Investors’ Benefits from Preferred Equity in Real Estate Deals

Preferred equity is a powerful means of aligning incentives between real estate investors’ interests, the developers/operators driving the project, and iFunding’s real estate crowdfunding platform. How does it work exactly?

First, real estate investments can be divided into equity deals and debt deals. Equity deals give investors participation in the profits and losses on a building or project. Debt deals function like a private loan, or mortgage, with an interest rate returns. Within equity deals, one component of the return is “preferred equity” and the second is “common equity” or the “profit share.”

Preferred equity means that, after a project covers costs-to-date and begins generating profits, the first x% (typically 8-10%) of profit is shared only with investors who have contributed capital.  The main component of the project operators’ profits only begin after this initial profit is paid to investors, motivating them to manage costs well, focus on the most attractive enhancements, and generate profits that are better than “good.”

Note that the developers also may commit cash to the project and be modest equity holders. This is valuable to the deal because it reinforces the developers’ commitment to seeing a project through and gives them more of the perspective of the other investors. If so, they also will receive a proportional (commonly 5-10%) share of the preferred returns, to reflect their complementary role as equity investor.

After the preferred equity return is distributed, remaining profit is split between the investors and the project operators/administrators.  The ratios will vary depending on the project – its size and complexity, operator demands and financing needs – however the investors typically receive between 30% and 70% of the profit split above and beyond the preferred share.

Let’s look at an example:  Take a project that cost $200,000 all-in (equity invested was $200K), and profits after all costs – construction fees, closing fees, brokers fees, insurance as well as transaction fee – was $50,000. The stated preferred return is 10% and subsequent profit share to investors is 50%. Investors would receive $200,000 in return of their original investment, plus $20,000 in preferred equity (10% of $200,000) and plus one-half of the remaining $30,000 profit.  If costs turned out to be $10,000 more, it wouldn’t affect the return of 10% preferred, but the remaining profit to split would be reduced from $30,000 to $20,000.

iFunding’s project administration fee is included in the overall calculation of profits and costs and is always line-itemed in the pro forma spreadsheet and in a deal’s operating documents.  All costs including this service charge are accounted for in calculating your overall returns (preferred plus profit share). After listening to our investors’ feedback, we further have arranged for the service fee to factor into the basis of preferred equity, in effect increasing the target preferred monetary return.

With equity investments, please remember that while average returns tend to be noticeably more attractive then with debt, your original capital is not guaranteed, as you are participating (usually as a member in an LLC) in the profits or losses on a projects. However, preferred equity strengthens the likelihood of profiting, since real estate projects generally are backed by the land and existing building assets. Overall, preferred equity deals are a common type of investment opportunity that has been traditionally available only to institutional-class investors and very high net-worth individuals. iFunding is pleased to make these types of opportunities available to all of our accredited investors.

Single Family Flips and Social Media in Cincinnati – with Wendy Doris

Real estate investment opportunities come in big and small ‘packages’. For many investors, the small-to-medium sized, single-family house refurbishment, or “flip,” is often attractive due to the speed of the project. iFunding interviewed one of its real estate operators that specializes in quick-redesign flips and makes use of social media to promote her projects.  Wendy’s projects can be found at her customer facing page: www.facebook.com/dwellingstudio or her peer-to-peer focused account,  http://instagram.com/flippinwendy .

Q: Wendy, what’s your background in real estate? 

A: I’ve been refurbing homes since 2006 and have completed about 20 properties since then.  My mother had always been a DIY-er and money was tight, so that’s probably where I caught the budget conscious redesign bug. Right around ’06, some of the early house-flip TV shows appeared on cable, and after watching I thought I could make a go with my own projects. I started by doing cosmetic updates to my own home, then branched out from there.

Q: What types of properties do you invest in?

A: I focus on small, single family homes: 1,000 to 2,500 square feet, which in my Cincinnati area typically have an all-in, purchase and construction cost of $100,000 to $250,000.  They can take from 4 to 6 months from close (purchase) to close (sale).  That includes 3 to 6 weeks to renovate, 2 to 3 weeks on the market, and 45 days to close after going to contract.

Q: Given the projects are relatively straightforward, what kind of help do you rely on?

