Working “On” Your Real Estate Business vs. “In” Your Real Estate Business
A few weeks ago, I attended a subgroup meeting of my Philadelphia REIA group, and there was a locally well-known, extremely successful, real estate investor in attendance.
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He truly is an expert in his market, with all his systems and methods, especially with renovating and managing tenants, and building up a large portfolio of real estate.
There were only two issues that I saw. The first one was more apparent as I asked this retirement age gentleman what his future goals were for his retirement, personally, as well as for his real estate portfolio.
And, honestly, he didn’t seem to know. It kind of reminded me of having a portfolio that’s only worth something on paper, but it’s really not tangible until it’s liquidated.
The second issue I noticed was that all of the tasks revolved around him, so it really wasn’t a true business in the sense that it was scalable as a business unless the new buyer wanted an insane, full-time job.
What he really had was many investment properties. I’m certainly not saying that’s a bad thing, but how long would you want to manage them, until your 80 years old or 90?
I know the usual answer is to eventually have a property manager take over some day. But, the truth is: they're not always fun to manage either. I'm doing it right now, and I'm not so sure I'll love doing this in retirement.
Another truth we may need to face is that our heirs may not be trained to manage a real estate portfolio (or mess in some cases). Also, do they really want to inherit your real estate portfolio? The more common answer is that they don’t—they just want the money.
For example, I used to be a contractor, and I used to do much of the maintenance on my properties, but that doesn't mean that my wife is familiar with contractors, townships, or general maintenance schedules.
Although it would be easier for my wife to manage my notes, since these require less work, she wouldn't be crazy about managing my real estate properties. Also, one of my heirs lives in California, so how could he easily manage my rentals in Philadelphia?
So, whether you’re into notes or real estate, are you managing investments or are you running a business?
Real Estate or Notes as an Investment
I have a buddy on the West Coast, who has a pretty sizable real estate and note portfolio.
He has a great lifestyle, and his investments really don’t revolve around him too much. He does have a good property manager in place, and he utilizes a servicer to manage his notes, so this allows him a lot of freedom in how he manages his time.
But as we were discussing over dinner the challenges of operating with or without employees, we both recognized the advantages and disadvantages. We all know the general disadvantages of managing people, but the real disadvantage for my buddy is that he can’t sell his investments as a business in its current form, only as investments.
The second big disadvantage is he can’t grow exponentially (just incrementally), nor can he actually duplicate himself very well. But, there’s nothing inherently wrong with that.
Real Estate or Notes as a Business
The first time I realized my note business was a club (and not a business) was the first time another outfit tried to buy us.
Talk about a learning experience. It was eye-opening. I quickly started to realize what a business buyer was looking for, the areas they saw value (or no value) in, and what I needed to start doing to convert my club into a real business.
Initially, I had to define the structure of my organization, as well as the roles and responsibilities of all the employees. Next, I had to get all the processes down, as well as fine-tune all our legal and accounting practices.
If I were to sum it up, it’s like the book, “The E-Myth,” by Michael Gerber, that points out how you need to work on your business instead of in it; otherwise, you just have a job. A good analogy for this would be comparing a street wholesaler to a Home Vestors franchisee.
A real business buyer doesn’t want a job, they want a business. And in my past situation, their goal was to buy us, improve the business, and then flip it within three years.
How to Bring Value to Your Business
Recently, I sat down with an accountant and a business planner to go through a Core Values, 18 point, Business Value Assessment (corevaluessoftware.com).
What a neat process for revealing your organization’s strengths and weaknesses, as well as the best strategy to improve your company’s valuation by focusing on the areas to give you the best bang for the buck in regards to improving your overall enterprise value.
This program was designed by Chuck Richards, who has a BA in Economics from Williams College and an ME from MIT in Engineering and Business, and here’s a short sample of some of the categories it covers:
Growth – Does your company or business have a history of consistent growth greater than its competition, coupled with projected future revenue growth above the market rate?
Large Potential Market – Does the market (real estate or notes) support significant growth of the business?
Domestic Market Share – Does your company own the highest percentage of the available market relative to its competition?
Recurring Revenue – Can your company rely on a portion of future revenue from contractually committed customers?
Barriers to Entry – Are there significant obstacles facing a new entrant into your company’s market?
Product Differentiation – Is your company’s product/service have any unique characteristics that provide a competitive advantage?
Brand – Does your company have a recognizable brand that reinforces the business’s presence in the marketplace and supports the company’s objectives?
Percent Margin Advantage – Does your company enjoy gross and net margins greater than the industry norm?
These are just a few examples of the 18 overall value drivers of any business. With the program, we were able to look at where we are today and examine the Value Gap of what we could be doing better.
It was great to be able to use these outside pair of eyes, looking at our business, to come up with a plan to bring the most value to the company in the quickest amount of time.
After all, if someone wanted to buy your business tomorrow, you would want to be ready. This might explain why a friend of mine, who does M&A work (Mergers and Acquisitions), was telling me that 80-90% of companies with less than $50 million in revenue are never actually sold.
It all starts to make sense. If you’re running a business, can it run without you?—seems that the more it can, the more it is worth to a potential buyer.
Now, I’m not saying running a business is better than managing investments or vice versa; it’s just important to recognize the difference. Liquidating your investments and selling your business are just two very broad examples of potential exits.
Another potential exit for your investments, specifically real estate properties, could be selling the properties and holding the paper on them.
My mom did this, and she’s still cash flowing, but she no longer has to deal with the day-to-day hassles of owning properties. See article: “Equity Rich and Cash Poor.”
Another option is selling the properties outright and placing the capital in an investment vehicle or donating it to your favorite charity. For example, someone could sell their properties and donate the proceeds to their favorite charity in a Charitable Remainder Trust, which would off-set the tax on those properties.
In that case, the charity places the capital in an investment vehicle, he/she makes a return on that money until he/she passes away, but during that time, he/she could be using that return to pay for a life insurance policy that will support his/her heirs.
Placing notes with a mortgage servicer removes a good portion of the work, and you can really manage them from anywhere. If you did want to exit your notes as an investment, it’s pretty simple.
You can sell/liquidate a note very quickly. So, it is much easier to settle an estate with notes as the investment vehicle than it is to settle an estate with many rental properties.
A few other examples of potential exits for your business could include selling the business outright and placing the capital in a more passive investment vehicle.
Or, you could sell the business and hold the paper. Another option is setting it up so that key employees can buy out the partners of the company in stock; we actually did this with an ESOT (Employee Stock Ownership Trust).
Of course, these are only a small sample of the potential exits.
Regardless of whether you’re in real estate or notes and whether you manage investments or run a business, it really comes down to planning your exits.
So, I’m curious to hear back from some Bigger Pockets folks on this topic.
What’s your retirement look like, and what kind of legacy will you leave behind?
Be sure to leave your comments below!