“Great things in business are never done by one person.  They’re done by a team of people.” - Steve Jobs

Just the other day, we were talking to one of our colleagues about scaling his business.  He was discussing his current struggles with his workload and has placed hiring as a top priority.  

Given our love for that kind of stuff we offered some very brief (and basic) advice to him: “Remember, it’s not WHAT [you hire], it’s WHO.”

Which brings us to our topic today.  The recent conversation inspired us to write about our approach on building a real estate team, an extremely important area.  And we’re not just talking about hiring internally.  We’re talking about collaborating with individuals and businesses that will help us succeed with our investments and day-to-day operations; both internal and external. After all, this business is without a doubt a team sport, and this topic is critically important to making a significant impact and reaching meaningful goals.

None of this is rocket science, but a methodical process paired with thoughtfulness and craft is the recipe we employ towards this end of strengthening our team

So where do we start?

Building the Base: The Extended Team and Identifying Needs

To kick things off, it’s important to know what it takes to build a fully functional multifamily real estate investment operation. 

Just like any industry, it’s recommended to cover all core verticals of the business: Operations, Sales & Marketing, Finance, Technology, and Production.  

Production, for illustrative purposes in this case, is a broadly used term to define the department that is core to the existence of any product or service offered by a business.  For us, our production team is our investment team.  At a very basic level, CF Capital “produces” a (financial) service of managed multifamily real estate investments and offers it to a broad marketplace of qualified accredited and sophisticated investors.  

From these verticals we can break things down further into key areas of responsibility:

Finance

• Sourcing and managing the debt leveraged to acquire a real estate property 

• Overseeing and managing all company funding and finances

• Managing the books through accounting methods and principles

Operations

• Dealing with legal matters and compliance 

• Improving, maintaining, and securing the asset and the company’s entities

• Interfacing with technology providers and vendors

• Implementing and maintaining checklists and standard operating procedures

Sales & Marketing

• Marketing investment opportunities to the investor market (i.e. business development or fundraising)

• Contributing to the efforts of tenant occupancy levels, as well as managing the (potentially new) brand and the sub-market’s overall awareness 

• Leading education based marketing efforts through mediums such as email, social media, website, blogs, podcasts, video series, print materials, meetups, etc.

Technology

• Implementing systems (hardware and software) to improve and streamline operations of a real estate property

• Leveraging technology to optimize our (CF Capital, the investment manager) business’ efficiency

Production

• Managing an entire business that revolves around investment partners on all sides of the multifamily real estate investing company (tying things together with the investment management service offered)

• Operating and (strategically) executing a the requirements for an effective investment department

Now that we have identified the key responsibility areas, it is time for the reality check.

First things first, know what you cannot do in terms of capacity, and know what you are not best suited to do, based on your talent, disposition, and interest level.  Also, right in the middle of the spectrum, one should address the areas where experts with a specialty or focus would probably do better.  To paint the picture, and not go overboard with the details, we have provided examples of the personnel needed for three business verticals -- finance, operations, and sales & marketing.

In the finance department, a real estate investment management company will need a:

1. Lender: This is self-explanatory -- the lender is the party that provides the financing, typically in the form of a pure loan (i.e. debt).  A lender may be a government-sponsored enterprise (“GSE”), an international or national bank, or a third party lender.  A third-party lender would most likely be utilized if the normal GSE or bank qualifications are not met (see our post on Financing Secrets for additional information) for the purposes of a temporary bridge loan, and the source of third-party loan may be an individual or a group of individuals, but most often the loan would come from some sort of a financial services firm.

2. CPA/Accountant: This may or may not be a part of the property management team

3. Insurance Broker: This party proposes and connects you with the proper insurance to cover your property investment.

4. Investments: This can be done internally with outsourced extensions as needed (e.g. for due diligence or quantitative purposes).

5. Broker: A partner (new or existing) that manages a real estate property sale and is often involved in the sourcing of new property investments.

6. Title & Escrow Company: This is the party that takes care of the formalities dealing with the sale process and owning the property.  In this case it would be the verification and transferring of title, as well as holding of the cash in escrow during the signing/sale process. 

For operations, the following are the main parties (note, there is some personnel overlap with the finance department):

1. Property Manager:  The property manager and it’s extended team members run the day to day operations of the property and assist us with implementing our overall business plan..

2. Attorney:  The attorney is involved with everything from the sale and purchase to the regular legal dealings of managing a property investment. 

3. General Contractor:  A general contractor is an excellent party to “take care of business,” especially with any renovations or enhancements to the property.

