JF1002: A Unique Way to Pay Investors Using a Property’s Cash Flow
When borrowing private capital, some investors may require that after borrowing the funds, they get a preferred return, which is a return that goes to them before you get paid. Listen how these two guests pay that preferred return with a separate cash flowing property.
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Matt Wood and Mike O’Connor Real Estate Background:
– Multi-family Investment Experts who have portfolio of 140+ units in a few years
– Purchased a 100-unit building for $2.8 million with no money out of pocket
– Scaled a 16 unit complex that required a full rehab
– Began investing in real estate in their mid-20s while working full time jobs in 2013
– Based in Atlanta, Georgia
– Say hi to them at www.foundationsrealtygroup.com/
– Best Ever Book: Rich Dad, Poor Dad
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Joe Fairless: Best Ever listeners, welcome to the best real estate investing advice ever show. I’m Joe Fairless and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any fluff.
With us today, Matt Wood and Mike O’Connor. How are you two doing?
Mike O’Connor: Good, Joe. How are you?
Matt Wood: We’re doing well, thanks.
Joe Fairless: I’m doing well, nice to have you both on the show. A little bit about Matt and Mike – they are multifamily investors who have a portfolio of 140+ units and they’ve acquired that in a few years. They purchased a 100-unit building for 2.8 million with no money out of pocket, and began investing in real estate in their mid-twenties while working their full-time jobs. They’re based in Atlanta, Georgia. With that being said, do you two wanna give the Best Ever listeners a little bit more about your background and your current focus?
Mike O’Connor: Yeah, absolutely. You hit on some of the key points there. Matt and I have known each other since college, and we actually happened to join the same consulting firm out of college, where we both realized we had a similar interest in real estate. In about December 2013, after doing a lot of analysis and talking about the real estate market, we co-bought a small $65,000 house in a submarket called Stone Mountain here in Atlanta, Georgia. That really was the beginning of the whole snowball, if you will.
We sat on that for about a year, when we decided that we actually wanted to do a little bit of an up trade, if you will, and we can dive into some of these specifics later, but what that essentially lead to was us purchasing our first multifamily deal, which was 32 units. As you alluded to, we then jump to a 100-unit deal, and then our 16-unit deal, and now we’ve got a couple quads, a sixplex and a duplex under contract. That’s kind of the very high-level background on us and what we’ve done, and I’m sure you’ll have some questions about some specifics.
Joe Fairless: Sure do, yeah. What money did you use to buy the $65,000 house? Your own money?
Matt Wood: Yeah, we used our own money for that one, and we just did a standard 30-year mortgage on that property; I think we still had to put 25% down, but for a $65,000 house, that was reasonable with our day jobs and with our savings. We used our own money on the first multifamily property as well, the 32-unit complex. We got 80% financing from a bank for that property, but after that 32-unit, we were a little bit tapped out, and that’s why we had to get creative with the 100-unit and do some seller financing, pull in some investors… We flipped the house during that process to pay back some money for the investors and things like that. So in order to scale and really grow, we learned pretty quickly that we were gonna have to find ways to leverage other people’s money.
Joe Fairless: That’s gonna be a fun thing to talk about. You’ve just mentioned you flipped a house to pay back investors – can you elaborate?
Matt Wood: When we bought the 100-unit complex, we seller-financed 10%, the bank provided 80%, and then investors provided the remaining 10% of the purchase price, but we were giving them a preferred return and we were paying them that 10% back over a five-year period; so we have investor payments to make on a semi-annual basis. Our goal really has continued to be to have no money out of pocket on that 100-unit complex. We’re both real estate agents, we work with a lot of investors, and we found a property that had potential to flip, it had a good after-repair value, it had good comps in the area, and we flipped it and made some profit and used that to pay the investors back.
Mike O’Connor: In account to what Matt was saying, the way we structured it is — if we knew what we know now we would have been a little more selfish, if you will, with the equity piece, but we gave up 50% of the equity to the investors for the money that they brought, but we also paid them back 5% on an annual basis. That money comes out to something in the ballpark of $35,000 around 1st July every year or so. At least once a year — flipping isn’t necessarily our main objective, but we found a flip and we were able to make a quick $30,000; we turned it around, pumped it right back into our investors and we continued this whole theme of letting the business fund itself with no money directly out of our pockets.
