S.E.C. Real Estate Observer

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In many, perhaps even the majority of syndicated partnerships; the cash investor receives a priority return at a nominal rate, plus a share of the profits. Phil Corso, S.E.C, nicely illustrates an example of this financial arrangement in another article in the issue, “Capital Formation Planning – OPM and Safety First.” In Mr. Corso’s article, the cash investor earns a 10% per annum return plus 50% of the profits.

That arrangement seems to work well for longer-term real estate investments with more traditional rates of return. However, what is the value of capital in relatively short-term investments with very high rates of return? We have a little different perspective that we offer here for your consideration.

It is true that investment capital plays an important role in any real estate investment. However, cash alone does not automatically lead to a highly profitable investment. That is clearly evidenced by the trillions of dollars now sitting in banks earning minuscule rates of return. In real estate investments, it is the responsibility of the real estate entrepreneur to create an impressive profit. It is the entrepreneur’s experience, vision, creativity, and management skills that are the key factors in creating a high-yield real estate investment. It is never capital acting alone that generates high profits.

G5 Enterprises, Inc. (G5) has a non-traditional philosophy about profit sharing with our investors. G5 syndicates real estate investments that have a relative short duration, typically twelve to twenty-four months. Because of the higher yields available in certain types of investments, we have focused on new construction and condominium conversions. These types of projects are a much more active, hands-on type of activity. The reality is that these projects are often more “job” than “investment.” The reward for this extra effort is that it is not unusual to earn a rate of return in excess of 100% per year on the total capital invested.

It is our policy that capital contributions are to be generously rewarded on a “safety first” basis. Just as in the example in Mr. Corso’s article, G5 does not take front-end fees or brokerage commissions upon acquisition, nor do we charge an annual asset management fee. All, and I mean all, of the G5’s compensation is dependent upon our ability to perform at a level that provides the cash investor with the stated priority rate of return, as well as the return of all of their capital, before the G5 receives any profit.

Here is an important point and where we differ from the more traditional thinking about profit sharing. It is our belief that all profits in excess of 18% per annum are logically attributed solely to the efforts of entrepreneur, rather than to the availability of the invested cash. Therefore, once the investors have been paid in full, all of the then remaining profits are to be distributed to the entrepreneur. In simple terms; before G5 earns a dime, the cash investors get 18% per year plus the return of their entire investment. However, after paying the investors, G5 gets 100% of the remaining profits.

How did we arrive at the number of 18% per annum? Our reasoning went like this. We asked ourselves, “What are private lenders earning on their loans in today’s market?” The answer at the time we did our analysis was 12% to 14% per annum. So, one avenue we considered was to borrow capital from private lenders and pay 12% to 14%. However, private lenders require some owner’s equity in the project and, for our initial projects, we were looking for nearly all of the capital to come from other sources. Therefore, since the cash investors are funding all of the required capital, we reasoned that we should offer more than the 12% to 14% offered by private lenders. “How about 18% per annum? That is considerably greater than the 1% to 2% they are earning in the Bank, and a whole lot better than losing money in the stock market. It should be easy to attract passive investors at 18%.” “OK, then, let’s go with 18%.”

“What about the cash investor’s security?” “Well, let’s make the cash investors the sole owners of the property. That will provide the best security.” The form of ownership that we chose to accomplish that objective is a Limited Liability Company (LLC). In our LLCs, the cash investors are the sole owners. G5 and its principals have ownership only to the extent of their cash investment in the LLC. In each LLC, G5 serves as the Manager of the LLC. The LLC Operating Agreement is the contract that defines, among other items, the manner in which the profits are divided.
If the proceeds were to yield, say, 10% to 18% per annum on capital invested, then the cash investors would receive all of the profit, leaving nothing to be distributed to the Manager. If the proceeds were to yield, say, 20% to 25% per annum on capital invested, then the cash investors would receive the great majority of the profit, leaving only a modest profit to be distributed to the Manager.
However, if the profit is sufficient to yield an annual return that is well above 18% per annum, such as 100% per annum, then the Manager will be appropriately rewarded for the entrepreneurial efforts in earning the higher profit. We design our projects to yield at least 100% per annum on total cash invested.

One of the advantages to the G5 profit sharing structure is that it incorporates an inherent method of buying out the cash investors. Once the investors are paid in full through cash flow, from proceeds from refinance, or from sale proceeds of less than all of the assets, the cash investors have no further participation in the investment. At that point, the Manager owns all of the future cash flow and profits. Once the investors are paid in full, we have a provision in the Operating Agreement that automatically transfers all shares to the Manager at the end of the year in which the investors are paid off. That gives us the ability to terminate the LLC or extend the life of the LLC should we decide to maintain the LLC for liability protection.

Another advantage in this arrangement is that it eliminates any question, confusion, or debate on how “profit” is defined. Sometimes, when an agreement includes profit sharing, a dispute may develop about what items should be included as income and expenses in calculating profit. Only a very carefully thought out and detailed definition of “profit” will eliminate such disputes. In contrast, in the G5 arrangement, anyone can easily calculate the amount required to pay off the investors. It is simply the cash invested times the rate of return multiplied by the time. In the G5 structure, the concern about defining “profit” does not even come into play.

At this writing, G5 is wrapping up a condo conversion project for which we expected to earn $700,000 after paying the investors 18% per year on their $1,000,000 investment. Because of a red-hot market, we sold out in 21 days rather than the 90 to 120 days we originally projected. Early into the project, we changed our target market from entry-level buyers to mid-level buyers by deciding to upgrade interior improvements to include, among other amenities, new cabinets and granite countertops that were not originally planned. That decision, combined with phased releases at increasing prices, and a strong seller’s market, allowed us to increase the total sales prices dramatically over our original appraisal for the completed project. We are closing out in nine months rather than a year. Because of the higher profits and the shorter term, we will voluntarily pay the investors for a full year, rather than for just nine months. This decision will increase their annual rate of return. Because of the price increases, reduced marketing costs, and reduced holding costs, after paying the investors in full, the G5 profit will be $3,000,000 rather than the anticipated $700,000.

Had we structured a profit sharing arrangement, say, for example, as outlined in the Corso article, we would be paying the investors $1,627,500 in nine months on a $1,000,000 investment. Likewise, G5 would receive $1,552,500 instead of $3,000,000. For the investors, a 217% per annum rate of return would have been sensational. However, that rate of return would create unrealistic expectations from the investors for future projects. Instead, for their nine-month investment, we are paying $180,000 on their $1,000,000. That is a 24% per annum rate of return.

In summary, we believe that investment capital deserves a high rate of return and should receive priority over other distributions, but it is the entrepreneur who creates dramatic profits. Capital is only a tool. In fact, when you think about it, the Bank furnished 80% of the capital for this condo conversion project at 6% per annum and no one expects us to share our profits with the Bank!