4. Investments:  The investment team must also coordinate with the on-the-ground operations teams (e.g. property manager) to make sure the investment is executed according to the business plan.

5. Photographer:  Although a seemingly more “minor” role, the photographer is used for a number of things: from the due diligence process before the sale, to the ongoing marketing and advertising of the property.

As with the operations department, the sales & marketing department will have some overlap with the other departments in terms of personnel:

1. Property Manager: The property manager’s team or the team that is hired to be on-site (e.g. superintendent, leasing office staff, etc.) often can run the marketing and advertising process sufficiently to maintain/expand occupancy levels.

2. Marketing/Advertising Team:  This can be in-house or a third-party marketing agency to aid in anything from a rebrand to general market presence (e.g. digital advertising).

3. Photographer: A critical individual for the sales & marketing department.  Prospective tenants need to be able to see pictures, right?

4. Network (as a team member): We always see our network is always a team member.   Whether it is a simple phone call or via social media, the network always seems to help us in one way or another. 

Remember, it’s WHO

Although we may have our checklists, it really is about who we hire, not what we hire (or even how we can tell them to do their role).  We’ve found this is the best way to achieve our goals.

Sometimes it’s best to put it in a metaphor: “We want everyone rowing to the same cadence in the same direction.”  At CF Capital we strive for excellence.  Naturally, we want to team up with the best out there… the “best in class.” When we find smart, committed people, we ask them to tell us “how” to best accomplish our goals, and we get out of the way so they can bring us there.

We typically look for thoughtful people who default towards taking initiative, and individuals with a temperament that aligns with ours, but have complementary interests or abilities.  Because after all, we will be spending long, sometimes challenging hours “in the trenches” together at some point.  Lastly, we seek out a little bit of dreamer in our partners to bring an ambitious craft to the table. Ambition is the core to our firm’s identity, and to align with us you’ve got to have big dreams for yourself as well, and simultaneously be humble enough to work towards creating something much larger than yourself. 

Closing Thoughts

The combination of art and science in tailoring, structuring, and executing on the team building front is entirely dependent on the needs and goals of a real estate investment operation (or business).  Despite the case by case adjustments, at CF Capital, we are relentless in putting together an unified team effort to achieve greatness.

“If everyone is moving forward together, then success takes care of itself.” - Henry Ford

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Interested in partnering with us? Join our investors list here. 

"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." -Ben Graham

“I see all these return metrics on your presentation. There’s ERM… there’s CoC… there’s AAR… and there’s this IRR metric.  Can you give me a refresher?  What do all of these return metrics mean, again?”  One of our potential partners asked me this the other day.   

Let me first say that we are extremely thankful for our engaged audience.  As you may have noticed, many of our recent posts were inspired by the incredible dialogues we have with “our tribe.”  This is not intentional, but we do want to cover topics that matter on top of the topics that WE THINK matter.

We believe it is absolutely critical for our audience to understand the fundamental building blocks of real estate investing in order to fully comprehend areas of greater complexity.  With our blog, we aim to cover it all.  This blog series is YOUR RESOURCE.

Going back to the question.  After thinking about it, we thought it would be helpful to provide our audience with insightful details on the return metrics we use in real estate.  After the “essentials” are covered, we will dive deeper into one of those metrics.  

The first in a series of blog posts related to investment performance measurement is internal rate of return, also known as IRR.

So let’s get started with the broader overview.

The “Essentials”

There are quite a few performance metrics in the investment industry, but to keep things simple, we will cover the ones that we believe to be the most common in our multifamily investment universe:

Average Annual Return (“AAR”)

• Definition & Calculation: AAR is the average amount that is earned each year over a given period of time. To calculate AAR, you take the sum of the return rates of your investment over a specific number of years and divide it by the number of years.  In our case, this number would almost always be shown in our presentations as net of fees.

• Application:  AAR is just another metric used by investors to look at the overall historical performance of a property investment, which is often used as a relative benchmark for the current or future (i.e. projected) AAR.  AAR  is most frequently measured over the life of the investment, but it is also common to measure over three-, five-, or seven-year periods.  

This metric is helpful if an investor wants to know the potential investment's current annual return as compared to its historical return.

Some say that an attractive AAR is somewhere in the range of high teens to 20%+.  This varies in our industry based on the amount of risk you are willing to take in a property investment.

It is important to remember that average annual return is not the same as average annual rate of return (i.e. annualized returns or the geometric mean of returns) -- this is an entirely different metric from AAR that factors in compounding.

