JF1354: 5 Ways to Show Alignment of Interests with Passive Investors #FollowAlongFriday with Joe & Theo
For syndicators and passive investors, today’s episode is packed full content for you! A lot of this episode also applies to other real estate investors, because all of us need to build and maintain credibility. Being able to show alignment of interest when reaching out to potential money partners is HUGE. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Mentioned in this episode:
Carlos Vaz episode: JF1112: He Attributes Having The Right Mindset & Character to His Success with Carlos Vaz
How the General Partner Makes Money from an Apartment Syndication:
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Joe Fairless: Best Ever listeners, how are you doing? 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 of that fluffy stuff.
Today is Friday, Follow Along Friday. We’ve got a very helpful episode for apartment syndicators, or any syndicators, people looking to raise money and buy something with investors. We’ve also got an episode that’s gonna be helpful for passive investors, to help understand the inner workings of deals and thought process of general partners. How are we gonna do this, Theo?
Theo Hicks: So when we’re starting off in our investment careers, and let’s say we’re buying apartments with their own money, experience is important, finding the proper team members is important, but once we transition into using other people’s money, another factor comes into play, which is our own personal credibility. We can use our own money to buy deals, and of course, we want to have credibility to find team members, but we don’t need credibility ourselves to use our own money.
For me, for example, I just jumped right into real estate without really any experience at all, whereas that’s not going to work if you’re raising money from people, because when they ask you what your background is, what your experience is, maybe prove that you can do this, if you say no, then why would they trust you with their money.
I know a big question we get from a lot of people that wanna be apartment syndicators and raise money is “How do you show that credibility to your investors?” I know from your personal experience you’ve got some ways that you’ve done that in the past, and we’ve also kind of come together with a list of five ways in total with increasing the levels of alignment of interests to show alignment of interest to your investor.
Joe Fairless: Absolutely. I believe I’ve done all five things on the list; I don’t have the list in front of me, but I know you and I created it together, so I’m pretty sure I have. I’ll give commentary about each of them, and mention a personal story if I have done it, which I’m pretty sure I have.
As you mentioned, this is one of the challenges that everyone will come across, unless you were born in a real estate investing family, and you grew up in the business, and perhaps your family got you in on some rentals early on, and it’s not as much of a necessary thing to establish credibility, because you’ve already been raised with credibility through your circumstances.
But for most people, it’s something that needs to be established, and unfortunately we can’t just create credibility, we have to fortunately be resourceful enough – I say “fortunately” because that’s what will help separate us from our competition, if we’re resourceful enough, to establish alignment of interests with other parties in the deal, to show our investors that “Hey, we might not have all of the experience that’s necessary, but here’s the team that we have in place and the alignment of interests that we have with the team”, so that you can piggyback on other people’s experience to then do what you need to do.
I like to say – I heard this in some seminar, I don’t remember which one, but the world will tell you you’re too young to do something, until one day you wake up and they tell you you’re too old to do something. So if you wait until the world finally says “Okay, now it’s your time”, then you’re gonna miss out on a lot of opportunities and a lot of growth experiences. With that being said, we can kick it off and get into number one.
Theo Hicks: Number one you’ve kind of already touched on. The lowest level of alignment of interest in this hierarchy that we’re gonna discuss – not low as in not worthy, but compared to the other ones, it’s at the bottom… And that’s just simply bringing on a team member who has credibility, has the proven track record doing exactly what you are going to do, which means apartment syndications, but also implementing the investment strategy you’re doing. So if they’re a value-add investor, like Joe is, then whoever that team member is (I’ll mention who they are in a second), needs to have experience doing that.
And before I pass it back to you, Joe, the team members are either a property manager, which would be the highest level of alignment of interests; below that would be a consultant or a local owner, who again is active in the investment strategy that you’re following, and then directly below that would be the real estate broker who has experience selling or listing the exact type of property that you are working on.
Joe Fairless: Okay. So these would be team members that we would bring on just as “Hey, we have these team members who have decades of experience”, and they’re not in the deal, but they are working with us on the deal. Is that correct?
