tells me I’m at my LTV limit for now….please advise. thanks!
If there is another post that addresses these issues, please link me–thanks!

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Michael Blank January 16, 2014 at 12:49 pm

Hudson – good questions, that I will try to answer as best as possible but will likely follow up with an article!

First, every lender’s underwriting requirements are different, and it’s your job to understand them *before* you go after properties.

For 5+ units, the loan will be a commercial loan, and my understanding is that those kinds of loans do not fall under the residential loan restrictions WRT # of loans you can have. Make sure your lender does the kind of loans you want to do.

WRT LTV, 43% sounds a bit low, normally commercial loans are done with 25% or 30% down. Another consideration is the cash flow to debt ratio (called the debt coverage ratio), banks normally want to see a 1.25 ratio.

You want to avoid having your investors on the note. Having said that, if you are not “good enough” for the lender based on your personal financials, you may have to “partner” with one of your investors to co-guarantee the note, in which case he will have to go through the lender’s underwriting process. You can offer him some extra equity in the building for the additional risk.

Hope that helps!

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Patrick McMahon January 21, 2014 at 8:36 am

I believe your lender is referring to a 43% Debt-to-Income ratio. As you acquire rental properties, your income should increase. However, lenders don’t count 100% of your rents as income — they prefer to be conservative and only give credit for, say, 70%.

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hudson January 21, 2014 at 1:17 pm

Yes, you’re right. That should be debt-to-income ratio.
As you allude to, my lender tells me only after 2 years will they recognize the income from my properties. After these 2 years, do you know if it is possible that a lender would recognize these as cash flowing assets vs. liabilities and therefore not count them against me as debt?…or am I dreaming…. Not sure how to see my way to acquiring more properties if my debt-to-income ratio won’t be dramatically changing anytime soon…?

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Patrick McMahon January 21, 2014 at 7:21 pm

Hudson – Some of your questions are best answered by your mortgage lender, as different lenders have different answers. Heck, talk to different lenders!

An example, using the “70% of rents” that one lender quoted to me (I think it was Bank of America a while back and they may have changed their guidelines). Lenders only count a portion of the rents because there will eventually be vacancies and repairs.

Debt:
1) You pay $600/month PITI on your primary home.
2) $200/month car payment
3) $800/month mortgage on the rental property
Total Debt: $1,600

Income:
1) $2,000 a month W-2 income.
2) Your rental earns $1,000/mo rent
Total Income: $2,000 + 70%of $1,000 = $2,000 + $700 = $2,700.

Debt/Income = 1,600/2,700 = 59%

This exceeds 43% and no loan. :(

This is kinda where I’m at with traditional loans on residential properties. So, the last couple of properties I bought using cash or seller financing. Now, I’m running out of cash and that’s why I’m reading Michael’s post about commercial property — the loan is based mostly on the property, not your personal income. (See how I got back on-topic there?)

Dennis Tierney January 15, 2014 at 4:29 pm

I’m on my second syndicate and the question I invaribly get from investors is “How much are you investing in it?” or something similar. I make sure I’m also investing along with them so they have a comfort level that I also have “skin” in the game and if they lose $ I also lose $. I have structured them as an equity position they are buying and they share pro rata in the profit depending on their % of ownership. I find they feel that is the most fair arrangement.

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Michael Blank January 16, 2014 at 1:51 pm

Having “skin in the game” is not a requirement. It depends on you, the deal, and the investors. However, it is something you can do to make an investor more comfortable in investing. The way I think of it, if I have money laying around, what better place to put it in an investment I control and that will likely make a higher return than if I put it into the stock market or give it to someone else. On the other hand, if I don’t have money to invest in myself, should I not do deals? Of course not, you should do deals !

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Godess Clemons January 17, 2014 at 10:17 am

Great article thanks a bunch.

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James January 16, 2014 at 11:21 am

Great article, Michael.

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Glenna Bryant January 16, 2014 at 5:20 pm

Which one is more important should we focus on. Cap. Cash on Cash Return or Inernal
Rate of Return?

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Michael Blank January 17, 2014 at 6:06 am

Glenna – they’re all important, for different reasons. Cap rate influences the value of the building. Cash on cash return is what kind of cash the building puts out each year, and the IRR is a way of measuring the return over the life of the investment.

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Ben Leybovich January 17, 2014 at 5:12 am

Michael – good stuff.

I am about to do my first one. I’ve found that it’s not really necessary to syndicate $500,000 deals as I can finance them 100% with relative ease with debt. Now – looking at $5 mil. is a different kind of proposition…

Give me some perspective please. Considering IRR or Average Rate of Return – I understand why people want to know this, but it seems so useless due to the extremity of assumptions that we have to make relative to calculating it. I can plan on forcing appreciation by driving the NOI, but I can’t predict what the marketplace is going to do in terms of the CAP Rates, which naturally determines the end equity position at the time of liquidation/refinance. It is the end position that is responsible for the majority of the return in a syndicate. How do you make promises based on something you can’t know ahead of time?

Your thoughts are highly welcome – thank you!

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Michael Blank January 17, 2014 at 6:13 am

Hi Ben! First a question … when you say you can finance deals around $500,000 with relative ease with 100% debt, is that a combination of loan and investor debt? If so, what are you paying your investors?

To answer your question. Projections are a tricky thing. They’re rarely accurate, but you still need them! The thing is that projections should be conservative. The assumptions and business plan should make sense to the investors and should reflect a certain degree of competence by the you, the syndicator.

With projections, you have no choice but to make assumptions, and to use them to drive your financial model, which ultimately drive your projected cash on cash returns and overall returns. What other choice do you have?

Investors, however, must understand that none of your returns are guaranteed, and it will state this in bold letters in the disclosure documents you need to give to your investors (per SEC regulations).

Aside from drowning your investors in 85 pages of legal disclosures, you need to set expectations with your investors: at least 5 yr term, no guarantees, etc. and you need to remind them periodically.

To summarize, don’t make promises or give guarantees – you can’t. State your assumptions, make the projections, do your best, and manage expectations ….

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Ben Leybovich January 21, 2014 at 12:27 pm

Hahaha – give me your money; I may give it back to you; I don’t know when; and I don’t know of you’ll make money or loose. Sounds like a killer deal :)

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Shaun January 17, 2014 at 11:07 am

Very informative article.
Do you ever have different structures for different investors in the same deal?
I could see different people wanting different things, but you might need to get them all on board.
Can you do different blends of equity and preferred interest and the like to satisfy each investors desires?

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Michael Blank January 17, 2014 at 11:28 am

Shaun – I think you’re a psychic or something. Working on that article right now, hopefully should be posted Sunday or Monday!

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Shaun January 17, 2014 at 4:02 pm

I am pretty awesome. Thanks for noticing. :)

I’ll keep an eye out for that post next week.
Thanks!

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Ben Leybovich January 21, 2014 at 12:30 pm

Haha Shaun – you are awesome. But, I love Brandon :)

Mary B January 23, 2014 at 10:40 am

This is just what the doctor ordered, Mike. I appreciate it.

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Luis January 23, 2014 at 11:53 am

Love it… thanks

I am bookmarking this

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Michael Blank January 27, 2014 at 7:40 am

Thanks for reading!

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