JF1417: How to Answer the Most Common Questions From Passive Investors (Part 2) #FollowAlongFriday with Joe and Theo
The guys are back for another edition of Follow Along Friday, continuing last week’s talk about common investor questions. A lot of great content in this episode, you’ll want to star, download, bookmark, or whatever else you do to keep track of the good ones! If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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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.
We’ve got Follow Along Friday, we’ve got Theo Hicks with us, as he usually is, and we’re gonna dive right into it. What have we got, Theo?
Theo Hicks: This is gonna be a continuation of last week’s episode, where we went over five common questions that are asked by passive investors before committing to investing with your company. This week’s gonna be part two, and we’ve got five more common questions; I’m gonna ask them, Joe’s gonna answer, and then we’re gonna have a little conversation about each one about how to approach it and what the investor is implying when they’re asking that question, and things like that.
Make sure you guys check out that first episode, “How to answer the most common questions from passive investors, Part I”, with the first five questions… And you have basically a running list of the questions they’re gonna ask. All of these are actually on our Passive Investor site, BestEverPassiveInvestor.com, but we’re gonna go into a little bit more detail here, just because we can only do so much in a couple paragraphs.
Are you ready to jump into these questions, Joe?
Joe Fairless: Absolutely. The episode that we did part one on was last Friday, so it’s seven days ago… Whatever the episode number is today, just subtract seven and you’ll find the other episode.
Theo Hicks: Perfect. So the first question, Joe, is “What happens if the project I’m investing in fails?”
Joe Fairless: Well, then it depends on what degree of failure the investment actually fails at. If it is Armageddon and the project loses all of your money, plus we do a capital call and you invested in that, and we lost more money, then you’ll lose both your initial investment plus your additional investment.
Now, that’s worst-case scenario. It’s important to note the structure of the agreement that you’ll be completing, so that you know the pecking order in which the funds will be distributed. If the project takes a downturn, then your preferred return, that is 8% – if we’re not able to pay that, that will accrue until the next pay period or next distribution period, which we do monthly, some groups do quarterly, annually, whatever… But we do monthly. So it would accrue until the next month, and it will continue to accrue until the sale of the property, if we’re not able to catch up through the cashflow.
So at the sale of the property, because you have 8% preferred return, you must receive 8% on your investment, plus your investment dollars back and everything that’s accrued, before the general partnership receives any profits from the sale.
Now, if there are no profits from the sale, and there is no money to be distributed, then you won’t receive any of that, because there’s no money… But because of the preferred return, you are ahead of the general partnership, not only to get an 8% annualized return, but also to receive your investment dollars back before the GP receive any profits.
Theo Hicks: That’s usually how it’s structured – the loan, and then above that is the investors, and then above that is you, the syndicator?
Joe Fairless: Well, you’re saying above that, but I think of it as below that… So first is the debt or the expenses for the property, because we’ve gotta pay our bills first off; second would be additional capital contributions that were made, and then third would be the investor preferred return and their investment dollars, and then fourth or fifth (depending how you look at it) is the general partnership share.
Theo Hicks: Okay, yeah. I know we talked a lot about — when you’re talking to investors, you wanna try to communicate alignment of interests, and that’s just one example of alignment of interest that they get paid before you get paid. So the syndicator wants to meet the return projections, to distribute those to their investors; if not, then they don’t get anything, at all.
Joe Fairless: And to clarify, when you say they don’t get anything at all, there’s an acquisition fee that the general partnership receives at closing, so the general partnership does get paid some at closing, and you can look at it in any number of ways how you wanna look at it – it’s reimbursement for their time, it’s compensation to put the deal together etc., however you look at it, but they do get paid at closing, assuming there’s an acquisition fee. However, after closing they don’t receive any funds — and again, it depends on how the operating agreement is structured; I’m just talking about our deals, because other people could structure it differently. For our deals, we won’t receive compensation unless we’ve been paying out the preferred return to our investors.
We actually put that in our legal documents, that we won’t receive the asset management fee unless the investors are on track to receive their preferred return… And that’s not typical to put in the legal documents.
