All Forum Posts by: Sherman Ragland

@Robert Howard Why an LLC and not a Trust?

@Account Closed - Many (35+) years ago I got my real estate license. I remember on the 1st page of the 1st chapter of the book, reading the definition of real estate: "...a bundle of legal rights."  The more I learned about real estate, the more I have to agree that this one sentence is absolutely spot on.  In goes without saying, that a wise person in this business will run stuff past their attorney, especially when embarking on a strategy for the first time.

Specifically on the topic of raising money, you'll need the proper legal documents.  Where you get these documents is a function of how you decide to structure the deal.  If you keep your money raising to "partnerships", then pretty much any attorney in town with real estate experience can assist you, at a very reasonable cost.  However, if you embark on putting together a "Security", then you'll need an attorney with demonstrated securities experience.  Securities attornies have a dramatically higher fee structure.  Partially because they take on more liability for the work they do, if your deal goes south.

So how do you know if what you are proposing to your investor(s) is a Security v. a Partnership?   

In 1946, the Supreme Court heard a case in which the US Securities and Exchange Commission (SEC) sued the defendants (Howey) over several transactions they had structured, claiming that they broke the law by not filing a securities registration statement. The Supreme Court found that the defendants had (unknowingly) created a form of security. SEC v. Howey, developed a landmark test for determining whether certain transactions are securities and, therefore, subject to securities registration. Under the "Howey Test", a transaction is an investment contract if:

1. It is an investment of money
2. There is an expectation of profits from the investment
3. The investment of money is in a common enterprise
4. Any profit comes from the efforts of a promoter or third party

In other words, if you are putting together a deal in which people are investing their money (rather than donations, or contributions to a charity), and the money is "pooled", and the only way your investors make money is from what you do as the "Promoter"/Deal Maker/"Sponsor", than it probably is a security, and it probably needs to be registered (at the state, and possibly Federal) level.

On the other hand, if you are getting a group of people together, and your are jointly putting in money, and "other services", and equally sharing in decision making (so it's not "all on you) then it may not be a Security, but is more than likely, a Partnership. If it is a Partnership, then an LLC Operating Agreement, or Partnership Agreement might be all you need. A Partnership Agreement is significantly less involved than a securities offering.

Finally, a variation on this would be if you structure a deal where you have "one investor in one deal", and structure it as a mortgage.  Note: PLEASE BE VERY CAREFUL IN STRUCTURING THIS. Read up on a guy from a Ohio named John Ulmer.  It is generally accepted that a mortgage is NOT a Security. However, even structuring mortgages involves getting legal assistance, and it's important you don't pool money to do the mortgages because this too could be viewed as a Security.

I've done mortgages, Reg D's, PPMs, and we're doing our first Reg? A (Crowd Funding/Public Offering) now.  Bottom line: figure out what you want to do, then go get the right legal help to structure it properly.  Also, don't be afraid to "Crawl, walk, run... then win Gold Medals!"

@Account Closed - first, congrats on pulling together your (first?) apartment deal, well done!  Second, there is no "right or wrong" answer to the question.

Here, however, are some guidelines and suggestions...

1) What you offer to investors is, and will always be, a negotiation.  The stronger your hand, the more you can demand/ask. As you get more deals under your belt, and your reputation grows, you can offer less, and raise more;

2) As you know, you cannot offer a higher return than the deal can provide.  In addition, it is always best if you match the risk you are taking to your proposed deal structure.  If there is a possibility that you may go for a period of time without positive cash flow, then do not promise to pay out cash to your investors.  If there is a possibility that you will need additional cash, then require your investors (partners) to aLos have to put more into the deal;

3) Determine if your partners are in for the long haul, or short term. Again, this will be subject to negotiation.  Some investors like to be in (very) short term, as in 12 months, or less; some short term, as in 3-5 years; and some will want to be your partner for life;

4) In general, under promise, and over perform.  If it sounds too good to be true, it not only will scare off investors who know what they are doing (and tend to have deeper pockets), it might set you up for failure, if something unexpected happens and you can't perform.  Personally, I'd be afraid of any real estate investment where the sponsor is offereing more than 10% in the current interest rate environment;

5) Here is my typical deal structure (today): I look for deals that can yield 12% or better. I offer my investors 4% to 7%, which steps annually. I take nothing for the first 5-7 years, and often times cover cash short falls. I use the cash flow from the deal to pay back, and pay off investors within 5-7 years, afterwards all cash flow comes to me.  This is one structure, but not the only one.

