S.E.C. Real Estate Observer

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OPM and Safety First

There are three fundamental rules of capital formation planning when considering how to attract investors to any real estate venture. In other words, there are some “Golden Rules” for utilizing “OPM,” (other people’s money) to create value for yourself and your investors and, along the way, build your personal estate:

The first rule…and the most important is… SAFETY.

Safety starts with your ability to give the investor a business plan for a project that is so complete and so true that they are totally convinced and cannot say no. Here is the key to success:

• Tell your investors that you will match your work, talent, expertise and knowledge against their money.
• Make them confident of the success of the venture by contributing your share as subordinated to a priority return and a complete return of invested capital before you participate in cash flow and profits. Why should you care? You know what the project is going to do and you are totally committed to its success. You are motivated by profit and equity creation for everyone, including yourself.

The second rule is just as important…NEVER put any of an investor’s money into your pocket. That is the absolute worst thing you can do. Period. Think about this:

• Most developers/brokers want to have money to live on while they are doing the deal. Set yourself apart from the crowd and get it from somewhere else! Don’t use investor’s capital for anything other than directly investing in the project.
• Do not take one penny until your investors have been repaid all of their invested capital and a preferred return for the use of their capital during the ownership period.

Remember, you can only do this if you “know your deal.” Knowing your deal means you must have absolute, complete confidence in your decisions, your numbers, your instincts and your success. Anything less is unacceptable.

The third rule is to give your investors a… JACKPOT DATE…

Offer each investor a specific time frame within which they have the option to make a call on you to return their invested capital, their accrued preferred return (if any) and the current value of their proportionate share of the projects equity. In other words, give your investors a “Jackpot Date…”

A Jackpot Date essentially gives your investors a predetermined time that they call make a call on you and get out of the project. Here is an example of how it works.

You propose to your investors that after a minimum three-year holding period, each investor can call and demand to be bought out of the investment one year from the date of the call. You then have one year to refinance or find new partners and time to solve the challenge. Make sure you document carefully all the details as to how the value of the investor’s position is determined, how the ownership transfer is implemented, and how the call provision can be issued. Remember, trust but verify…in writing!

There are many formulas to “Fund your Vision” and attract both debt and equity capital to your project. The structure you chose will depend on your track record, financial strength, the risks/rewards scenarios of your project and the sophistication of you and your investors.

Here is a simple example of a key formula to use when seeking capital for your project.

Safety First with a Preferred Return

(1) The Deal:

• You create a “Business Plan” for a project that costs $500K to build, will make $75k/yr. NOI and be worth $750K upon completion and income stabilization.
• Your “Capital Formation Plan” assumes an equity investor provides $500K for 30 months.
• The project will be built for cash (no debt) and ready to rent within 5 months.
• As it leases, all rental income will be used to pay operating expenses and to establish operating reserves per your project business plan.
• The Equity Investor then receives all net income first as priority return, (plus accrued balance if any from the start of construction), second as return of capital.
• Once the building is complete and the rental income stabilized, you will get a 500K loan from the bank.
• You may get the loan in 1 year but no guarantees. Remember, you have the investor capital committed for 30 months.
• The equity investor will recieve 100% of his money back plus a “preferred return” of 10% while his money is invested and he will own 50% of a great project.
• You WILL NOT take one penny until after he has ALL his invested capital back, either from refinancing proceeds or from operations. Then you will share cash flow and profits.
• You will take a 50% interest in the project but subordinate your interest to his until he has received 100% of invested capital returned.

(2) The Result:

• For the use of his $500K, your investor has $125 K of the “created value” or equity and he gets $12,500/yr in net cash flow. (Actually a little less if the principal is being repaid through an amortization schedule).
• You end up with the $125K of the created value or equity for your work and 50% of all future cash flow and profits.
• After this first project performs, as you know it will, you do it again and again and again.

Remember, investment capital always finds good people with well-conceived and well-structured projects.

Editor’s Note: Phil Corso, S.E.C. teaches a two-day education program entitled “Broker Estate Building.” The program is based upon the original class created and taught by Colby Sandlian, S.E.C. and Cliff Weaver, S.E.C. in the 1970’s and ’80’s. Totally rewritten to reflect the realities of the real estate business today, the program is offered nationwide. For additional information, visit the S.E.C. Education Foundation web site: www.secedfoundation.com.