It came from one of my early, early on investors, who invests with us from the very beginning… He said, “Well, why should you receive an asset management fee if something happens and you’re not paying our (my) preferred return?” I said, “Well, we wouldn’t do that…” He’s like, “Well, why don’t you put that in writing?” I’m like, “Alright, cool. We’ll put that in writing.”
We talked internally, among my team, and the consensus was it’s not typical to put in a legal document in our industry, but we did anyway, because it’s not like we would take an asset management fee if we’re not returning that preferred return.
Theo Hicks: Yeah, it’s interesting, because I was reading an investment offering the other day where the syndicators – I think it was one of their first deals, so they weren’t asking for asset management fee at all… And you kind of get the same point across by putting it in the position above (or below, however the terminology is) the preferred return, than you would just not having it at all, because… Their entire point is they don’t want you collecting money unless they get their money, so instead of just not collecting it at all, just say “Well, I won’t collect it until I paid you back” instead.
Joe Fairless: Put it in the second position.
Theo Hicks: Yeah. I think we answered that question pretty well… And we had another question on this list…
Joe Fairless: And one other thing to mention – it also makes sense for beginning syndicators not to have an asset management fee, or not to need it… I still would include it, just to make sure that you’re setting the expectations with your investors on how your fee structure will be. But as beginners or starting out, you won’t have as many team members helping you with the property. Most likely, it’s gonna be you and whoever else who’s putting the deal together, therefore I don’t think you’d have hired outside employees just for that project to do asset management, whereas once you get to have a larger portfolio, you must; for the sake of the projects, you must have new employees come on and help you out, otherwise your projects will slump due to lack of proper oversight.
Theo Hicks: Yeah, and I think that’d be a good thing to talk about in a future episode, kind of when you make that transition, and what you should do when you’re hiring someone. I’ll remember to make that a topic of a future episode.
Another question we had on our list was “What happens if you don’t make the projected cashflow?” and we’ve already kind of answered that… It accrues. The process will be written in the agreement, correct?
Joe Fairless: Yes, you betcha!
Theo Hicks: Okay. We have already answered what happens if you can’t [unintelligible [00:08:51].06] Another common question that might be asked is “What types of reserves are typically established with each property in order to shield investors from any potential capital calls?”
So you’ve mentioned the capital calls a few times, specifically in the worst-case scenario, so the question is kind of asking what types of things do you put in place in order to mitigate the risk or mitigate the chances of that actually happening?
Joe Fairless: You help with our underwriting… What do you think?
Theo Hicks: So number one, you wanna have an operating account fund upfront. So you wanna have a chunk of money in the beginning for paying things like upfront taxes or insurance, but also for the unexpected. If your capital expenditure budget is $3,000/unit, and then you get in there and it ends up being $5,000/unit, where are you gonna get that extra $2,000 from? Or if for some reason you didn’t do adequate due diligence and you realize that half the boilers are broken and you need to buy a bunch of new boilers, where is that money gonna come from?
So you need to essentially — not necessarily expect that to happen, but have the funds for the “just in case.” So that would be anywhere between 10%-15% of your actual renovation budget; that’s what we typically budget for that up front.
Then also you wanna have an ongoing fund, because if you have to use all that stuff upfront, you’re still stuck with something else potentially happening later on in the property. A standard in the industry is between $250 and $300/unit/year. So you figure out how many units there are, and then you multiply that by $250-$300, and that’s how much you should be saving every single year into your operating account fund.
So those are the two main ways that syndicators — when they’re underwriting a deal, the extra funds you wanna account for… So the operating account funding will be an upfront cost, so you have to raise additional capital for that, and then the ongoing $250-$300 – that’s something that’s gonna be looked at as an operating expense; we’ll look at that in the same way as maintenance and repair costs. You wanna make sure when you’re underwriting the deal that you’re accounting for that.
When I’m underwriting deals and looking at T-12’s, I’m not seeing many T-12’s actually have that in there… So when you’re looking at the T-12 and you see that it’s zero, don’t just assume that you’re gonna be doing zero as well. Make sure you input that in your underwriting. And even if you’re not really doing apartment syndication, you should be doing the same thing for any deals.