Joe Fairless: Interesting. So you’re using an outside investment to pay a preferred return for an investment that the investors invest in.
Mike O’Connor: That’s exactly right.
Joe Fairless: And they’re fine with that?
Mike O’Connor: Yeah, they’re absolutely okay with that. The properties themselves are cash-flowing as well. The main objective for the whole process was for us to do a full cash-out refinance, hopefully within the next year, once we have stronger numbers, with that cash-out pay back both the seller financing and the remaining debt service that we have due to our investors, and hopefully that will bring us even keeled. But they’re okay with that as long as the money is coming back to them, they’re getting their interest, and if the properties run smoothly, they give us the autonomy we need.
Joe Fairless: With the 5% preferred return – because it’s basically a preferred return – when you did the underwriting did you project that the property would be able to pay the 5% preferred return?
Matt Wood: It’s interesting… When we bought this property we knew that it had some immediate upside. All the units were [unintelligible [00:06:59].09] for water, but the owners were paying for water, so we immediately charged that back to the tenant. We made some upgrades in some units and we slowly worked on increasing rents, so there is an element of the property paying back investors over time, but as of now, since we’re only two years in on this property, we knew that we would be making those investor payments either out of pocket, or with returns from our other properties or from flips. I mean, we could make the payments out of pocket if we wanted to, but our mindset and our goal has really been to try (to Mike’s point) to make those payments and to do everything with business returns.
Mike O’Connor: Yeah, and then the big thing that we’re marching for is that we underwrote during the analysis [unintelligible [00:07:37].26] so we have a balloon on that after five years for the pure principle amount; we pay monthly interest payments only for five years on that, and that is one that we’re confident that will absolutely be paid back through the property itself. But the property – we’re also hoping to just cash out, and we’ll handle the remaining investor payments that we have for the next two years.
Joe Fairless: When you had the investor conversations, when you were talking to them about the deal, you mentioned that the 5% will be paid from outside investments in the property instead of the actual property for the first couple years, and that conversation was okay?
Matt Wood: I think we would have had to have a different conversation if we were gonna tell the investors that we were gonna pay them back using money from the property, since they also are equity owners, right? So it was cleaner even to show that we’re building up reserves in the property and we’re leaving that money there, in the property’s account, and that we’re paying them money back from our own pockets. To Mike’s point, they don’t care where the money comes from, as long as they get paid back.
Mike O’Connor: Right, and it’s nicer to have the reserve build up there, and they know that that’s all kind of shared money for the property. It keeps it cleaner.
Joe Fairless: Huh!
Mike O’Connor: You seem surprised by that…
Joe Fairless: I’ve never heard of this; I’ve never heard of paying from another property the preferred return. Usually, my deals – and every deal I’ve heard of, which as long as it’s kosher and there’s no co-mingling of funds or anything, then I assume it’s fine.
Matt Wood: Not at all. I mean, just to simplify it totally, we owe them money to pay them back on the investment, and the way that we structured the promissory note, the money comes in however it comes in.
Joe Fairless: Huh… Okay. And when you do a refinance or when you sell, are you then repaid that 5% that you’ve been paying them from outside sources?
Mike O’Connor: No, the 5% is basically what we’re giving them as kind of a “thank you for you fronting the money”, to account for that. The guys that we brought in are higher net worth individuals who have very diversified investment portfolios, so there’s a certain element of desirability in a 5% return. For me, a 5% return is not as appealing, I’d like to look for something higher, but for these guys, the fact that they could get both equity and 5% on this money made sense. So as far as that 5%, we won’t be taking that back out; that’s just going straight to the investors.
Joe Fairless: How did you two find the deal?
Mike O’Connor: The same guy who brought us the 32-unit deal actually stumbled across this. There’s a couple of [unintelligible [00:10:06].10] in the submarket that we’re in – it’s Albany, Georgia – who picked this property up a few years back for real cheap, and they’re actually builders, so they were looking for some capital to go into a few new building projects. The guy’s name is Erik, he brought it over to our group and said “Hey, I’ve come across a deal… It’s 100 units for 2.8 million dollars. a) Are you guys interested in getting in on this? b) do you know how we’d be able to figure out the financing component?” So aside from that, we have two other day-to-day partners, [unintelligible [00:10:33].26] and we’re really sort of underwriting the deals, seeing if it made sense, looking at the numbers, looking for potential areas for value-add, and it made sense.