A: I often will look to wholesalers to locate properties with potential for a good return, then visit the sites immediately. I also use contractors for the on-the-ground demolition and construction.  My very first project was completely DIY but took 6 months of work, so I’ve since become a fan of investing in trusted contractors to speed up project turnarounds. In terms of selling, I will promote the home via social media, as well as turn to brokers for assistance. And finally, I have a young daughter who I just took with me when first looking at the property I’m fundraising on iFunding. She tags along with me to the job site when it’s safe. I like to say tongue-in-cheek that she will be my next assistant.

Q: You mention social media to market your projects. I notice you don’t have your own website up yet, but are prominent on Facebook and Instagram, as well as a few other sites. What’s your online strategy?

A: First, I plan to have my own website soon. But my first focus is on the quality of the projects themselves, which is most important to selling the homes at a profit. Beyond this, a number of the social media sites work quite while themselves. Bigger Pockets (https://www.biggerpockets.com/users/flippinwendy) is an excellent community to discuss real estate questions.

In addition, Facebook is a great way to promote fixed-up homes to potential buyers. You can target by location, age group, and interest such as HG-TV (www.hgtv.com), the home investing and design cable channel. I placed my first ad recently and received 5,000 click-through views back to my FB page (www.facebook.com/dwellingstudio). The click rate was close to 10%.

I use Instagram for connecting with other flippers and interior design pros.  Previously, I had written a blog (for travel) but found writing takes too much time, especially when I think about my projects more visually. Instagram (http://instagram.com/flippinwendy) provides a platform where I can share my work quickly, as well as get feedback from my peers. It has really been helpful in connecting with others in the same line of work.

Q: Let’s return to your project investing strategy.  Tell us more about neighborhoods, design approaches, etc.

A: I stay focused on Cincinnati and its suburbs, which I know very well (with the exception of the West Side).  There’s a particular district that has caught my eye, the “Over the Rhine” neighborhood. A few years ago it was more downtrodden, but now it’s turning into a hip, artsy scene.  You have to carefully consider these projects and think about the opportunity, street by street, but there’s potential for upside returns here.

My favorite part of the flipping is the design.  I try to make each bathroom and kitchen a little unique, to fit the space and the feeling of the house. Then there are common upgrades, like granite tops in the kitchen, that sell well.  I look very closely at tile patterns and at how all the home’s finishes from stone to wood complement each other.  Depending on the house, there may or may not be budget and timeframe for opening up the floor plan.  We examine the location of load-bearing walls and beams to make an initial decision on that.

Q: Finally, what’s one of the biggest lessons you’ve learned about real estate?

A: I’ve learned that staying focused on a style and size of house makes your projects more reliable and efficient.  I have put systems in place to make the entire process run more smoothly, within budget and complete on time. Early on in my real estate career, I turned a 2-family home into a large single family. The size added complexity to the design plan and I found potential buyers of larger homes tend to be more particular about layout and customizations. Since then I’ve narrowed my focused to modest-sized, single family homes. With more focus and a bit of luck, that hopefully will enable me to do 10 projects this year. I’m already on my fourth!

Flipping Multi-Family Properties

When most real estate investors hear about multi-family properties, they usually think of rentals, or cash-flowing investments. However, multi-family properties, especially 2-4 unit buildings, can be equally attractive as quick house refurbishments, or “flips.” As a flip, a multi-family project can generate high-quality, preferred-equity type returns in a relatively quick timeframe.

The purchase evaluation and property enhancement strategy taken by the real estate operator can differ from one-family home refurbishment. To explain the differences for our investor network, iFunding turned to Mr. Malico Watson of the Orange Group, a real estate operator based in Milwaukee. The Orange Group has funded four properties through iFunding in the last six months, with one fully-funded in under an hour. In the last two years overall, they have sold 35 properties, both multi-family and single-family, and will flip or buy-and-hold units. They also provide property management services.

Q: What’s the difference between refurbishing a single family home versus a multi-family property, in terms of investment criteria?