For example, for my four-units I wish I would have had an upfront operating account fund… And I guess if you’re not doing renovations like I was, then it can be like a flat number, just based off of your experience, or it can be a percentage of the purchase price (1%-3% of the purchase price)… Because I guess if you’re not doing renovations, I don’t want you to think “Oh, I don’t need one.” That’s when you probably need one the most.
So I wish I would have had an operating account fund for my smaller fourplexes, because of all the boiler issues I talked about. If I would have known up front to have 10k set aside for unexpected maintenance issues, then I would have had that in my underwriting and I would have been like “Alright, these are the returns I’m gonna get on this property”, instead of being surprised by it.
So on a smaller end it’s more of a surprise, and on a bigger end you might have to actually do a capital call, which you don’t wanna do.
Joe Fairless: Nailed it. Yup, I completely agree.
Theo Hicks: And as I mentioned when I asked the question, I’m assuming that they’re asking this question because they wanna know what are the ways to mitigate the chances of a capital call… Reserves is obviously one of those. Then if someone asks you what are the other things you’re doing to mitigate the chances of a capital call, what would you say?
Joe Fairless: Other ways to lower the chance of a capital call, or mitigate the risk? And by the way, we have never done a capital call. Well, that goes into the three immutable laws of real estate investing. Is that what you’re referring to, Theo?
Theo Hicks: Yeah.
Joe Fairless: Okay, got it. Smooth segue, my friend. [laughter] So basically, the question is — I never hear it phrased that way; I hear it phrased “We’re likely going to have a recession or some sort of correction… What are you all gonna do to mitigate the risk from this investment? Because that is likely coming.” And I agree, there is a likely correction coming, and I do not think it will be anywhere close to 2008… But that’s speculation, so let’s just stop speculating, let’s talk about how we’re structuring these deals so that we are mitigating the risk and setting ourselves up to be successful regardless of what the economy sends our way.
Theo Hicks: And before you answer the question, this is actually another question I had on the list today… So we’re moving on to the next question that Joe is gonna answer, and that is “What type of plan do you have in place for the investment if we happen to go into another recession?”
Joe Fairless: Yeah. So the three things that we do – and by the way, you can search “three immutable laws of real estate investing Joe Fairless” and you’ll get the blog post that we have on our blog, and you’ll be able to read all about that.
The three things are 1) we don’t buy for appreciation, we buy for cashflow. And when 2008 hit, we saw people lose money or lose property, and the reason why is one of these three reasons. One is they bought for appreciation, not cashflow… Because when you are cash-flowing on a property and the economy goes in the tank, and you are now underwater on your property, well, who cares, if you’re making money every month? It does not matter what the paper value is, it matters what the cashflow is, because it’s probable – I’m not gonna say likely – that the value will go right back to where it used to be, or very close to where it used to be, eventually… Who knows when, but eventually… But if you’re cash-flowing along the way, then it’s not mission-critical, because you’ve got money.
So one, all of our properties that we buy cash-flow from day one, and should a correction take place – or when it does – we will stop the renovations on those properties or slow them down, depending on what makes the most sense, and we’ll simply sit tight. We won’t cash-flow as much as we’d like, but we’ll still cash-flow, assuming that there aren’t many other variables in play.
Two is that we are buying the property, and when we buy the property we put the right financing on it. We put long-term debt on our properties. Now, there could be an exception where we do a bridge loan, but if we do a bridge loan, we’re gonna make sure that we have it for three years with at least a couple one-year extensions included, and we’re going to do something with that loan within 36 months, within those first three years.
And if we do have a bridge loan, and regardless if it’s a bridge loan or an agency like Freddie Mae/Fannie Mac, if it’s a floating loan, then we’ll buy a cap on that. That way we know what our worst-case scenario is from an interest rate standpoint, and we’ll underwrite to that with a sensitivity analysis and see what that looks like.