Cash-on-Cash Return (“CoC”)

• Definition & Calculation (CF Capital’s common use case for CoC): The metric is calculated using a formula that divides the property's annual net cash flow, after paying debt service, by the initial investment amount, and it is shown as percentage.

• Application: CoC is one of the simplest approaches for measuring a real estate investment's performance.   This metric can be split up over specific periods of the lifetime of the investment, but it is almost always used to reveal the performance over the life of the investment (i.e. entry to exit).  

We should note that CoC as a return metric doesn't take into account the time value of money.  In other words, when looking at the investment performance of two properties with the same CoC, there is no consideration for which property was sold first.  The metric also doesn’t include the property’s appreciation (only after the property is sold). 

Some say a good cash-on-cash return for our investment universe is 7-10% over the lifecycle of the hold period.  But really it is subjective and depends entirely on the amount of risk taken.

Equity Return Multiple (“ERM”)

• Definition & Calculation: The equity multiple on an investment is a metric that measures the total cash return over the entire lifespan of the investment.  The formula is the amount at exit (i.e. total amount given back → distributions + total cash back at sale) divided by the amount at entry (i.e. initial investment amount).  Note that this takes into account any fee deductions involved with the investment.

• Application: You might also see ERM referred to as Multiple on Equity (“MOE”), Multiple on Invested Capital (“MOIC”), and Return on Equity (“ROE”).  ERM can be shown as unlevered or levered, but in our case, we will always show ERM on a levered basis because our investments benefit in many ways by properly leveraging some sort of debt financing to amplify our returns. 

One simple and easy way to think about ERM is to look at it as how many times you get your capital back on an investment.  Many operators target an  ERM of 2x, but this also is subjective and depends on the idiosyncratic risk taken.

As with the CoC return, the ERM’s drawback as a performance metric is the fact that there is no consideration for the time value of money.  The multiple only shows how many times you multiplied your initial investment amount.  This also means that the metric can easily be skewed if there were many cash inflows and outflows over the investment period (we can dig into this in a future post).

Internal Rate of Return (“IRR”)

• Definition & Calculation:  IRR is the rate (%) earned on each dollar invested for each period of time that it's invested.  Some simply call this interest.  But you may alternatively perceive IRR as the rate needed to convert the sum of all future cash flow to equal your initial investment.  It sounds confusing, but it is nothing an excel spreadsheet can’t handle, we promise.  The formula is shown as follows (setting the NPV to zero and solving for the discount rate, which is the IRR):

(Note that the IRR presented to our investors deducts any fees related to the investment.)

• Application: IRR is a popular way to measure investment performance in real estate.  IRR considers the time it took an investor to get back an initial investment and any of the investment profits.   

Unlike the other metrics, the timing of when cash flow is received has a significant and direct impact on the calculated return (thus, it is dollar-weighted [aka money-weighted], taking into account time value of money).  In other words, the sooner you receive cash back, the higher the IRR will be.

A “good” IRR often is considered to have a range similar to AAR (unintentionally); high teens to 20%+.  But just like the other metrics, it is subjective and is dependent on risk.  It is also dependent on so many uncertainties and when invested capital is actually returned to investors.

It is worth noting that IRR doesn't always equal the annual compound rate of return on an initial investment.  An internal investment can increase or decrease over the life of the investment, and IRR does not account for what happens to capital that is taken out of the investment.  Another flaw with IRR relates to the formula potentially producing negative returns in between the time of the initial investment period and the time of the sale, causing multiple results for IRR.  This disruptive issue of negative IRR happens when the aggregate amount of cash flows caused by an investment is less than the amount of the initial investment.

The main thing our audience needs to remember is that no single measure is all-encapsulating and does not cover everything needed to assess a real estate investment.  Multiple measures are needed to determine the performance of an investment.  

A Deeper Dive Into IRR

Broadly speaking, the internal rate of return (“IRR”) is a metric used to estimate the profitability of investment by calculating the rate of return on each dollar invested for the time period when it was invested.

IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.  IRR calculations rely on the same formula as NPV does, but it is not the actual dollar value of the project.  It is the annual return that makes the NPV equal to zero.

Here are the items you “need to know” organized in bullet points:

• General Use Case → To measure attractiveness of an investment.

• General Rule for Judgment → The higher the IRR, the better.

• Exception to the Rule → If cash flows back to the investor (i.e. inflows), including sale proceeds are early/quick, and the total return is not significant (e.g. ERM) .

• Information Need to Calculate → Initial investment amount, size and timing of cash flows (including the cash proceeds from the sale, if there was a sale).