A: First, they are similar in terms of selecting properties based on a sound foundation, potential for improvements we can introduce, attractive neighborhood, and good value for money.  The difference however is in the buying. Most single family homes are bought by individual families, with a longer-term plan for residence and hopefully value appreciation.  The buyers of multi-families are investors or landlords themselves, with a focus on operating costs and multi-year rental income potential.

Q: How does this affect the refurbishment plan?

A: We find that residential, single family buyers, have a keen eye for the finishings. A marble counter-top in the kitchen, the type of wood used on the cabinets, and having two sinks in the master bedroom make a difference. Houses should fit a common style but it’s OK to have unique features. With a multi-family acquisition by an investor, they will pay more attention to the age and efficiency of the mechanicals like the boiler. We’ve done a few conversions from oil to gas energy, for example. The investor also will be interested in the insulation and heating bills if they are paying for them, and a layout that is suitable for a wide base of potential tenants, since they may turn over at some point.

Q: What is your turnaround strategy when you plan to flip a multi-family property?

A:  As you can see with the properties we have funded on iFunding, we refurbish the common areas and the units, then usually we’ll rent out the units ourselves, and finally sell the rented property to an investor. And, we’ll offer our property management services, which the investor can use turnkey, or they can choose their own property management. Our service, however, has an extensive track-record of upkeep in the same community. Having that available can significantly speed up the average sale time for a multi-family plot.

Q: How important are property management services for someone who is holding a property for a longer time period?

A: Property management is one of the most important decisions to get right. You want a service that has qualified staff available to visit a property at any hour of any day.  Those staff should have deep skills in repair and have proven that they’ll treat tenants with honesty and care.  And you want to be sure that the staff professionally handles the administrative side, such as collecting rent and paying common utility bills.

We typically offer management services for 7% to 10% of rent, plus $29/hour and materials for any special repair. This is a fair price for a quality service in our area. We tell investors to beware of services charging, say 5%, because they are likely skimping on how many people staff the office and how experienced they are. When issues can hit, for example during a flood or snow storm, you need a bench that can visit multiple properties at the same time.

We also do quarterly inspections of each property under management. We find that tenants take much better care of the premises if they know someone will be dropping by and compare how the place looked between, say, September and January. And they are that much more satisfied by the attention to upkeep from the landlord.

Property managers also can give an investor guidance at the outset of an acquisition, similar to an inspector but with a keener eye to operating costs. For example, we had a rental investor come to us with a property she had just acquired from another source, sight unseen. The returns looked fine on paper, but when our management team was asked to examine the property and provide a quote, we pointed out several factors that would affect her costs, including cracked pipes and water leakage. The units were showing their age and were going to cost more to upkeep than expected, hurting the cash-flow potential for her investment. If she had come to us earlier, we could have pointed her to sturdier and more profitable properties, including several we had on offer ourselves.

Q: What types of investors do you see purchasing multi-family units?

A: I’d say roughly half have significant real estate investment experience before. Others are first timers that may have inherited the property through an estate, or are just getting their feet wet and like the idea of income-generating properties. The lending banks also will refer business to us based on our history of operation in the state.

Over time, investors come to see the potential in multi-family units for scaling their investment. It’s one property to oversee, but generating income from multiple tenants. The Orange Group has kept to an attractive size investment- that is, 2- to 8-units – for a wide range of real estate investors.

Q: In your opinion, how do multi-family properties fit into the crowdfunding market and your relationship with iFunding?

A: There’s certainly a place for both single family projects and for multi-families, if the operator in the deal is experienced in turning multi-families around.  The other way to look at it is whether you, as an investor, are more interested in a flip with quick returns, or long-term cash flow. I think that the responses to our flips, including a recent two-family unit that was fully-subscribed very quickly, show strong demand for the quick refurbishments.

This particular two-family deal only required a small amount of investment, in the low five figures, and had a target turnaround time of four to six months. To entice tenants to rent as soon as it’s ready, we have used move-in specials that include 6 months of no maintenance to the tenant, and 6 months of guaranteed rent rates. Then with rentees and property management in place, our flips have been usually very quick to rent through our broker/agent service.