6) Gary Rappaport, who is the past president of ICSC (the International Council of Shopping Centers) has a very good book on deal structuring.  It's called: "Investing in Retail Properties: A Guide to Structuring Partnerships for Sharing Capital Appreciation and Cash Flow." His deal structuring can be used for any type of commercial, income producing, real estate partnerships.  In his book, Gary recommends keeping investors in the deal, long after you have paid them back AND given a good return.  I do not follow Gary's model, but many people do.

Hope this helps.

@Vera Herlihy - great questions!

Loan to Value, or LTV is the amount of the loan a lender will make on a property, as a percentage of its value. As you can imagine, no lender wants to fund 100% of a deal because the borrower would have little to no "skin in the game".

Typical LTV's for single family investment properties is in the range of 60% to 80%, depending on the type of lender, and duration (term) of the loan. For single family properties where the borrower will live in the property, the LTV will typically go up to 80% to 90%, with the theory being that a borrower is less likely to default on the loan for the house they live in.

Typical LTV's for non-single family houses is almost always lower than 80%, with many being 65% to 75% for multifamily and other types of commercial, and as low as 40% to 50% for (non-income producing) land.

Every lender establishes their own rules, and lenders who receive Federal support (FDIC insured, or FHA, etc.) following Federal guidelines. Private lenders, and private investors can do what they want. Which is why it is not uncommon to see experienced investors setting up private investor (attraction) programs, and structuring deals with 100% LTV's.

Cap Rate, or "Capitalization Rate" is a little less straight forward. In theory, a "Cap Rate" is a simple mathmatical formula, where you divide the properties Net Operating Income (or NOI) by the purchase price (assuming it's an all cash transaction). So as a example: If I pay $1.0 million cash for a property, and in the first year of ownership I receive $100,000 in net operating income (NOI), then I will have earned a return of 10% on my investment and my cap rate would be 10. Oh, cap rates are almost always expressed as a number, not percentage. So if my NOI (in thus example) was $75,000, then my (first year) return would be 7.5% and my cap Rate would be 7.5.

Now, here's where it gets tricky... often times a real estate broker (agent) will say, you can purchase this property for a 6.5 cap. Using the example above, (again) if I purchase for $1.0 million, then my expected (first year) be operating income (NOI) would be $65,000. But what if I purchase it for $1.0 million, but my NOI turns out to be only $45,000, because there was an additional $20,000 in expenses I did not know about? Then in this example, my actual cap rate (for the first year) would actually be 4.5

The challenge with cap rates is twofold: 1) It only looks at the first full year (of new ownership) of NOI when you calculate it, 2) What is in your NOI, versus what should not be in your NOI. In general, NOI should include: a) your gross possible income/or actual income, minus b) a reasonable allowance (deduction) for bad debt and vacancy, minus c) property operating expenses (including property taxes, but NOT debt service for any loans, or personal taxes). This is where things can get a little squirrelly. Should things like "reserves for (ultimate) replacement of equipment and roof be included in your NOI. Some will argue "yes", while others say "no". But "what's in, versus what's out" can gave a huge impact on NOI, and ultimately value, and Cap rate. As an example, let's go back to the million dollar purchase above. Let's say you thought NOI was going to be $100,000, but during the first 2 months of being the new owner you get a property tax bill that is $20,000 higher than what you were told it would be. You go down to City Hall and ask "what's up with the huge increase?" And are told the prior owner was given a 10 year tax break for Rehabbing a historic building, but the credit has now been used up, and for the future the tax bill will be higher. You thought you were getting a property with a "10 cap", but now realize it's going to be a 9 cap. This may, or may not be a big deal.

Bottom line: cap rates are just one tool for valuing income producing property. An important one, but not the only one.

Hope this helps.

@Eric Siebert - Zillow has been sued numerous times about the impact of their valuations on neighborhoods and individual home owners. In a FORBES magazine article (several years ago now) the President/CEO of Zillow stated emphatically that "Zestimates are not appraisals!"  He went in to say that Zillow knows that their Zestimates could be off by as much as 30%, and that they should never be used independent of an actual appraisal.  Recently, like this week, Zillow announced a contest with a $1.0 Million Dollar 1st prize to any group of programmers who can help them improve the accuracy of their Zestimates.  Most experienced investors simply consider Zestimates as a joke.  In time, Zillow will crack the code.  For now, stick with BPO's from knowledgabe real estate agents/brokers, or better yet, figure out how to pull your own comps, and get good at doing your own value estimates.