Usually, we have Fannie Mae/Freddie Mac debt on our properties, but sometimes properties just don’t qualify for it, because they are needing more of a repositioning than others. They still cash-flow, but they more of a repositioning than others, therefore we need to do the repositioning and then we’ll get Fannie Mae/Freddie Mac agency debt, which is more secure, more conservative debt, in my opinion, than bridge loans.
And then lastly, you already touched on this earlier… We have an adequate operating account with our property. So we’ll make sure we have the adequate cash reserves in our property – you already touched on exactly what we look at and how we approach that, so no need to go into it.
So those three things:
1) buy for cashflow,
2) conservative, long-term debt – that way we’re not forced to do something whenever the correction takes place; we can just sit on it. The problem is when we’re forced to do something at a bad time; then the music stops and we’re screwed… Whereas if we can just continue to hold onto the property, ride out the storm – that’s where the real estate investors who are in this for the long run and have long-term success thrive.
We’re actually gonna buy a whole lot more during the downturn, and I’m looking forward to a correction, because then there won’t be as much competition from people, from other groups who are currently competing with us, because maybe they have bridge loans that aren’t able to be extended, or maybe they’re buying massively distressed properties and they’re not cash-flowing, so they’re gonna be in a cash crunch… I don’t wish this upon anyone, but it’s the reality, it’s gonna happen.
Theo Hicks: You have less competition, but you also have potentially more supply opportunities, because of people that didn’t follow the three laws prior to the downturn; they’re gonna have to do something with their properties.
Joe Fairless: Yup.
Theo Hicks: On a kind of similar note – the only reason I’m bringing this up is because it’s still fresh in my mind… We wrote a blog post yesterday titled “How to become an award-winning five-star property syndicator.” It was based off an interview we did, and it’s talking about all the different ways that you can basically create and foster a community at your apartments. I’m not saying this is an extra rule, or anything like that, but when I was listening to it, I wanted to move into this guy’s apartment community because of all the events and just the different things that he was doing to get the residents engaged… And as a result, he’s got basically a five-star rating and a really high, upward 90% occupancy rate.
So if you read that blog post and pull a couple of his ideas from there and implement those at your property, and you foster community with the residents, then they’re not gonna wanna leave… And you’re gonna attract more people, and that’s something that could help in the sense that people aren’t gonna leave; if the downturn happens, you already have a really high occupancy rate, so a dip in occupancy rate for you is not gonna affect you as much as it will affect someone else.
But also, you’re gonna have the go-to apartment community in the local market that people are gonna wanna live in, and that has to have benefits if markets take the turn, over other apartment communities that are not necessarily doing that at all because of the extra marketing costs that takes.
I wanted to just mention that blog post that we had yesterday, and again, that’s “How to become an award-winning five star apartment syndicator.” Check that out and look at some of those strategies. I 100% plan on implementing that whenever I buy my first apartment community.
I was on their Facebook and I was looking at the videos that they had, and they had a bunch of people turn out for those things.
Joe Fairless: Only good things can come from creating a sense of community. Instead of waiting until you buy a larger apartment community, why don’t you implement something to a lesser degree with your 12-units?
Theo Hicks: Yeah, because they are all on the same block, they’re all next to each other… I could cook outside a barbecue and have some sort of raffle… Basically, since I’ve just raised the rents, I can afford it now… I haven’t had any maintenance issues for a while. Yeah, that’s something I’m gonna have a conversation with my property manager about… Doing something small, once we get all the new people in there, so everyone can meet each other.
Because yeah, if you know your neighbor, you’re also not gonna wanna leave either, unless they leave, too.
There are so many benefits of doing that; you’re not gonna see it affect your bottom line on the P&L, but it’s definitely there, it’s definitely happening.
Joe Fairless: A couple thoughts. One is that some pessimistic, or more practical Best Ever listeners are thinking “But what if all of your residents get together and then they start talking about what their rent is, and how there’s a discrepancy in the rents?” and that’s possible, because you’ve mentioned on this show that based on when they rented, and all that other stuff, some pay more, some pay less… So that’s a reality that will likely take place, in some form or fashion. But all roads lead back to the value that you’re providing for their living experience, and if you’re providing value and if you’re competitive with the market, then okay, that’s just based on when they signed the lease, or however you position it. That’s one thing.