• Advantages and Weighting of Return → Appropriate for those looking to measure performance of cash flows and the speed of the growth of the investment value.  As a metric, IRR would be very helpful to use for budgeting, especially over longer periods of time.  IRR is a Dollar- or money-weighted rate of return.

• Limitations → Calculation is not as simple as other metrics and could result in multiple IRR values; IRR values are difficult to predict; 

What else might be important to know?

As mentioned above, generally, the higher the IRR the better.  Also, the IRR metric is a good way to compare the real estate investment in focus with benchmarks, such as other opportunities in the marketplace, or historical IRR’s for the respective investment universe. However, if the real estate investment resulted in realized profits very early and the IRR is skewed high, the total amount given back may or may not have been significant.  One can find this out by calculating the ERM, which is explained above.

We realize that the formula and calculation process seem daunting, but we would be happy to walk you through it or provide you with a template to get a better, hands-on understanding.

Essentially what you need to know to calculate IRR is: 1) set NPV equal to zero and solve for the discount rate (i.e. the IRR); 2) The initial investment will always be negative because it shows an outflow occurred (i.e. an outflow to be invested in the real estate); 3) after the initial investment, each cash flow could be positive (an inflow) or negative (an outflow); 4) because of the nature of the formula, you must solve by trial and error or use software to do so (i.e. Microsoft Excel)

What’s the difference between compounded annual growth rate (“CAGR”) and IRR?

• CAGR typically uses only a beginning and ending value to provide an estimated annual rate of return, IRR uses values in between the beginning and end, including the cash flows.

• CAGR is a simple calculation while IRR is more dynamic.

Also, what’s the difference between return on investment (“ROI”) and IRR?

• ROI measures total growth of an investment from start to finish in percentage terms (ERM in multiple terms), while IRR measures annual rate of return.

• ROI is a simple calculation, involving the beginning and end value of the investment, but is not always as helpful for longer time periods and factoring in periodic cash flows and returns.

It is important for you to know the difference between IRR, and all the metrics mentioned above -- AAR, CoC, ERM, ROI, and,, CAGR.  (We know… there are a lot of acronyms being “thrown around.”)  By knowing the differences, you can tell when it is appropriate to use IRR as a return metric and you will be armed with the ability to properly analyze investment opportunities based on the projected return metrics.

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For those looking to understand our financing process a bit more, and for those of you who have not read our e-book, we thought it might be helpful to talk through debt selection.  That is, the how and why that goes into selecting a certain type of debt to complete the financing of a multifamily real estate deal.  

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First, we determine how the property is operating in the current marketplace by reviewing the property financials.  We work to identify potential upside through either physical reposition of the property and/or operational upside.  From there we formulate a business plan that our team could potentially implement over the projected hold period of the property.  A key piece of our business plan includes asking ourselves, “What are our debt options?” and ensuring that we marry the appropriate financing to the business plan and opportunity.  Different business plans and objectives will require different types of flexibility and exit options.

Two Types of Debt: Categorized by Set of Lenders

In our case, we would be working with two different options for loans: GSE (Government-Sponsored Enterprise) and non-GSE.

GSE - A Government-Sponsored Enterprise, often referred to as an agency, in this context is what we know as Fannie Mae or Freddie Mac.  For simplicity, these are the houses that would provide us a permanent loan that often has a fixed rate over a specific period of time.  They also offer adjustable or floating rate loans, sometimes with flexible terms like an interest-only period.
Non-GSE - These can be life insurance firms, CMBS lender, regional or national banks, as well as alternative lenders (i.e. non-bank, third-party loan providers).  Life insurance firms and CMBS options are typically longer terms and require more stringent terms than a loan originated under one of the above agency programs.  These types of loan options will typically require lower leverage and longer lock out periods and/or larger prepayment penalties in return for attractive rates.  

Alternatively, bridge financing options are short-term loans that “bridge a gap” while you reposition a property and wait for a permanent loan to become more achievable after a property has been stabilized (see below).  Bridge financing would be leveraged by CF Capital to bridge the gap between the acquisition and reposition of a property allowing for a great deal of flexibility on when to sell or refinance.  In most cases bridge loans typically have higher interest rates than GSE options, are interest only payments, and are for shorter terms ranging from 18 months to three years, often with an option to extend for one to two more years. 

So what factors determine if we should choose a GSE loan or non-GSE loan?  

Determining the Property Type

Within our investment criteria , there are two property types within multifamily real estate we could potentially look at: Stabilized and Distressed.  One could take a guess what these types mean, in general, but when it comes to the more technical definition we must look at specific factors that might make a property categorized as stabilized or categorized as distressed.