Once we identified it, to closing it really was a quick time, probably about a month and a half that it took. But it was Erik, we’ll give him credit for that. He has this wide network of investors and owners throughout the Atlanta and surrounding areas.
Joe Fairless: That was my follow-up question, perfect segue… How many investors do you have in the 100-unit deal and what’s the total equity that they brought?
Mike O’Connor: The investor group – I think they’re like a five-person group; I’ll kind of break down the numbers. 80% of the loan came from the bank, 10% of the loan is seller-financed, and then 10% of the loan came from the investors themselves. Now, again, knowing what we know now, we probably would have diluted ourselves less just because we’re operating the property on a day-to-day basis, it’s a good deal… We really were giving them a good opportunity. When it all shakes out, the investors get 50% and then we on our end get 50%, which comes down to 10% each, which again, in the grand scheme of things isn’t a ton, but the fact that we’re each getting 10 units for an apartment complex for absolutely no money out of pocket… Essentially, if you look at opportunity costs with what we’re doing with our flips, that money could have gone to better use elsewhere etc. but as long as we’re getting in there, getting those 10 units for no costs instead of our own pocket, we’re satisfied with that. So there is some dilution there, but it was the way that it made sense at the time.
Joe Fairless: What have you done differently on the 100-unit that you didn’t do on the 32-unit?
Matt Wood: Good question. The deals were totally different. The 32-unit required some rehab up front, and it required a lot more stabilization because about 12 of the units were vacant when we purchased the property, and we were able to get it leased out pretty quickly. The 100-unit was about 80% leased when we bought it, but we went in and immediately made some upgrades on the flooring of the units, or [unintelligible [00:12:30].23] or things like that, just to improve the quality of the property.
Then we had some additional decisions to make as far as the property management aspect, because the 100-unit complex has a full-time leasing agent and a full-time maintenance technician at the property… So that was a little bit of a different beast than the 32-unit in terms of the operations.
Joe Fairless: What’s a lesson learned or a mistake that you made on the 32-unit that you didn’t make on the 100-unit?
Mike O’Connor: The 32-unit was a great first deal in the sense that the numbers were great from day one; it really was a strong deal. That’s really what catapulted us into quickly over the next six months closing on another 116 units. A big takeaway that I always harp on is the quality of the tenants. When you’ve got a lot of vacancy or you’re working on stabilizing a property, there’s this element of wanting to increase the cashflow as quickly as possible, so you start to loosen your restrictions or your requirements for the tenants that you’re placing.
We were doing 2.5 times income – your income has to be 2.5 times the current prices, and we brought those best practices (or not best practices) over to the 100-unit, but then we started to realize that this is leading to more evictions, it’s leading to a lower class of tenants, so we quickly cut that off when we bought the 100-unit deal. We really just realized we’d rather wait an extra two or three weeks and place a good, quality tenant, than to jump the gun and put in a lower quality tenant off the bat. I think that saved us a lot of money across the road with leasing fees, paying someone to go and show the unit, turn costs, eviction costs, costs of non-payment, things like that.
Joe Fairless: On the 100-unit, what’s been the most challenging aspect of doing the asset management?
Matt Wood: Good question. There are a couple aspects to that – we actually recently transitioned property management companies after just realizing for a number of different reasons that the original company that we were working with wasn’t a good fit. The current company we have has been great… I would say one of the challenges though is that the property is about three hours outside of Atlanta, so we don’t get to that property in person as often. We’re allowing our on-site leasing agent to be the eyes and ears on the ground, but I think there are some elements that we would have been able to manage quicker and more easily if the property were in our backyard.
We’re still happy with the deal, and we would invest the same distance away from Atlanta if the numbers made sense, but that has been a challenge.
Mike O’Connor: That’s an interesting question, and I’m gonna break that out a bit as well. A benefit of having 100 units is you do have the need for an on-site manager and on-site maintenance tech, and I think that’s been great. Shifting that question a bit and looking at the 32-unit or the 16-unit one, the hardest thing about those (especially at the 32-unit), you’re getting to the point where you need some type of on-site presence; maybe not full-time, but part-time. Figuring out how that model looks, how you pay someone to be there, what they’re doing while they’re there – it’s kind of challenging; it’s that awkward in-between phase where it’s not a single-family home where it obviously doesn’t require on-site staff, and it’s not 100 units where you definitely need someone; it’s definitely in-between. We’ve gone back and forth on models with that, and that’s been a big challenge.
