We didn’t want to write the post. But. This is going to be geared towards the real estate fanatics. As many people have noted, rich people practically *always* own real estate. Naturally, we also own real estate. We just don’t do it like most people.
Outline: 1) Overview of Private Equity Real Estate Transactions; 2) How to Spot a Good Value; 3) How Does it Actually Work?; 4) Rentals: Short-term, Long-term, Fees and Why We’re Against Hotels; 5) S-Corp and Exit Strategy
1) Overview of Private Equity Real Estate Transactions
Many people don’t know what Private Equity is, but our readers are elitist so they definitely know. Private Equity is simply the act of buying poorly run or broken down assets and fixing them. No need to complicate the definition. If you want to add additional detail, the goal is to eventually sell the asset or take the company public (if we were doing this with a poorly run company with operational issues).
Reiteration. Since we are talking about Real Estate in this case, your goal is to find a broken down building, fix it, and sell it for a profit.
Structuring the Deal: There are only two real parties in the transaction: 1) Private Equity Firm and 2) the Investors. We don’t like complicating definitions or using finance lingo such as “consortium” so this keeps it clear and simple. You are either working for the private equity firm or you are an investor.
Investor: The investor supplies practically all of the cash for the deal. To keep things simple we’ll assume 100% of cash comes from investors. In return, the investors receive a *preferred* dividend. This means the investor is paid a dividend of ~6-10% (annually) paid out on a monthly, quarterly or semi-annual basis (after the ~1-2% of operating expenses are taken care of). What does this mean? If the Private Equity firm is not able to generate returns *above* the preferred dividend… They will make ZERO dollars in the form of dividends. In addition, when the real estate asset is sold, the investors will receive between ~40-60% of the upside in valuation. (Note: the two and twenty rule is for companies, not true for real estate… Yes there are always “exceptions”)
Private Equity Firm: The firm takes on the headache. The Private Equity firm is not using their own money so they take care of everything. They 1) spot the undervalued asset, 2) hire the right people to fix the asset, 3) manage the property and 4) participate in *upside* only. If the asset produces a yield or cap-rate that exceeds the preferred dividend… That is money in their pocket. Also. If they are able to sell the asset at a higher valuation than the total investment (they better!) then they receive a handsome return.
Return Profile: The same return profile applies. You generally want to see a ~20% return on a year-over-year basis. If you can clip 20% returns then both the investor and Private Equity firm will make a grip of money. The real estate asset should be sold roughly 3-5 years down the line. So. You’re trying to double your money in about 4 years.
Concluding Remarks: That is an extremely basic overview. But. Now you know how the transaction works. 1) Investors receive preferred returns and are “hands off” on the process, 2) The Private Equity firm generally participates in the *upside* only, 3) You’re looking for 20% annualized returns – as we have stated before rich people don’t own a ton of bonds and 4) you are doing this with straight cash because equity is the highest form of leverage while regular people take out debt for their 30 year mortgage @ 4%.
2) How to Spot a Good Value
We always come to the same conclusion. Do the opposite. Or more clearly:
“Crisis is just a another word for opportunity” – @WallStreetPlayboys
Back in 2009 when the housing market crashed, practically everything was a screaming buy. You could have bought housing assets in *practically* any major metropolitan area and made a huge return over the next 5 years. When everyone is selling because there is a [insert name] crisis, you know it is time to do some due diligence. Wait for regular people to start purchasing, see them lose money over 6 months, then buy when they think they made a “mistake” and are back to selling.
High End: No surprise here. If you’re going to go through with a Private Equity transaction, you need to do this in a place where money is sloshing around like white water rapids. This means… Luxury only. While you can certainly make money by going through the headaches of renting to Low Income Housing tenants… You shouldn’t. It just isn’t worth it. Dealing with these groups is just not worth the time.
Multiple Sector Exposure: Choose a city that is exposed to many different economies. New York City is a great example and has many major economies: finance, fashion, entertainment etc. Even if one of these sectors is slow to recover… Others will certainly come back to life. You do not want to be exposed to a large city with *only* one economy. If that sector is down for 5-7 years, you’re going to be in a world of hurt from a cash flow perspective and your returns will nose dive. Valuations for the actual asset will also drop off a cliff.
Minimal Foreclosures: While many will say that the best value will come in areas that had a high foreclosure rate, we’d look for cities with a *low* foreclosure rate. Why? It means that most of the people living in that area are actually well off. During the housing crisis the best metropolitan areas saw housing prices decline but not fall off a cliff. In addition, the foreclosure rate was relatively low. This means that rich people are going to stay in this particular location. A net positive and should be looked into.