The most important factors are occupancy and the amount of value-add (which can be operational and/or physical value-add).  

To fit in the stabilized category, a property would need to have occupancy levels that are greater than 90% and needs a relatively low amount of value-add.

A property in the distressed category would be the exact opposite: less than 90% occupancy and/or a relatively high amount of value-add. 

Why does the property type matter when choosing debt? Let’s talk through why.

Tying it Together: Debt Options According to Property Type

By identifying the occupancy and value-add factors, we are now on the right path in figuring out who to go to for a loan and what type of loan that is most appropriate for our investment.

Stabilized

Typically, a stabilized property would put us in a good position to work with a GSE lender for a permanent loan that might have fixed or floating interest rate terms.  

Among the various market conditions that would allow us to determine the type of interest rate terms, one important area to look at is where the market rates are at the time of the loan relative to historical averages.  If they are significantly lower, a fixed rate might be preferable.  

An interest-only period in this loan might be an option, but it is not always a guaranteed part of the equation.

To receive a loan from GSE lenders, our property we need to meet the targets required by the GSE lender -- loan-to-value (“LTV”) and a debt-to-service-coverage (“DSCR”) of at least 1.25.  Meeting these metrics and others, will tell us if we are in a position to be approved for a permanent GSE loan.  

At CF Capital, we like to take things one step further and optimize these targets so that we are not over- or under-leveraging, as well as considering a more attractive break even point.  

We would like to think that this reveals our partnership mentality with our investors.  If we are cognizant of cash-on-cash returns by optimizing the key loan metrics, we believe we are best serving our investment partners.

Distressed

Back to our comment about the ability to choose the type of loan or not -- if the property does not meet the requirements by a GSE, then we may have no choice but to go the non-GSE loan route.  

In the case of a distressed property, we would approach alternative lenders as well as local and regional banks to (typically) provide us with bridge financing.  The lenders here understand that there is a need for a more significant transition, but may charge a higher interest rate in the short-term and require some sort of collateral.  Often, these are loans with an interest-only period and may or may not have fixed or floating interest rates.

The goal with bridge debt from a non-GSE lender is to use this short-term temporary financing and switch to a permanent loan.  That is, if the situation permits.

Main Takeaways

1. A stabilized property would typically require 90%+ occupancy and less value-add.  In this case we would be more inclined to go with the GSE lender for a permanent loan, but we must factor LTV and DSCR into our decision-making.  We also must be cognizant of cash-on-cash return metrics, as well as the risk factors of leverage and market conditions. 

2. A distressed property would typically have less than 90% occupancy and significant value-add.  In this case, we would most likely go with a non-GSE lender to provide bridge debt as a means to transition to a permanent form of debt.  Interest-only provisions are more common here. 

It is worth noting that each property is unique and specific, so choosing the form of debt should be treated as such.  By partnering with the best lenders and brokers in the business, we should set ourselves up nicely for long-term success.  But, ultimately, we (as the investors ) make the final decision.

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“Successful investment is about managing risk, not avoiding it.” - Benjamin Graham

Recently, I've found myself talking about risk with a lot of people.

Most of it is because of our previous articles -- Navigating the Market Cycles, Due Diligence, and Underwriting Bad Debt, just to name a few.  People believe that investing in real estate is much riskier than investing in the stock market.

These discussions triggered an immediate reflection on how we evaluate and manage risk in our property investments.

There's a lot you can do to reduce the chance, it turns out.

First Things First: Put the Property in an LLC (see our post about syndications)

Having rental properties exposes us to the risk of being sued, just like any other company.

The trick is to keep our property investments apart from one another and from our personal finances (i.e. the CF Capital team, our co-sponsors, our property managers, and most importantly, our investors).  You accomplish this by forming a separate LLC for each property (or in a series LLC).  Then you treat each LLC as if it were its own business. EIN numbers are assigned to each of you separately. 

You'll get your own bank accounts.

Is it a decent amount of effort on our end? Yes, but it is more than necessary to protect ourselves and our investors legally.

More Legal Protection: Get the Proper Insurance (get in touch with us about our e-book covering more of this topic)

While the LLC provides some security, you should still have adequate insurance coverage.

Not only should you have adequate coverage for the property, but you should also be covered by umbrella insurance to cover something that the property insurance doesn't cover.

Downside Protection: Buy the Properties that People Live in During a Recession (see our post on Navigating the Market Cycle)

We don't typically seek to purchase "A" assets as a part of our core acquisition criteria.