Theo Hicks: Correct.
Joe Fairless: That’s an important distinction, because we’ll get into other alignment of interests where they’re actually in the deal, not with us, versus just working on the deal. So in versus on is a very important distinction.
And what’s the crack in the foundation with this alignment, Theo?
Theo Hicks: Well, they don’t necessarily have any of their own skin in the game financially, that’s the biggest crack. Obviously, this is better than me having no experience, managing the property myself, being the broker and not having any consultant. So this is better than that, however it’s not the best, because as you mentioned, there’s a big crack, which is the lack of financial skin the game.
Joe Fairless: Yeah, because I’m gonna pretend that I’m just starting out, I’ve got my single-family homes, and I feel confident enough to bring in private investors; I’m confident enough, but I don’t have the experience… And then I go find an experienced property management company, I go find an experienced consultant, and I go find an experienced broker… And I go find the deal, and then my investor says “Oh, this deal looks pretty good, but you’ve never done this before”, and I say “But these people have”, and then the savvy investor says “But they don’t have any of their own money in the game. They don’t have any money in the deal. So yeah, they are experienced, but if the deal goes South, they’re not losing money, I am. You are.” “Oh, yeah, that’s a good point.”
So this can be beneficial, but as you mentioned, it’s the lowest level of checking the box from an alignment standpoint, because they don’t have their own money in the deal.
Theo Hicks: Exactly, which brings us to the next level up alignment of interest – you have your experienced team member, whether it be the property manager, the broker, and/or a consultant, and you offer them equity in the deal. So the reason why obviously this is better than just bringing them on is because they are incentivized to screen he deal properly, qualify the deal property and operate the deal efficiently, so that they themselves can make money… But as you kind of already mentioned, they don’t have their own money in the deal.
I know we talked about this on a couple of episodes before – the story about someone would much rather not lose money than to make money; I’m not sure exactly what the numbers were, but basically it is capital preservation and saving their own money that they have is more important than actually making money. In this case, they have the opportunity to make money, but their own capital isn’t necessarily at risk.
Joe Fairless: Yeah, as someone who had nothing, then became a multi-millionaire, and then went back down and maybe they lost everything in 2008, and then has nothing again, ask them what was harder – the first time when they didn’t have nothing and didn’t know what it felt like to be a multi-millionaire, or the second time when they were a multi-millionaire and then went back down again?
They’re gonna say the second go-around, going back down again, because they got a taste of the golden apple, they got a taste of what it was like to have a lot of money, and then they didn’t. And conceptually, that process or that concept holds true with a dollar. If you have a dollar and someone takes your dollar or you lose your dollar, misplace your dollar, you’re more disgruntled than you would be excited if someone just gave you a dollar.
And as far as the equity piece – this is a second level – when I interviewed Carlos Vaz, and I’ve mentioned his interview a couple times… If you search his name and Joe Fairless, you’ll get the interview, and I’m sure if you’re following on Facebook, then Grant will post a link to it… He found a deal, he didn’t have the money, so he researched local owners and he ended up giving a whole bunch of equity to a local owner who owned the apartment building next to the one he had under contract… He gave that local owner a whole bunch of equity. But, so what? Whatever you need to do to close the deal.
And from an investor conversation standpoint, it’s certainly helpful to show that others who have experience have equity in the deal; they may or may not say “Okay, they’ve got equity in the deal. Are they investing their own money in the deal?” If they do ask that, then you tell them “No, they don’t.” Or we’ll go into level 3, 4 and 5, and I’m sure they’ll be co-investing later in these additional levels… But if the group or person doesn’t not put their own money in the deal, but they have equity in the deal, it’s certainly better than if they are just working on the deal, because now they’re in it, but it’s still kind of weak… Because they have been gifted something, versus they already had it and now it’s theirs to lose.
Theo Hicks: Exactly, which brings us to level 3. So level 1 – you bring on someone experienced to work on the deal; level 2 is you offer that person equity. Level 3 is that that team member actually invests their own capital into the deal.