@Eric Jan - we're in Bowie, MD. Not sure if that works for you, but we have agents all over the state, and in DC and NOVA.

@Kevin Magelsen First, congrats on landing your first deal!  Couple of things to think about...

1) If you fix and flip you'll pay ordinary income.  Make sure in doing the calculation to take into consideration all costs, including transaction costs and costs of making additional repairs when you're under contract and the prospective purchaser gets their home inspection.  Sometimes it's just cheaper (better) to reduce the asking price, or give a lump sum at settlement than make all the repairs listed.  As an older home, the inspector is going to find lots of things to point out;

2) It is generally better to hang on to properties as rentals for long term wealth creation.  My rule of thumb, in our market (Prince George's County, MD, just outside DC) is to get at least $1,000/month positive cash flow (on paper) to even consider doing the deal.  Once you get a tenant in the property you'll need to maintain things to certain standards and (again) on an older home, it can add up pretty quickly.  Pipes you thought were ok, suddenly break and flood the floor (and ceiling) below, etc.  Just make sure you have enough in reserves for your "worst case" scenario.  Such as, pipe breaks in 2nd floor master bath, floods kitchen below shorting out light fixtures. Total damage is $3,000.00, but you also have to put tenants up at a hotel for the week because your local laws say you can't do this type of work to the property with then tenants in residence;

3) Which brings me to my last point. If you have not done so, seen out local experts (mentors) who have demonstrated skills in Rehabbing and reselling (flippers) and landlord/tenant matters. Don't be surprised if you get two very different (and very strongly opinionated) answers.  Most "fix and flip" guys/gals don't want to be landlords, and visa versa. Just go into this with your eyes wide open.  There is no "right or wrong" answer, but you'll get better (more complete) answers from someone who's "been there/done that", which will be hard to find outside your local market.  I've done both, but have a (strong) bias towards "buy/fix/keep", but (also realize) not very property is a keeper.

@Dave Morrow, Sherman Ragland here. I think you are giving away, way too much. If you did the deal using a hard money lender (HML), someone who is in the business of putting up the money, you would NOT give up 65% of the value you created. With the deal structure you have proposed, you might as well get a job, managing rehabs fit others, and demanding a salary of at least $150,000/year plus piece of the profits.

If your money partner is "just bringing the money", and you are the one creating value through your efforts, your connections and your ability to "get the job done", then you should value the money accordingly. Which is, the going rate that HMLs charge in your area, or less.

In our market, we call these types of people, "Private Investors" and we normally pay them 4%-8% of the funds they lend. If you are totally new to this business, and are considered "high risk", then this would jump to 18% to 24% interest on the funds actually lent, similar to what HML players get.

@Duke Nguyen, by-law, the money "belongs" to no one.  That is why it's held in an escrow account.  If the tenant does EVERYTHING they are suppose to do under the lease, the money is RETURNED to them.  If not, then a portion is deducted to pay for what the tenant failed to do, and then returned to them.  Who is RESPONSIBLE for the escrow account is a negotiation between the owner and property manager.  It would be wise to understand what the law says, prior to deciding who takes the responsibility for managing the escrow account.  Whether it is the Landlord, or the Property Manager, the law dictates what happens to the money, both while it is in possession of the Landlord/Property Manager, and upon its return.  As an example, in Maryland, if the Deposit is not returned (or a full accountung given) within 45 days of move out, then the Landlord has to pay treble damages to the Tenant, regardless of the condition the Tenant left the property, or their breach of lease.

@Dolores Waldron - you'll need to speak with knowledgeable investors, brokers and bankers.  Like pulling combos, you'll want an "apples to apples" comparison of deals that have closed.

As an example, I'm looking at a 20-unit apartment development in West Baltimore, in the city. Cap rates for this part of town are 6.5 - 7.5. I have a piece of dirt near the Inner Harbor, where deals are trading at a 5.7 cap. Assuming the rents were the same (note: they are not, but this is fir discussion purposes), the same NOI of $195,000 could yield a value of either:

a) $2,600,000 or

b) $3,421,000

A difference of $821,000!

#CapRatesMatter