What does it mean to have a class A property?  Picture a glass-enclosed modern apartment building with a dog park or pool, or a charming Tudor house with a backyard in a neighborhood.  These are the apartments that rent for $2,000 or more a month.  

These aren't our rentals.

We purchase properties in the “B” and “C” range.  What is the reason for this?

Consider what will happen if an individual who is living beyond their means in a "A" property loses their job during the next economic downturn.

What happens to that person?  They'll be relocating to our B or C rated property.

Similarly, if the economy improves and everyone has a job, people in the D and C classes move up to the B class.

The sweet spot for rentals, we assume, is somewhere in the center.  You'll be able to profit from an upswing while still weathering a storm during a downturn.

Protection We Can Manage: Cover Our Bases in Our Due Diligence, Underwriting, and Business Plan (see our posts on Due Diligence, Underwriting Bad Debt, Cap Rates, Rent Growth, and Vacancy, as well as our Business Plan)

When it comes to research, underwriting, and crafting our business plan, it is all about the grunt work -- we are not afraid of the tremendous amount of work it takes to be thorough and thoughtful.  

We wouldn’t be able to sleep at night knowing our investors’ (and our own) capital is at risk because we took a shortcut.

Formally, it is our fiduciary duty to be excellent stewards of capital.  How we see it, the only way to do that is for us to do everything we can to protect our investors’ money with our “blood, sweat, and tears” (particularly, deep research, thorough and conservative underwriting, as well as thoughtful creation of our business plan).

Actions, Not Just Words: Execute in Asset Management (see our post on Asset Management)

Building off the previous section above, let’s make things simple here: if you put your investors, the community, and the residents' interests above all else, you maximize your chances of success.

Having PURPOSE for what we are doing makes things so much better; probably one of the main reasons it is one of our core values.  Not only is it a driver, but this (perhaps counterintuitive) approach actually puts us in a better position to “win.”

The funny thing about this world is that “the more you give, the more you receive.”  And this is speaking in terms of receiving both tangible and intangible benefits.

That is why we choose to do everything humanly possible to make sure every party is pleased with the outcome.  

In the area of asset management, WE EXECUTE.

Asset Repositioning: The Little Things Count (see our previous post)

Vacancies tend to rise during a downturn, and housing options expand dramatically.

So, how can you make sure your apartment complex isn't one of those that sits empty during a downturn?  Aim to make it the “nicest property on the block.”

The benefit of making your property the nicest on the block is that you can charge premium rentals during good economic times.

I'm not suggesting you go overboard with stainless steel appliances and granite countertops. However, a little maintenance and slightly higher finishes than the group average are a perfect way to reduce danger in the long run.  

CF Capital’s value-add strategy focuses on the “numbers” in our models as well as our cost-benefit analysis to determine the appropriate measures to take in order to reposition our asset, the property.

In essence, when you have a desirable property that is in high demand, your risk goes down.

The Bottom Line: Cash Flow, Cash Flow, Cash Flow (again, read more about this in our e-book)

Be sure to “buy it right” when purchasing investment properties.

What exactly does this imply? It means that you have pre-defined requirements for buying a property and only buy properties that meet those criteria.  Never, ever compromise.

The cash flow generated by a property is one of the most important criteria.

We like to use a cash-on-cash return threshold of 7%, as stated in previous articles.  We normally won't acquire an asset unless we can hit this minimum average threshold over the hold period.  Of course, there are exceptions to this law if a property has a significant amount of untapped secret value, for example.

You will reduce the risk by maintaining a certain minimum amount of cash flow.  And if rents fall marginally during the next downturn, you'll be able to bear the loss.

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I opened up an email the other day from one of our readers:

Hi,

I would like to first thank you for being so transparent in your blog post discussions.  I look forward to your posts every week and I find them extremely helpful. 

Since your writing pieces are so informative on investments, I have a question for you: if I were a potential investor in one of your deals, I am just curious, how does CF Capital receive compensation for managing a real estate investment?  

I think any investor would like to know how you all get paid for what you are doing.  Any details related to this would be much appreciated.

Thanks

I love these emails.

We are grateful that our readers are so engaged in our blog posts.  This kind of email brings a smile to our faces, as it is our goal to be as transparent and informative as possible to our  audience. 

With that said, who are we to deny our readers the answers they are looking for?  So our blog post today, inspired by a member of our loyal audience, is about how we, the General Partner (or “GP”), are compensated.  We know this is not the most exciting topic, but we have tried our best to make it as “interesting” as possible!