Then the reason why I commented “Why wait?” is it reminds me of when Jim Rohn talked about how he recommends donating 10% of your profits to charity, and people are like “You know what? Yeah, whenever I make a million bucks, I definitely will” and he says “I’m not so sure about that. I’m not sure if you wait, when you’re making a million if you’ll then choose to donate $100,000.” It’s much easier when you’re making $100,000 to donate 10k, or 5k, or whatever it is, and then start conditioning yourself and your business and your mind to incorporate that in to what you’re doing, and then as you grow, you’ll be able to implement it on a larger scale.
But also, if it is true, which I believe that growing a sense of community within our apartment communities is a great way to increase profitability and make it a better living experience, then it’s possible that by doing it on your smaller 12-units, it will help you get to the larger one faster.
Theo Hicks: Yeah, good point. And the thing about it is that if you start implementing that strategy on your earlier deals, it’ll be easier to do it on the bigger deals, than if you’re saying “I’m gonna wait until I get my big deal to do it…”, kind of like “I’m gonna wait for my million dollars to donate my 100k.” So yeah, that’s a great point.
We’ve hit a lot of questions, we got a couple added bonus questions in there too, so that wraps up this section of questions that passive investors are going to ask you before investing in your deals, and how to answer them.
And again, these questions are also listed on the passive investing site, BestEverPassiveInvestor.com, and we will come back with part 3, either–
Joe Fairless: Part 3, huh? Rock and roll!
Theo Hicks: Yeah, part 3, next week. Maybe we’ll start doing three questions, just because we have a lot to say about these questions. I think five might be too many. So do you have any business updates or observations from this past week, Joe?
Joe Fairless: I’m starting to do some shorter episodes based on just things I’ve learned, that I’m coming across that particular day… So I have a computer in my home office where I do all these podcast interviews, and it’s a more formalized setup, and I have a separate laptop that I do all my work on, and stuff.
Well, I’m usually on my other laptop, my other work on and stuff laptop, and because of that, when I come across things that I’m like, “Oh, that’d be a good podcast episode, I should mention that”, I don’t do it, I haven’t done a good job of documenting it, and then transferring it over and sitting down and recording… So instead, I now have a separate microphone, a separate cord that goes into my laptop I’m usually on, and I’m able to just record something for 10-15 minutes, whatever it is, whatever makes sense for that… We’re gonna start having some of those episodes sprinkled into this show; I’ve done one of them already, and it’s something called “How overachievers can get the most out of a BLAH day”, like just a day where you’re feeling BLAH…
One thing that I’ve learned from that exercise, in addition to a coaching call I had with my business/life coach Trevor McGregor is I put together a list of 2018 second half things I will celebrate on December 31st, 2018. It’s a way to help rejuvenate me, because I needed a little bit of a kickstart, because I was just kind of in a funk, thus the whole episode on how to overcome BLAH days for overachievers… And I’m mentioning it because it will be helpful for any Best Ever listener who is needing a kickstart in the middle or any part of the year.
So if you’re listening to this episode and it’s not exactly in the middle of the year, then who cares, right? Just — this is my three-force plan, or this is my plan for the last quarter of the year… You get the point. But I separated it into seven categories. Those categories, real quick:
Those are the seven categories I have, and I have different outcomes for each of those seven categories that I will celebrate by the end of the year, because I will have accomplished these things. So Relationships – it’s magical moments with Colleen, and continue to help my family and friends reach their goals, continue to build relationships with investors and clients… Some of these aren’t quantifiable, so it’d be more subjective on if I achieve them or not, but at minimum it’s a reminder to myself. I’m posting it up on my wall to focus on these things. I didn’t tell you all of Relationships stuff, some of it is kind of personal.