Joe Fairless: Yeah. When we were starting out (Ashcroft), we partnered on the first couple deals with a group, and they invested their own money in the deal, and they also did something else, which I won’t say, because you’re about to get to it, and then I’ll say it; it’s a different level. So I’ve done this before with our company, and it’s a great way to leverage the experience of others to get to where you wanna go, and then depending on the relationship and where you wanna take your business, maybe you continue that dynamic, or maybe you evolve and don’t continue it. We have not continued it, we don’t need to do partnerships like that anymore…
But to start out, you do what you need to do to get deals done, and certainly, if you can attract a quality team member, like a property management company, like a consultant or like a broker or someone, and they invest their own money in the deal, that is powerful; that is so powerful, because then you have a tremendous answer when an investor of yours who is looking at the deal says “Okay, you don’t have the experience… How can we know that this deal is really good?” You can say “Well, we did XYZ underwriting, blah-blah-blah”, but in addition to that “So and so (this property management group) manages X number of units in this area. And oh, by the way, they love this deal so much they’re putting their money in the deal.” That’s powerful.
Theo Hicks: Another kind of hybrid on this — because of course, if the person is putting in their own money into the deal they already have, a hybrid of this (let me know if you’ve seen someone do this) is have the broker put their commission into the deal. Is that something that people do?
Joe Fairless: Yeah, absolutely. I have on my very first deal – before we even formed Ashcroft, before I knew my business partner, I did that… The brokers put their own commission into the deal, $317,500, and they became equity (they have combined 80 years of experience) — are putting their commission into the deal because they like it so much.
Theo Hicks: I’ll side-track from this, but also the syndicator himself could put their acquisition fee into the deal. I know that’s kind of off this alignment of interest in regards to team members, but that’s another way to promote alignment of interest, as you yourself putting your own capital in the deal.
Joe Fairless: And one thing that happened on my very first deal, before we’ve formed Ashcroft and before I knew my business partner – with those brokers who put the $317,500 in the deal, they pulled a fast one on me and I wanna mention this, because it’s interesting, and it’s kind of real estate 2.0, and I was at real estate 1.0 education level at the time… They said they can put their own commission into the deal, which they did, but they formed an LLC, and then the LLC that had the equity ownership, they then sold ownership of that LLC to people they knew. So they actually got most of their money out by way of bringing their own investors into the deal.
Now, you might consider that additional alignment of interest, because now they’re bringing investors into the deal, and there’s an additional layer of accountability, or you might consider that less of alignment of interest if they’re shady people – which in this case they kind of were – if they do that, because now they’ve got their own money from the commission of the deal, and they simply pass it along to people who they talked to and they knew, and brought them into the deal.
So anything is not just surface level. We’ve gotta dig a little bit deeper. That’s just something to look out for. It could be a pro, it could be a con…
Theo Hicks: Exactly. And based on what you’ve just said, level four is they have their own investors invest in the deal. Something that I forgot to mention is that a lot of these are kind of like stacked on top of each other. So it could be and/or, because as you’ve mentioned, if they have their own investors investing in the deal, but they’re not, or if they invest in the deal and then kind of like sell those shares to other investors, it’s a little bit different than if they have their investors investing in the deal, they’re investing in the deal, they obviously have equity at that point, and then they are obviously working on the deal.
As you said, there’s nuances of this, and the way that this hierarchy works is that they’re stacked on top of each other. So it’s either this, and this, and this, and this… But yeah, so level four is they bring their own investors into the deal.
Joe Fairless: And that is what I was referencing when I said with Ashcroft when we started out earlier – we not only had our property management partner invest in the deal, but then they also brought their own investors into the deal, and that’s true alignment of interest. We’ve got the management company on board, they’ve got their own investors, and then they’ve got their own money in the deal. That’s pretty powerful; that’s whenever I said I won’t mention all of it, because we’re about to talk to it… That’s what I was referring to.
I have done this in our company, we don’t do it anymore. We just have a strictly third-party property management company that manages our deals. But when we got started – you do what you need to do. We brought 70% of the equity, but we only got 50% of the general partnership. Whatever. You do what you need to do to get the ball rolling, to get your own track record and continue to evolve.