The Fee Structure

Our two previous posts (syndications and accredited investors) reviewed terminology relevant to investors looking for the same answers related to compensation.

The general partner (“GP”) is also referred to as the sponsor in an investment partnership.  In the case of CF Capital, we are the GP/sponsor in our investment offerings.  Sometimes there are co-sponsors (i.e. multiple investment managers) in a real estate deal, but for simplicity, we will discuss scenarios with one sponsor.

Typically, there are two types of fees that compensate a GP: an asset management fee and incentive fee.  

• Asset Management Fee - This is the amount the GP charges for overseeing the management of the real estate investment and implementing the business plan.  In our case, the asset management fee amount is a percentage of the collected income at the property.  This is separate from the property management fee that is allocated to the on-the-ground property managers are paid for doing their jobs. .

• Incentive Fee (i.e. Carried Interest or “Carry”) - This is also known as “carried interest” and is the GP’s portion of the LP/GP split.  An LP is a limited partner, which is an investor.  Any time you see LP in this discussion, think “investor.”

If the split between the LP (i.e. limited partners or investors) and GP is 70/30, this entitles investors to 70% of the investment profits and the GP to 30% of the profits.  It is called an incentive fee because a GP is incentivized to generate large profits so that they are able to receive a large sum for being successful in an investment.

In order to align interests with LPs, the incentive fee is put into place and it is where the GP makes most of its money.  Think of the incentive fee as a “we only win if you win” mechanism.

Pref

Taking investor alignment one step further and to reduce principal-agent conflicts, a GP may set the terms so that the incentive fee can only be earned once an annualized return is earned by LPs.  This rate of return hurdle in the real estate investment industry is most commonly called the preferred rate of return or preferred return (“pref”).

Typically, the pref is set to a reasonable percentage (e.g. 7%), and it is equal to the amount of return an LP must meet on top of their initial investment in order for the GP to start earning their share of the incentive fee.

Furthermore, the pref terms could also be accompanied by a mechanism called, catch-up.  A real estate investment manager, like CF Capital, would include this mechanism to arrange the way profits are shared between the GP and LP once the pref is attained.  

A frequent incentive fee structure might be stated as “30% incentive fee over a 7% pref with a 50% catchup” or an “LP/GP split of 70/30 over a 7% pref with a 50% catch-up.”  This means that the partnership has to earn at least 7% return before the GP earns their share of the profit split.  Anything above a 7% return, the sponsor gets half the profit (i.e. the catch-up is 50%) until the ratio of profit split is 30% to sponsor. 

Thereafter, the profits are split 70% to the investors and 30% to the sponsor. Although the catch-up can be negotiable (usually from 50% to 100%), this is just one example of a compensation structure for private real estate GP.

For those of you who are interested in seeing an example of how the math works, let’s walk through the fee structure involving a 70/30 LP/GP split over a 7% with no catch-up and an annual asset management of 2% and a hold period of five years -- excluding any impacts from taxation.  (For those uninterested in the “numbers,” feel free to skip to the Main Takeaways below):

Management Fee 

• The GP initially invests $980,000 of the $1,000,000 capital from LPs.  

• The $20,000 difference is attributed to the 2% management fee and goes to the GP.  

• An amount of $20,000 is then drawn each year for the remaining four years -- a total of $100,000 of management fees over five years.

Preferred Return and the Incentive Fee from Cash Flow Profits

• Rental cash flow profits over the five years equal $200,000, which are periodically distributed according to the incentive fee arrangement.  

• The pref of 7% entitles the LPs to $70,000.  

• Once the LPs earn this amount, this preferred return ($) is taken away from the $200,000, leaving $130,000 to be split 70/30 between the LPs and GP.  

• The LPs earn $91,000 on top of their already earned $70,000 for a total of $161,000 (i.e. the LPs capital has now grown from $1,000,000 to $1,161,000 at this point).  

• The GP earns $39,000 from the rental cash flow profits

Incentive Fee from Sale Profits 

• Once the property is sold at the end of the five year hold period, profits equal $300,000.  

• Since the LPs have already earned their pref, the split of the sale profits remains at 70/30.  

• This split gives LPs $210,000 in profits -- a grand total of $371,000 in profits, and their capital has grown from $1,000,000 to $1,371,000 over a five-year holding period.  

• The GP is entitled to $90,000 of the profits -- a total of $129,000 earned in incentive fees for the five-year investment.

Total GP Fees (Management + Incentive) 

• Total fees paid to the GP over the five-year holding period are $229,000.

• Keep in mind that the $100,000 in management fees are basically a breakeven cost to remain operational during the life of the real estate investment.