Joe Fairless: How did you find the original property management company and what were the red flags that made you ditch them and pick someone else?
Matt Wood: The 32-unit complex was being managed by that property management company, and since we were scaling from a single-family house to the 32-unit complex, we wanted to try to keep everything as consistent as possible. There was already a lot of change going on in our investing lives, so it made sense to keep them. And they’re nice people, they still do good work, but it just wasn’t a fit for us.
Some of the lessons learned that we have on our end is that we’re all four guys with day jobs who are very type A and we like to know all the details, and we micro-managed them. Granted, you still have to manage the management company, but we probably went overboard on that. It just wasn’t a personality fit, in some ways.
The current company that we have also invests and has their own properties and understands a lot more of the elements that we’re looking for, and we like the personnel and it’s been a great fit.
Joe Fairless: As far as the personality – I imagine the operations or the numbers were suffering, because if that wasn’t the case, the I suspect (maybe I’m wrong) that you wouldn’t have made the change. From an operations standpoint, what specifically does the new property management company do that perhaps the other one was not as efficient or effective at.
Mike O’Connor: They’ve got a lot better oversight on the property. The two models are very different. The new company – and this alludes to my earlier point about on-site versus off-site – is much more remote. We’ve got more senior level people overlooking our property operations, but from a remote perspective; handling the financials, really looking to work orders, making sure that they’re valid work orders, running the accounting, vetting tenants…
The previous company was very big on on-site presence, so we had an on-site manager that we were paying an hourly wage too that was working on a couple of our properties for about three days a week. This individual, for a lack of better terms, was not a more senior person, so a bit more junior, green behind the ears, and they were essentially in charge of running the property, handling the accounting, handling the finances, the tenant placement… So the decisions that they were making just weren’t great. We were placing bad tenants, rent collection was lower, things slipped through the cracks; every work order that came through the door got fixed and it came out of our pockets… There was just a variety of different ways where we weren’t either capitalizing on opportunities or we were bleeding from an expense perspective. That was one of the big drivers of the actual change.
Now things are much more tightened up, we have less oversight and overhead as far as on-site presence, and the properties are performing much better than they were before.
Matt Wood: The only thing that I’d add is we could tell pretty quickly with the new property management company that they took things up a level in terms of their accounting, their reporting, their software portals… You could tell pretty quickly that it was a professionally-run operation and we had some qualifications, some references on the company. That’s a lesson learned – we would ask any new property management company for client references that we could speak to to learn a little bit more about them.
Joe Fairless: Lots of good lessons learned, thank you for sharing that.
Matt Wood: Yeah, absolutely.
Joe Fairless: What is your best real estate investing advice ever?
Mike O’Connor: Matt and I would probably go different ways on this, but I would say don’t hesitate to jump in. You need to understand your markets, you need to understand the numbers on what you’re doing, but you could sit there and you could analyze deals – and this is more for a newer investor – absolutely all day. There’s plenty of deals to run numbers on; actually taking the leap and getting in the game is absolutely critically important. I think the other thing for someone that’s obviously more experienced – really understand and manage your finances and your accounting very well, especially pertinent now that we’re in tax season, it’s never fun trying to go through and figure out what’s going on through all your collections, your expenses, but really at the end of the day we’re doing this to make money, and if you don’t have your finances figured out, then there’s really no point in doing this.
Joe Fairless: Are you two ready for the Best Ever Lightning Round?
Mike O’Connor: Ready!
Joe Fairless: Alright. First, a quick word from our Best Ever partners.
Joe Fairless: Best ever book you’ve read?
Mike O’Connor: Best ever book I’ve read is the Robert Kiyosaki book, and I’m drawing a blank on–
Joe Fairless: Rich Dad, Poor Dad?
Mike O’Connor: Rich Dad, Poor Dad, yeah. A lot of people give that book, but it honestly got me into real estate investing.
Joe Fairless: Best ever deal you two have done?