Theo Hicks: Exactly. The last level – and I wanted to get your thoughts on this one, Joe, to see where this falls in the hierarchy… But it is having this team member sign on the loan. So they act as the loan guarantor in addition to a couple of these other duties. So where would you say that falls in this hierarchy of alignment of interests?
Joe Fairless: I’d say you got it at the right spot. You sign on the loan; that’s putting your balance sheet on the line. Even if it’s non-recourse, you’re saying that who you’re working with will not commit fraud or gross neglect… So you are certainly vouching for their character and their work ethic. So I’d say that’s up there.
Theo Hicks: And it hits on the losing the one dollar as well… Obviously, a lot more than one dollar in this case, but from that concept — it’s 100% on that, because if they’re investing their own money in the deal, then they can only lose that. If they’re signing on a loan, then they’re obviously liable for potentially more than what they initially invested in the deal in the first place.
Joe Fairless: Yeah. I mean, if it’s a personal guarantee… [laughs] That’s by far the highest degree of alignment of interest. If it’s recourse, where they’re doing a personal guarantee, then by far. If it’s non-recourse, then you’ve still got it, but it’s more of a safety there, as the person signing on the loan.
Theo Hicks: And for this specific way to have alignment of interests, this person is called a loan guarantor, and we have a blog post where we go over the different ways a GP makes money in the deal. I think it’s eight ways the general partnership makes money on the deal. In one of those eight ways we explain what the loan guarantor does. In this case, you’re gonna have to compensate them for their signing, so the blog post will also outline the industry range for how they are compensated… I just wanted to mention that, too.
Joe Fairless: Okay. So for people listening on Facebook, that’s easy, because Grant can put that link in the Facebook notes, but how can people who are not listening to us on Facebook right now get access to that article?
Theo Hicks: If you go to TheBestEverBlog.com, we’ve got our category for Passive Investors, and if you’re listening to it right now, it will be one of the top posts on there… But it is “How the General Partner makes money from an apartment syndication.” If you find a title that’s similar to that on the Passive Investing category on the blog, you will find that. One of the 8 ways is the guarantee fee.
Joe Fairless: Yeah, and just to be clear, not all 8 ways are implemented in a deal, it’s just 8 potential ways that the general partnership could make money, and then a general partner could mix and match those ways.
Theo Hicks: Exactly.
Joe Fairless: Sweet.
Theo Hicks: To summarize, level zero alignment of interest is just you yourself trying to do everything…
Joe Fairless: Good luck, buddy.
Theo Hicks: Yeah, good luck with that. [laughter] Level one would be bring on an experienced team member. The team member could be a property manager, which would bring the most alignment of interest. The next level below that would be a consultant or a local owner, who again is active in the specific investment strategy that you are implementing. Then below that would be a broker… In all three of those the same investment strategy that you’re implementing.
Then level two would be to offer that team member equity in the deal. Level three is when they first have their skin in the game, which is then investing their own money in the deal. That could be their commission, or that could just be company capital.
Level four would be the team member brings other investors onto the deal, so they have their own investors also investing in the deal… And as Joe mentioned, preferably they are investing their own money AND bringing on other investors, based off of your story with the broker on your first deal.
Then level five is having the team member actually sign the loan. Those are the five different ways to show alignment of interests with your passive investors.
Joe Fairless: Cool. Number five, have them guarantee the loan.
Theo Hicks: Exactly.
Joe Fairless: Sweet! Thank you for summarizing. I was going to ask you to summarize, or I was gonna try and summarize, so I appreciate that; that’s helpful for everyone, especially since we transcribe these episodes, and it will be nice and succinct for our Best Ever listeners whenever they read that transcription.
You can read all the transcriptions for all of our past episodes by going to — is it BestEverShow.com?
Theo Hicks: Yeah, BestEverShow.com
Joe Fairless: BestEverShow.com. That’s where all the episodes are. Cool!