Quantifying Returns to the LP and GP 

• The LPs earned $371,000 in profits from their initial investment of $1,000,000.  

• The total percentage of profits that go to LPs equal 74.2%, an amount higher than the 70% LP portion of the LP/GP split because of the preferred rate of return.  

• LPs earn a total return of 37.1% over the five-year holding period.  

• The GP takes $100,000 in management fees and $129,000 in incentive fees for a total of $229,000.  

• Using the cash flow profits plus the final sale as a base value or measurement point (i.e. $1,500,000), we can essentially say that over five years, the investment has paid the GP ~15.3% in total fees (management plus incentive).

There are also more complex compensation structures that “tiers” incentive fees once a pref level is met.  

For instance, a real estate deal might be stated as “20 over 7, 30 over 11 and 50 over 20” . In this way, the GP starts sharing 20% of profits once the LP earns a 7% return, switching to 30% of profits once the LPs have earned a 11% return.  Once the LPs have earned a 20% return, 50% of profits go to the GP.  

There may be no catch-up in this structure, but between the 7% and 11% pref GP incentive fee starts to drag on return, and the gross return (i.e. the return without any fees) needs to be higher than 12% before the next tier of incentive fee kicks in.

Although this does not apply to the type of fee structure used in CF Capital’s offerings and may be more common in opportunistic strategies, we believe it is worth mentioning.

The Main Takeaways

• There is a management fee charged annually to the GP for managing the real estate investment.  This is stated in percentage terms and is based on the total initial capital from LPs.

• There is an incentive fee (or carried interest) amount that the GP can earn.  This equals the percentage of profits that the GP is entitled to.  Often this is expressed in terms of a LP/GP split.  An example of this is 70/30, which means LPs earn 70% of the investment profits and the GP earns 30% of the profits

• The preferred rate of return (“pref”) is the amount that LPs must earn in profits from their initial investment before the GP starts to earn their share of the profits (or the LP/GP split).

• Sometimes there is a catch-up mechanism that allows the GP to take some or all of the profits after the pref to the LPs is attained.  Once the GP catches up to a percentage of the LP/GP split, the normal LP/GP split continues.  

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“The hardest thing in the world to understand is the income tax.” - Albert Einstein

Tax rates... probably seems like the least interesting topic to read about.  But we will do our best to make our discussion as concise and as interesting as possible.

First, before we begin, let's establish that in real estate investing, tax is (almost always) our largest expense.  

So what do we do to reduce such a significant expense?  We like to approach everything with thoughtful insight, and build a strategy around the varying tax codes in different markets.

Basically, our goal is to have a deep understanding of the geographical differences and approaching tax as something unique for every single market.  

Some real estate investment firms are comfortable with only  a basic level of comfort with each submarket’s tax laws.  We believe that such groups are doing their investors a disservice and are not being prudent stewards of their investor’s capital.

CF Capital applies a different attitude and a more sophisticated approach.

So where do we begin?  Initially, we craft a process that would help us identify tax rates and assessed values.  Because we look at deals in multiple markets, we make sure we partner with and lean on best-in-class real estate attorneys who help to provide guidance in this area. We also gain clarity through the industry experts in our target submarkets.

Although we all have our (somewhat impatient) moments, we remind ourselves it is a process.  And that process does take time.

After all, property taxes can make or break a deal.

As we navigate different states, counties, and submarkets we are attentive to how each governing body has set their laws for taxation.  At every level there is a wide variety of different mechanisms for how taxes are calculated, such as how the area counts millage rates. 

In Ohio, the deals we evaluate can be very subjective, which requires us to dig into everything a bit deeper.  Whereas in Kentucky, it is really just about the millage rates, with some caveats depending on individual counties. 

After we gain an understanding of a market, we run scenarios through our models in order to maximize efficiency from the tax expense standpoint.  

We take into account the types of business expense deductions that might reduce our tax base.  Among these deductions might be the cost of insurance or cost of maintenance.

Also, we factor in the impacts of our value-add strategy.  Capex, or the large improvement/renovation expenses, can significantly alter how much we pay in taxes.  To benefit from capex, we can do things like front-load depreciation or capture tax credits.

We want to make sure that you are not getting the wrong impression here.  Yes, we want to reduce our tax expense.  But we are not trying to do everything in our power to avoid paying our fair share.  Instead we are looking to figure out what we can do to keep taxes in line with expectations so that we are contributing to the communities in which we invest.   After all, as some of you may know, our tagline is, “Elevating communities together.”  

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