Some investors may be thinking of a fast return on investment through a crowdfunding site as much secure to them then a long-term hold, though both have their advantages. When you combine a low-investment-amount flip, with iFunding’s approach to offering preferred equity going first to the investors only, then profit-sharing on the rest of project, it’s compelling to look at equity-based flips of multi-family units as great crowdfunding investments. In fact, I’d like to do as many of these projects as I can with iFunding.

Early Adopters and the Rise of Crowdfunding

There are people who wait for the world to act and then they join the big movement. These people are known as the Majority. They often like to play safe and never stray from the beaten path let alone jump off it.

Then there are people who cast a vision and create a new world. These people are known as entrepreneurs and are often seen as risk takers, visionaries and/or crazy.

Then there is another type of person or group of people who haven’t been getting the attention they deserve. These are people who get the opportunity to see or be a part of this new world first, either through luck or active searching by exposing themselves to the “new thing”. They believe in this vision. They, too, can see the future. These people are what we call the Early Adopters.

 

Early Adopters are some of the smartest, most strategic and wealthiest people in the world. In today’s society, so much emphasis and media coverage has been focused on the entrepreneur.

An entrepreneur’s life is not always filled with impressive startup stories, Venture Capital-backed deals and multi-billion dollar exits, instead it’s a life saturated with hard work, going way against the norm and putting everything on the line over and over again. Without bashing too much on my own peer group as I, too, am guilty of having the entrepreneurial seizure constantly pushing forward and recreating my business, entrepreneurs and innovators are needed and serve a major purpose in the world at large.

However, what I am focusing on here is ‘the man behind the man’. The person or group of people who not only back the entrepreneur and the idea but actively mobilize, publicize and commit resources to the entrepreneur or the idea.

These people are a combination of customers who talk about a new product that they discovered and fell in love with and in turn sharing this new discovery to their friends and family. Chances are you can name a few people in your own life right now who do exactly this. You hear these individuals talking about the newest lotion on the market or how they just started trying out the new craze in the fitness industry that they are pulling you along to join.

The other side of Early Adopters are people who not only love the idea, product or service but who have the business mindset and/or resources to actively plug into the opportunity. These people are often referred to as Angel Investors or Venture Capitalists.

People such as Sequoia’s Jim Goetz who created a relationship and backed the cofounders of Whatsapp eventually leading them into the biggest tech buyout to date. Then there is Steve Anderson. He is the guy responsible for backing the cofounders of Instagram lending them money to the photo-sharing app way before it was ‘cool’ to snap a selfie. These people are often unheard of yet their involvement makes them the true winners.

The characteristics of Early Adopters are impressive. These people are confident, bold, strategic and financially secure. They are explorers not necessarily discoverers. They are similar to entrepreneurs in that they are able to see where the world is going and they champion for that vision.

Crowdfunding via the Internet is a technology that is destined to disrupt a number of industries from banking to the mortgage industry to investing in general. A great example of this disruption can be used by comparing what Twitter and Whatsapp has done to the SMS and text message business globally. Twitter is a site that was created so that everyone could see what people were texting, people could share what they were texting globally. This is similar to crowdfunding where previously investing was done via closed doors of investment bankers or brokers without much transparency.

There is definite adoption timeline and Twitter only started gaining critical mass in 2010. Four years later, it has grown into a platform that has changed the world and now has a $30 billion dollar valuation. Traditional cellphone carriers had to adjust the stronghold they had on texting plans to accommodate for the likes of Twitter, iMessages and Whatsapp. This pathway is similar to how the banking and investing industry are going to have to change to adjust to the transparency, fluidity and returns offered directly to the investing community through crowdfunding.

The entire world is changing. The question you have to ask yourself is if you are being a part of it.

In Summary:

Benefits of being an Early Adopter:

Often early adopters or lighthouse customers often get additional personal attentive service as well as preferential pricing and terms. They are often the ones to benefit the most from the technology as they become so familiar with the product or get the returns that come along with a new industry before it breaks into the mass market.

How to be an Early Adopter:

Early Adopters are bold, strong, and confident people. They don’t mind hearing what the majority has to say at the same time they won’t necessarily follow them either. Early Adopters surround themselves with people who are actively trying to change the world and they jump in and engage in opportunities that are a fit for their needs.

Erin Wicomb, Cofounder and Managing Member of The Mavrix Group