Recap:
– Financing projects of less experienced developers is like investing in startups with more predictable outcome;
– Real estate projects typically target 2x returns compared to 11.8% average return of S&P 500 over the years;
– GIS Companies has put together a structure to reward investors and mitigate their risks;
Full post to follow………………………………..
I’ll define or explain certain basics here and put them in italics, so feel free to skip if you know the lingo 😄
So you know how startups are financed? There’s seed capital, then rounds A, B, C, etc. If you are an “angel” investor, you look for great ideas and invest in early-stage startups with the hope that they will become the next Facebook, Google, Amazon, etc. Of course, the chances of spotting a great startup are very small. According to a Harvard Business Review article, more than two-thirds of startups never deliver a positive return to investors. This means that less than one-third of early-stage startups are likely to return a profit to early-stage investors.
If you simply invest in an index fund and have a relatively safe and diversified investment, you average about 11.8% annual return. Smart folks at Investopedia looked at S&P 500 returns over the last fifty years. According to my calculations, if you invested $100,000 in an S&P 500 index fund and held it for 30 years, you would have $2,901,174 at the end of the term. This is based on a simple math, ignoring dividends, taxes or anything like that.
For comparison, a real estate investor generally seeks a 2.00x deal-level multiple (also known as 100% return on investment or ROI), according to EquityMultiple.com. So, if you invested in real estate, you could double your investment at the end of the term. How long would it take? On average, it takes about five years. Some deals liquidate after 3, and some hold for about seven.
So, how do you get in on a real estate deal to double your money? The following list is for newbies, so feel free to skip ahead.
There are several ways an individual investor can get into a commercial real estate investment:
- Direct Investment: This involves purchasing a property outright. Most professionals in the commercial real estate industry got their start with single-family rentals. This is helpful because, though the investment is not the same, residential real estate gives you a good foundation for starting in commercial real estate. Individual single-family investment is not very scalable and may require active management, which is not always desired.
- Real Estate Investment Trusts (REITs): REITs are companies that own, operate, or finance income-generating real estate. They offer a way to invest in real estate without having to own property. REITs focus on specific sectors such as commercial, industrial, and residential. Some REITs are publicly traded, but most are private. The larger the REIT, the less the risk and the lower the return.
- Crowdfunding: Crowdfunding is a form of syndicating a financing pool by collecting funds from individual investors. Sometimes, there is a 3rd party platform between individual investors and the real estate company; other times, it is administered by sponsors directly. It’s essential to check out the firm’s track record before investing and understand its obligations and rights when it comes to withdrawing funds.
- Syndication: This is similar to crowdfunding. Real estate syndication is a way of investing in commercial properties with a group of investors who share the risks and rewards. The sponsor finds, plans, and manages the project, while the investors provide most of the capital and receive a fixed or preferred return, and some offer participation in profits. It can be a good way to diversify your portfolio and access lucrative opportunities, but it also has some risks and challenges.
Now back to investing in startups. Because we specialize in financing projects of first-time developers, we had to devise a way to minimize investor risk and maximize their return. With this structure, the investors reap the benefits first. The strategies include the following steps (saving the best for last):
- Single Purpose Entity. This is a rudimentary basics. Each project is setup in a single-purpose legal entity (SPE or sometimes SPV for single-purpose vehicle) – most commonly an LLC (limited liability company). This protects investors’ and sponsors’ liability.
- Wait to deploy funds. (Also kind of basic) Investors’ funds are not deployed until the entire project financing is committed. This ensures that no investors’ money is spent unless we have the necessary funds to finish the project. In some instances we might create a separate class of ownership for early-stage investors. Their money might be at a higher risk, but they would usually get the benefit of even greater returns.
- Engage GIS Development team. GIS’s team is very experienced in managing development projects. We assemble or manage the entire project team from architects and engineers to contractors and 3rdparty consultants. We also interface with the local municipality to help move the permitting process alone. Newer developers typically lack resources and experience in running this process, which could potentially increase the risk for investors.
- Engage GIS’s construction team. This is a critical piece frequently missed by less experienced developers. It is absolutely crucial to have a construction team on board to start estimating the project early on. The biggest mistake often made by young developers is plugging in an average cost per square foot they obtained form several resources and basing their entire business model on that figure. We have seen time and time again project budgets busted in the last minute when the cost had not been estimated properly. Of course, any experienced contractor could do this part, but GIS would also invest its profits in order to reduce the overall cost of the project.
- Investors are last in and first out of the equity stack. Of course, the senior lender is truly last in and first out, but when looking at the equity portion of the capital stack, the investors (also known as limited partners or LPs) are last in, first out.
So, you just read close to 1000 words and still have not seen how to double the money… 😄 I told you I saved the best for last.
The unique proposition of our new structure is that our investors get to double their investment BEFORE any profit sharing with the sponsors (also known as waterfall).
A financial waterfall structure is a way of distributing the cash flows from an investment among different parties, such as investors and sponsors. The structure is usually divided into tiers or pools, where each tier has a different allocation of the profits. The cash flows fill up the first tier before spilling over to the next one, and so on, until all the tiers are filled or the cash flows are exhausted.
In the scenario I described, where the investor gets to take all of the profits until they double their original investment, and then the profits get split between the investors and the sponsors, the waterfall structure would look something like this:
- Tier 1: The investor receives 100% of the profits until they recover their initial capital plus a 100% return on investment (ROI). For example, if the investor invested $100,000, they would receive $200,000 in total from this tier.
- Tier 2: The investor and the sponsor split the remaining profits according to a predetermined percentage. For example, if the split is 20/80, then the investor would receive 20% of the remaining profits, and the sponsor would get 80% of the profits from this tier.
This type of waterfall structure is favorable for the investor, as it ensures that they get a high ROI before sharing any profits with the sponsor. However, it also means that the sponsor has to wait to receive any compensation for their work and risk. Therefore, this structure may not be attractive for sponsors who want to have more alignment of interests with the investors or who need more cash flow earlier in the investment.
What do you think? Is it worth the conversation?