Career things – author of The Best Apartment Syndication Book Ever. That will be published. Some other things that I’m doing for my career…
Finances – specific, quantifiable goals for finances. Health – same thing. Spirituality… Philanthropy – how much money I wanna give away this year to causes… So it’s fun to do that, it’s a kickstarter, but also at the bottom of those seven categories I have “Why do I want these things?” and I talk about providing safety and security for my family and for other people’s families, i.e. my clients and my investors, and then “What do I need to do to achieve these goals? Who do I need to show up as?” and I have a vision, daily consistent action, and keep building a network of loyal friends by helping them out. I know by doing those things I will achieve much larger goals.
So having this document is helpful for me, and I mention it because perhaps it could be helpful for any Best Ever listener who needs a bit of a jump-start to the middle of the year, or after the first quarter, or whenever you need that jump-start.
Theo Hicks: Did you put on there something that you’re gonna specifically do at the end of the December or at the beginning of the year to celebrate?
Joe Fairless: That’s a great addition; I did not put that, but that’s a good one. I like it.
Theo Hicks: Like maybe give yourself a nice Civilization, or something… [laughter]
Joe Fairless: And for Best Ever listeners, I do play one video game and it’s called Civilization; they don’t make it anymore. It’s on PlayStation 3, and it’s like you’re a civilization and you conquer the world…
Theo Hicks: I actually found it on PlayStation — I was playing with my buddies and I was scrolling through on a library and we found that Civilization game, and I’m like “Guys, we’re not playing this…” [laughter]
Joe Fairless: Educational and addicting, yes.
Theo Hicks: Awesome. Anyway, so that’s great advice; I’m gonna do that as well, this last quarter, or I guess this last third of the year. It’s a good strategy. I don’t know, I’m not sure what my reward will be. I’ll figure out something.
Joe Fairless: [laughs] You sound like you’re gonna give yourself a good one, though… You’re like, “I’m not sure what I’ll give myself, but it’ll be good.”
Theo Hicks: Yeah. Do you have anything else going on?
Joe Fairless: No, I think that’s it.
Theo Hicks: Awesome. So just to wrap up, we’re going back to having a blog post on the question of the week. We paused that, because I was out of the country for a few weeks… But make sure you guys go to BestEverCommunity.com; that’s our Facebook community where we have a bunch of active real estate professionals who are asking questions, posting contents… And then we post questions each week as well. We also do Shout-Out Saturdays where you can go on there and essentially plug anything that you wanna plug – your business, your podcast, whatever.
But we’re starting to do question of the week again, where we ask a question and you guys respond and then we write a blog post on it, including your name… This week’s question is “After you became interested in real estate, how long until you closed on your first deal?”
The idea of the question is to not just give us a number, but also tell a story as to why it took as long as it did or as short as it did? For example, when I first started my real estate investing, I reached out to an agent the next day and had a property under contract within three or four days after… And of course, it was a good thing in the sense that it got me into investing, but it was a bad thing in the sense that it was a struggle at first.
That’s how you should approach answering the questions. Don’t just say “12 months” or “three days”, but kind of tell the story behind it as well. So that’s at the BestEverCommunity.com.
Then lastly, guys and girls, make sure you subscribe to the podcast on iTunes and leave a review. It helps us out a lot to know what we’re doing well and what we need to improve upon, and it also helps more people leave reviews when they see the reviews on there, and it brings more people to listen to the podcast, and we can add more value.
This week’s is from Eurythmitic (I think is what it is), and they said “Awesome insights from investing experts”, and their review is:
“Just discovered this podcast and I already highly recommend it. It’s like having direct access to successful investing experts. Joe asks all the right questions to get the most useful, eye-opening insights. I listen during my commute to work. It is like car-pooling with the best minds in the business, who just share their wisdom and learning for the whole trip.
Please keep it coming so I can learn everything I need to quit my job.”
Joe Fairless: Alright, I will keep it coming, and I appreciate those compliments, and we’ll just keep making it happen. And for any Best Ever listeners who have yet to do a review, please do a review. That will help us continue to keep it coming and get high-quality guests to the show, which will help you do better deals and make more money.
So thanks again for hanging out with us, thanks Theo for hanging out with me, and thanks to Grant for doing the social media stuff while we’re having our conversation, and then the whole team… Thank you, and we will talk to you tomorrow.