Mike O’Connor: Probably our 32-unit deal. We picked it up for $640,000 and it just got appraised for 1.35 million. It brings in roughly $18,000/month.
Joe Fairless: Best ever way you like to give back?
Matt Wood: We’re pretty involved in our church and we like to get involved with the service aspects there. We do different habitat type builds and stuff like that, so it’s just getting your hands dirty and getting involved.
Joe Fairless: Thinking back on your deals, what’s a mistake on a deal that comes to mind?
Mike O’Connor: A mistake on a deal… I would say on 16-unit deal which we didn’t do much discussing here, we basically rehabbed all 16 units; some of them were floor-to-ceiling molds, a good majority of them were. We — I’m not gonna say we cut corners, but we rushed the job in some areas, both with our repairs and with our tenant placement to get the thing up and running quicker than we needed to, and I would say that that probably cost us about six months of being at full stabilization, just because tenants were having to be evicted, repairs that we made weren’t holding up… So really going back and actually doing that right the first time would have saved us a lot of time and a lot of money.
Joe Fairless: You read my mind when you said we haven’t talked about it a whole lot… I do want to touch on it briefly real quick. With that 16-unit what are the numbers?
Mike O’Connor: We actually found that one on the FMLS, which is interesting…
Matt Wood: Aziz found that one…
Mike O’Connor: Yeah, Aziz found that. We picked that one for 471k, we probably put it about 100k, so we’re all-in (our base is) about 570k. It did just get appraised for 1.05 million, so all the work that we did really paid off, but that’s 16 units, it’s 8 duplexes, and each one rents out for about $850/month.
Matt Wood: One other thing we like about that property is that the whole area itself is really improving and we’re getting tenants like teachers and nurses… It’s been a good quality group that we’re getting in as far as that property goes.
Joe Fairless: Did you do a refinance to return your original equity?
Mike O’Connor: We cashed out $100,000 of it. Not all of it, but a portion of it.
Joe Fairless: How did you decide how much to cash out?
Mike O’Connor: Especially with interest rates being so low, leverage is great, it’s allowed us to scale the way that we have, but we’re cautious, too. We’re very conservative in our investments, so we thought $100,000 was a good amount to pay ourselves back, but at the same time not keeping the leverage too far… We love pay these things off, own them outright, and then our view is let’s get lines of credit against the property so we have our assets working for us, but we only pull it out if we need to.
Matt Wood: That’s a good question; that wasn’t an arbitrary number, we did spend a lot of time talking about “Should we take any money back? Should we take more than 100k?” because we did have the equity to make that decision. But we do ultimately wanna have these properties paid down for a better passive income, so it was certainly a discussion.
Joe Fairless: The line of credit that you took – that’s in addition to the 100k you got back out, right?
Mike O’Connor: Correct, so we’ve got a $200,000 line of credit that we have and we pulled out $100,000. The $200,000 is against the 32-unit, the $100,000 is against the 16-unit.
Joe Fairless: What’s the interest rate on that line of credit?
Matt Wood: It has a floor of 4% and then it’s prime plus 2%, so right now it’s probably in the 6% range, if I’m not mistaken. Better than getting hard money for something. Honestly, we started [unintelligible [00:23:57].02] it for just the reserves and to have that kind of money available, but we’re looking at some deals potentially where we could leverage some of that money (it’s a good interest rate), something that we could get into and get out of quickly.
Joe Fairless: And where did you get that line of credit from?
Matt Wood: Wells Fargo. Wells Fargo actually has a good program that we were able to get into for the refinances. It’s a 15-year term and 15-year amortization on the loan on the property, and then a separate line of credit because we have good equity in the property.
Joe Fairless: Where can the Best Ever listeners get in touch with you two?
Matt Wood: If you go to Foundations Realty, our website – we’ll have those in the show notes as well; you can find us on sites like Bigger Pockets, LinkedIn, places like that.
Joe Fairless: Awesome. Well, this was a fun conversation, because I loved hearing how your company has progressed and evolved from a $65,000 house to the 100-unit, and the full rehab and how you structured it with investors, the lessons learned along the way… I loved how you two got into the specifics of everything. Thank you so much for being on the show. I hope you have a best ever day, and we’ll talk to you soon!
Mike O’Connor: Thank you.
Matt Wood: Thanks, Joe.