Education: Everyone and their mom is trying to become an entrepreneur. But. At the end of the day *top-tier* colleges will be in demand. Parents want their kids to go to great schools and top tier schools offer decent careers that pay $150K+ out of college. Want an example? Just go to Boston. We realize mentioning both NYC and Boston in the same post is a hate crime to baseball fans, however, Boston has a fantastic college system. Even if you purchased at the peak of the housing market in 2006, you’re likely up ~20% today.
Poor Rent vs. Buy Math: Finally, if you really want to get leverage out of the model you want to search for areas that have low yields. This may sound contradictory but is not. If people cannot afford housing in the area, they are going to be forced to rent. This hurts in the *short-term* but you will make up for this huge on a long-term horizon. Simple math below:
If Cap Rate is generally 10%: This means a $1M income building is worth $10M
If Cap rate is generally 5%: This means a $1M income building is worth $20M
You want to slowly raise the rent over time and the *multiple* on the asset is going to carry the valuation of the building. This is where the value is. Don’t play the game for the short-term, it hardly ever works.
Concluding Remarks: We’re not going to give away the exact cities we’re talking about in the USA. If you work in private equity or in real estate you have an idea of what cities were ripe for real estate transactions in the past and which ones are starting to look good today. That said the key points are 1) rent to high end, 2) invest in cities with multiple “sub-economies”, 3) don’t buy in areas with extremely high foreclosure rates, 4) Education can help cities return to growth and 5) play the long-game and play the upside to the actual valuation rather than the yield.
3) How Does It Actually Work?
So you’ve taken a look and have a list of cities you’re targeting. Lets get started.
Minimum Investment: For Real Estate Private Equity you need about $1 million to invest through a firm. This will allow you to be exposed to many options and you will develop a long-term relationship (assuming its profitable of course! No one hates someone who makes them money!). Now, if you’re unwilling to put up $1 million, you can get into specific investments for around $100K if you’re friends with the firm or are looking at a single asset.
(Note: We are sure there are many exceptions to the rules, there always are, but generally $1 million for a Private Equity investment is standard and $100K would be normal for a single specific outlay. $50K is usually the minimum for higher risk private investments in *companies*)
Informational Memorandum: There are many phrases for this “Confidential Information Memorandum” (CIM), “Confidential Memorandum” (CM), “Information Memorandum” (IM). We’re choosing the latter since it is the most clear. You will receive a package with the short sales pitch for the investment you’re looking at. Within the document you will find the following:
Returns: How investors will be paid and how the Private Equity firm will be paid. Preferred dividends (usually 6-10% for investors), Equity upside (usually 40-60% of the upside for investors) and expected time horizon of exit (usually 3-5 years).
Pitch: The actual memorandum is much more thorough but we like to cut straight to it: 1) who the target market is, 2) why they believe the rates will be X% – expected occupancy, 3) city overview, 4) location specific overview, 5) investment minimums and 6) Base case and upside case – (it’s a pitch so they rarely show the downside!)
Facade and Design: Once they give you the quick overview, they will also provide photos/sketches of the expected architecture, number of units and expected yield of each apartment (again we are focusing on buildings). A good example of a sketch is below (no this is not the building we own, we’re not *that* dumb):
Contacts: You’re probably wondering why you don’t just do it all yourself! The answer of course is scale and contacts. The Private Equity firm will have deep relationships with construction companies, architects, designers etc. They will procure materials at much lower rates than an individual and will likely get the job done in a much shorter time frame as well. The Private Equity firm will also allow you to contact individuals you wish to speak to (Ie: provide emails and phone numbers for architects, designers etc.)
Gathering Up the Dollars: Once you are ready to sign the dotted line you place your deposit. This is usually 5-10% of your contribution to the project which waits in escrow (or held straight at the Private Equity Firm). It shouldn’t take more than a month or two to fully fund the project and once it is done you the rest of your cash is released and the project begins. ~6 months later you should be practically done and ready to go.
Concluding Remarks: Once you’ve decided to take the plunge you gather your list of private equity firms and 1) calculate the amount you’re willing to invest, 2) comb through IMs, 3) Dot all your I’s and cross all your T’s for which project you wish to participate in and 4) Make your initial deposit. Note: This is written from the view of an investor. For a Private Equity firm you’re calling and sourcing funds through your client list (new and old).
4) Rentals: Short-term, Long-term, Fees and Why We’re Against Hotels
Now that we’re through the high level items, it is going to get even *more* opinionated at this point. We’ll outline what we believe to be good and bad investment choices for short term and long-term rentals.
Short-Term: Calling all tourists. Repeat. Calling all tourists. This is the best time to invest in short-term rental buildings. If you have a building in the center of town in a tourist destination hot spot you should turn it into a short term rental. Many people will assume the occupancy rate will be in the 60-70% range but because of the location you should exceed this mark. Materially.
