Should You Raise Capital for Real Estate? (The Pros, Cons & “Chicken or Egg” Problem)

Hello everybody, Stephen Morris here with advisory and today we’re going to dive into a topic that I think is very important for you aspiring real estate investors and that is a topic around whether or not you should raise capital for your next project. So as I’m sure you’ve seen me say many many times over in all the videos that we have here on our YouTube channel, the biggest barrier to entry in investing real estate is money. You need money to do it. There’s pretty much no other way to get around it. You’re going to need a down payment and then you can borrow the rest from the bank in very rare circumstances. And I can think of only in the past a few times where this has happened, especially prior to 08, you could have borrowed 100% of the money from the bank.(…) Those days are pretty much gone.

Very very very unlikely you’re ever going to get 100% financing on any particular property, which means you’re going to have to come out of your own pocket to buy some properties. Now what the problem usually I see with most amateur or I’d say beginning real estate investors is that they put all the money they’ve saved into one property and then they’re out. They’re out of liquidity and they’re going to have to wait several more years and save and do all that sort of stuff in order to be able to buy their next property. Well the issue with that is the time, the effort, the energy and all the expertise you’ve gotten off your first property is kind of wasted because the amount of return that you’re getting off of one property is generally very small, especially if you’ve borrowed the maximum you can after expenses, after the mortgage, after insurance, after real estate taxes, you’re pretty much left with like if you’re lucky a cup of coffee a month in terms of the returns. So what does that mean? That was all that learning and all the time you spent understanding property management and construction and development really wasted? I would argue it’s not. And so what I’d highly recommend to a lot of our folks that work with us is that they consider to expand their portfolio and the way to do that is by raising capital from folks that they trust, from other institutional investors and anyone in their connections or networks, leveraging all the knowledge they’ve gotten off their properties that they bought with their own money to be able to perform that and replicate that same level of success for others.(…) So why do all this? Well the number one question I’d always ask folks who are a little bit hesitant about engaging in raising capital to buy properties is very simple one. Would you rather have 100% of nothing or would you rather have 20, 30, 40, 50% of something? Well I think usually most people are going to want the something. And so it’s okay to split some profits so that you can take your expertise and transfer it into other properties. There are other advantages too. Besides just having 30 or 40 or 50% of something, you can also generate fee income. For the property manager, it’s reasonable for you to charge a property management fee towards the properties that you’re managing with your investors and that’s income, that would, another income stream that you can develop. You get acquisition fees a lot of times for finding the property and sourcing it. If you’re a developer, you get to earn developer fees and there’s all sorts of other fees that are in the stack that could potentially be at play there and you might have other ancillary businesses that could potentially serve as the property that would generate additional revenue as well. And of course finally, the ownership is a huge piece. As I mentioned in this other video with the link below, how it promotes all sorts of syndications, work in terms of preferred returns and waterfalls. After you’ve achieved that investment income that you promised to your investors, then guess what? You essentially own a piece of the property after everything’s been accomplished. And so if you had a deal where after the investor gets an 8% preferred return, then the split goes 50-50, you’ve essentially now earned 50% of the property. And when you sell the property, you’re going to get 50% of the sales proceeds. Of course, after you pay off the mortgage, you’re going to get 50% of all the rental income that comes in. And so you’re effectively a half owner in the property. Not a bad deal considering you may have only put in 5, maybe 0%, but you might have put 5, 10, 15, 20% of the deal. To earn an outsized return, these are great outcomes and really helps you scale and move into the next level as a real estate professional. Unfortunately, there’s one major challenge when it comes to raising money. It’s this chicken and egg problem that we’re going to talk about momentarily here. That chicken and egg problem is, let’s say for example, you see a nice property that’s $3 million. It’s a potential rehab opportunity. Maybe it’s an old beat up apartment with a lot of deferred maintenance and also has some development potential. We can place two or three ADUs on the property and really squeeze out some fantastic returns.

Let’s say the equity checks a million bucks and then the bank will step in and give you another $2 million for acquisition and construction financing. Sounds good. The problem is you don’t have a million dollars in your account. Spend it all on the last property. You’re pretty much out of money. Where do you go from here? Well, I guess you can go to the investor and say, “Hey, I have a million dollars and I will try to pursue this particular property and get it under contract.” A lot of investors are saying, “I’m not going to give you anything until you have it under contract first.”

You go to the broker and say, “Hey, will you let me tie this deal up? Here’s my offer. Can I buy it?” The broker says, “Do you have the financing available?” “Well, no, I will get it.” “Okay, well, you know what? We’ll think about it. We’re not so sure. We’re going to go maybe with more proven buyers.”

That’s a problem that you might have. Depending on the market,(…) if the market’s red hot and there’s tons and tons of buyers out there chasing a few deals, you’re going to be too slow. You’re just going to be way too slow.(…) There’s going to be folks with all cash that are going to beat you to it. They might even put in no contingencies in place and they’ll go non-refundable and they’re positive on day one. You can’t beat that. You’re going to be way too slow for it. On the other end, if you’re in a soft market, as of the time of this video right now, generally a better time for buyers to buy properties out there, you can take your time to capital raises. You can try to solve this issue. Maybe there are brokers willing to let you figure it out. As long as they can convince their clients, of course, of that case, they’ll let you figure it out with your capital raise during best grow. Those are entirely possible outcomes. What I’m trying to say though is that it is a challenge that you’re going to have to surmount and your ability to raise capital ahead of time or build that trust is going to help you tie up that deal versus if you just come out of the blue out of nowhere and just start randomly raising money for folks. Well, then you’re going to struggle to get that deal under contract and ultimately you’ll fail at your raise. What does a raise look like? Well, there’s the simple one. You go to one investor and say, “Give me all the equity you need to buy the property.”(…) Good. A lot of times that might work out for you if you’ve got the right relationships. The downside is when it comes time to negotiate the terms of your arrangements, you have only one party who controls an outsized amount of power in the situation. They can call more of the shots on what the return structure is going to look like, how many fees you can earn, and so on and so forth.(…) Alternatively, you can mitigate that issue by raising money from multiple investors. You get raising a million dollars, for example, you can get 10 investors or $100,000.(…) Individually each investor is going to have a hard time negotiating with. In fact, you can simply say, “I’m not taking comments. This is the deal. Take it or leave it.”

Then you’ll be able to raise your million dollars through 10 different investors or five investors, $200,000, whatever the combination may be. The downside, of course, of that approach is it’s like herding cats. You have a lot of folks you got to chase up with. You’ve got to convince a lot of different people who have different motivations and different ways of looking at investment outcomes, whether or not they should invest with you. Then of course, when you’re calling in the cash, then that’s a whole other separate matter. I got to tell you, we’ve done many, many, many capital raises over the past decade and a half or so.