Theo Hicks: Perfect. I think it’s been a very powerful conversation. A lot of these strategies — you’re the first I’ve ever heard of these, so they’re very specific to someone who wants to become an apartment syndicator, so I think this is gonna be a powerful episode for people.
Joe Fairless: And I’ve done them all. Now that we’ve done every — actually, time out. I haven’t done level two. I haven’t given someone equity for free. There’s always been a value exchange, other than just them bringing credibility. So I haven’t done that, but I’ve done all the others in our deals.
Theo Hicks: Maybe on my first deal obviously I’ll have to use this. I’ve definitely got my consultant right now, who’s looking at it right now…
Joe Fairless: Yeah, and if you wanna do level two with me, free equity, then that’s cool. That’s fine with me.
Theo Hicks: [laughs] There you go. Alright everyone, so just to wrap up, make sure you guys go check out the Best Ever Community on Facebook; you can go to BestEverCommunity.com. I think we’ve got about 1,000 active real estate entrepreneurs on the site, who are posting questions and lessons daily, and then people are commenting below there… But in specific for us, we post a question every single week, as you guys know, and if you guys leave a response to that…
Joe Fairless: Guys and girls.
Theo Hicks: Guys and girls, if you guys leave a response to that, then we will create a blog post and we will mention your response to the question. This week the question is “How important is it to have written goals for your real estate business?”
Joe Fairless: Hm… Is that a rhetorical question? I mean, come on… Is that really our question of the week? It’s important.
Theo Hicks: Usually what happens when we ask these questions is people will go and explain their process of setting goals; do they have a board, like you do in the back…? Things like that. So it will most likely be a blog post on the variety of ways to set goals.
For example, what I do is I’ve got a note card with the month, and then 3-5 things that I need to accomplish that month… So I’m looking at it every single day, so it’s kind of difficult to not accomplish those goals.
Joe Fairless: How do you document your goals, so that [unintelligible [00:23:41].16] That would be a good one. Yeah, it’s important to have goals.
Theo Hicks: Grant, are you listening? Go ahead and edit that [unintelligible [00:23:47].00] right now… [laughter] So yeah, make sure you guys go there, answer the question, and we will include you in the blog next week.
And then to wrap up, as always, please go on to the podcast on iTunes and leave a review for your opportunity to be the review of the week. I really enjoy reading these reviews, by the way.
Joe Fairless: I enjoy hearing them.
Theo Hicks: I always get excited in this part of the podcast.
Joe Fairless: You have a different voice whenever you do it, it’s like you’re doing a commercial, or something, a voice-over for a commercial. I enjoy that.
Theo Hicks: [laughs] This week we’ve got a review from NotInTheLoopOnGameDay. I’m not sure what that means, but…
Joe Fairless: That means that person doesn’t do sports.
Theo Hicks: Okay. [laughs] And the header was “Great, not too long.” They said:
“I really enjoy this one. BP (Bigger Pockets) is great also, but I feel like Joe nails the questions on his show, and his guests are forced to divulge the good, the bad and the ugly of real estate investing.
I like hearing the stories about the mistakes that the guests have made in the past, because all too often real estate investors fail to mention any of that on other shows. I can get two episodes in on my commute to work, and it usually gives me more than enough to chew on throughout the day.”
So lots of positive feedback on that one.
Joe Fairless: Yeah, well thank you for that feedback… I think that’s what it’s all about – identifying a thing or two that you can chew on for the rest of the day, that perhaps once you think about it longer should be implemented in your business, or shouldn’t be… I don’t know, it just depends; it’s a daily podcast, so there’s lots of ideas coming at you. That’s one of the main benefits that the podcast gives me personally – the exposure to different business models on a frequent basis, and I always learn something from every episode.
So thank you for that, and please, everyone continue to leave the reviews; it helps us continue to attract high-quality guests. Thanks again for spending some time with us. If you’re in apartment investing and looking to go larger, or if you’re a passive investor, I’m confident that this was a good use of your time. And if you’re not, then I’m sure you’ve picked something up along the way. We will talk to you tomorrow.