The best part about a tourist hotspot is simple: Emotional Decisions = Expensive decisions. People are going on vacation so they have an “I deserve the best!” attitude. This is going to line your pockets.
There is no need to “price gauge” anyone. You’ll find that the best location in the best part of town from a tourist perspective is going to be highly overpriced. It doesn’t matter. If everyone is renting at $X/day and you’re renting at $X/day +/- 5%…. Who cares. You’re simply giving market prices for the best area.
Lets reiterate. Emotional Decisions = Expensive Decisions. This is the main takeaway from motivational speakers who make good money catering to losers and morons.
Long-term: Education, Families and Frugality. That is your bread and butter. If you are going to go for a larger complex (mainly 2+ bedroom apartments) then you’re likely better off targeting families and areas with great education. They should be *close* to metropolitan areas… this will drag in the right crowd.
What type of person cares about their child’s education? What type of person is going to be financially responsible and watch his cash flow like a hawk? You guessed it. Responsible risk averse families.
They will make great tenants and in this case you can actually bring *down* your rent a tad. They are going to jump all over the value of the rental unit! They don’t realize that you both win in this case. You’re giving them a slight discount to market rent for the 1-2 year lease agreement, but at the same time… They are good tenants! A good tenant is a huge positive and will keep your occupancy rate well into the 80 percentile.
Say No to Hotels: This is simply a belief. Hotels will be of value for corporations so we’re not saying you cannot make money off of them (Hat Tip: Donald Trump).
Instead. We believe that we’re entering into a sharing economy. As more and more people begin utilizing sharing and connected applications such as Uber, Twitter and Air BNB… The demand for rental apartments should increase. This is both on a short and long-term basis since the millennial generation in particular is all about freedom.
Concluding Remarks: Short and sweet here: 1) target short-term rentals in tourist destinations, 2) long-term rentals should be targeted towards responsible families, 3) we believe sharing will continue to grow in the future and 4) Emotional decisions = Expensive Decisions… utilize that decision for *your benefit*
5) S-Corp and Exit Strategy
Ahh yes. The golden part of the post and the part where we can quickly weed out the scammers from the legit winners.
S-Corp Wins: When you start making real money off of a *REAL* Business (not $200K a year or some BS you can make at 26 years old as an investment banker). You will set up your entity as an S-Corp.
To avoid going into details we’re literally going to copy paste the basic explanation from Wikipedia:
“S corporations are ordinary business corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. The S corporation rules are contained in Subchapter S of Chapter 1 of the Internal Revenue Code (sections 1361 through 1379). S status combines the legal environment of C corporations with U.S. federal income taxation similar to that of partnerships.
Like a C corporation, an S corporation is generally a corporation under the law of the state in which the entity is organized. However, with modern incorporation statutes making the establishment of a corporation relatively easy, firms that might traditionally have been run as partnerships or sole proprietorships are often run as corporations with a small number of shareholders in order to take advantage of the beneficial features of the corporate form; this is particularly true of firms established prior to the advent of the modern limited liability company. Therefore, taxation of S corporations resembles that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made. Thus, income is taxed at the shareholder level and not at the corporate level. Payments to S shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were previously taxed.
Unlike a C corporation, an S corporation is not eligible for a dividends received deduction.
Unlike a C corporation, an S corporation is not subject to the 10 percent of taxable income limitation applicable to charitable contribution deductions.”
We have emphasized the important parts of the overview. You’re smart enough to read between the lines and pay significantly less taxes once you understand what all of the bolded items mean.
Exit Strategy: Rolodex, Rolodex, Rolodex. Easy play on words. If you have a solid rolodex you’ll be rolling in money once it is time to sell. At the end of the day, real estate assets are cash flow kings. Rich people primarily own stocks, real estate and cash (minimal bond exposure).
If this is your “first rodeo”, from an investor perspective, you’re going to thank your lucky stars that you are working with a solid Private Equity firm. They simply display the last three years of cash flow net of expenses and should be able to sell at the current cap rate based on a trailing twelve month basis (TTM).
Concluding Remarks: We’re at the end of the post. The key actionable steps again are 1) set up an S-Corp and 2) have a thick rolodex come exit time.
Normally, at this point we outline key bullet points to write down. Unfortunately this post was extremely detailed and nitty gritty so the main “bullets” are going to be different for everyone. Unlike other posts, if you have an interest in this type of transaction you should probably read every single section. Don’t be afraid to go against the grain, we are simply stating how we think about things.
One thing is for sure. If someone is rich… They should always be able to make a *Real Estate-Ment*… If you don’t get that triple entendre please leave =)