As you know, the shin bone’s connected to the knee bone, and the knee bone’s connected to the thigh bone.

You may find a similar taxonomy in the field of real estate, where your personal and financial circumstances are connected to your investment objectives, and those in turn are connected to your investment choices. Unfortunately, many investors fail to make or even to think about these connections; but, of course, they should. What might your options be?

It’s simplistic and not particularly helpful to say that your objective is to make money. That’s a bit like saying your personal objective today is to continue breathing. You need to bring greater clarity and specificity to the process. Let’s indulge in a thought experiment. Consider some possible objectives you might have, and the type of property those objectives might draw you toward:

1. Your objective is to begin quickly to build substantial wealth; you recognize that great reward implies great risk and typically involves a significant commitment of time and personal effort.
2. Your objective is to build wealth slowly, with a horizon of anywhere from ten to thirty years.
3. Your objective is supplement your regular income with a steady and growing cash flow from your investment property.
4. Your objective is to diversify your investment portfolio with real estate that provides a modest but stable cash flow, and requires minimal commitment of personal involvement.

I do not want to suggest trafficking in stereotypes, but let’s hypothesize on who these investors could be and what kinds of property they might seek out:

The person with objective #1 doesn’t consider herself an investor at all, but more of an entrepreneur. Her goal is to build a full-time business. This person might rehab or flip houses, or choose to develop a condo project or perhaps a commercial building in the central business district. She might buy a piece of land, slog through the process of subdividing, and sell off lots or spec houses.

The second person might be an income-property investor with a very specific goal in mind. He may have small children and wants to build up a nest egg to pay those gazillion-dollar tuition bills ten or fifteen years down the road. He may be thinking about his own retirement thirty or more years hence. If we’re guessing right so far, then he probably is not looking at real estate as a career; so he could choose to buy income property that has a good upside but requires just a part-time commitment in regard to his personal involvement. A few multi-family houses or an apartment building with decent cash flow might meet his objectives. Likewise, a strip shopping center in a good location could suit his needs.

Our third investor is looking for current cash flow, and that would seem to imply a willingness to devote a bit more hands-on effort to maximize revenue and to stay on top of expenses. Residential property typically has shorter leases than commercial, and so offers more opportunities to enhance the income stream. An apartment or mixed-use building might be the investment of choice for this person.

Our final investor seems willing to trade off maximum return in exchange for least volatility and lowest-impact management. This could be a good addition to anyone’s portfolio, but might have particular appeal to a person nearing retirement. A triple-net-leased property could be a good choice here. The lease is typically long term with the tenant responsible for most if not all expenses. (Some landlords will retain responsibility for some exterior aspects of the building.) Hence, the cash flow tends to be stable and the management responsibilities minimal.

You should recognize that the purpose of this exercise is not to “profile” investors or to provide a prescription for who should buy what type of property. If anything, it should provide a template for how to think about your investment choices: First, assess your personal and financial circumstances. Next, given those circumstances, decide what your objective is – what you’re trying to accomplish with your investing or with your entrepreneurial plunge into real estate. Then, identify the type of properties or real estate activity that’s most likely to square up with your objective.

Finally, keep in mind that change is the greatest constant. Your personal circumstances will certainly change at some point, and so will your investment objectives. The kids are out of college. Make a new plan.

There is a well-known paraphrase of a famous passage from Lewis Carroll’s Alice in Wonderland: “If you don’t know where you’re going, any road will get you there.” In real estate investing, as in Wonderland, it’s essential to keep your destination in mind.

Come back soon for Commandment #5

Previously: Ten Commandments for Real Estate Investors: Commandment #3

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

A. The first point to make about real estate partnerships – whether limited, general or LLC – is that there is certainly no single, pre-defined structure used by all investors. In fact, you may be hard pressed to find two partnership agreements whose provisions are exactly the same.

Not all partnerships include a preferred return but, in those that do, its purpose is to counterbalance the risk associated with investing capital in the deal. Typically, the investor is promised that he or she will get first crack at the partnership’s profit and receive at least a X% return, to the extent that the partnership generates enough cash to pay it. In most partnership structures, the cash flow is allocated first to return the invested capital to all partners. The preferred return is paid next, before the General Partner or Managing Member receives any profit.

There are some variations as to exactly how the preferred return might be set up. If the partnership does not earn enough in a given year to cover the preferred return, the typical arrangement is to carry the shortfall forward and pay it when cash becomes available. If necessary it is carried forward until the property is sold, at which time the partners receive their accumulated preferred return before the rest of the sale proceeds are divided. Again, that assumes that the sale proceeds are in fact sufficient to pay the preferred return. If not, the limited partners have to settle for whatever cash is available.

The return may also be compounded or non-compounded. In other words, if part or all of the amount due in a given year can’t be paid and has to be carried forward, the amount brought forward may or may not earn an additional return (similar to compound vs. simple interest). The usual method is for it to be non-compounded. Hence the unpaid amount carried forward does not earn an additional return, but remains a static amount until paid.

An alternative but less common approach is to wipe the slate clean each year. If there isn’t enough cash to pay the preferred return, then the partnership pays out whatever cash is available and starts over from zero next year.

Real estate partnerships will typically define percentage splits between General (i.e., managing) and Limited (i.e., non-managing) partners for profit and sales proceeds. These splits do not come into play until the obligation to pay the preferred return has been met.

For example, let’s say that a limited partner invests $100,000. She is promised a 5% preferred return (non-compounded), 90% of cash flow after the return of capital and payment of preferred return, and 70% of sale proceeds. In the first five years, the partnership generates just enough cash to return the invested capital to all partners. Hence, all future cash flows represent profit. The partnership has a $16,000 cash flow the sixth year, a $20,000 cash flow the seventh year and also sells the property at the end of the seventh year with total proceeds of sale of $150,000. Here is what happens:

The Limited Partner should receive a preferred return of $5,000 per year (5% of her $100,000 investment). By the end of year 6 she hasn’t received any of this return so she is owed $30,000. In the sixth year the partnership cash flow is only $16,000, so that is all she gets; the balance due is carried forward to year 7. In that year the partnership cash flow of $20,000 is sufficient to pay the $14,000 owed from year 6, the $5,000 from year 7 and still leave enough ($1,000) to split 90/10 with the General Partner. Finally, the property is sold at the end of year 7 with $150,000 proceeds to split 70/30 with the General Partner.

Regarding the question, “To whom does the preferred return go?” it is of course possible to structure a partnership so that it goes either to the General or the Limited partner or to Donald Duck if you think that’s a good plan. However, I have never seen a real estate partnership where the return actually went to the General or Managing Partner. The presumed purpose of the preferred return is to encourage non-controlling investors to risk their capital in your project; and that encouragement often takes the form of a conditional promise of a minimum return, the “preferred return.” It seems to me that you would have a difficult time raising money from investors if your underlying message were, “This deal is so shaky that I need full control plus first dibs on the cash flow. If there’s anything left, you can have some.”

Run the numbers, but think beyond them. A good partnership is one where all the parties can enjoy a reasonable expectation of success.

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So — if you’re developing an apartment building, shopping center or other commercial property from the ground up — or if you’re renovating or expanding an existing property — take a look at this new version and check out its new features. It can help you plan your project, evaluate its feasibility, solicit partners, and make your case for financing.

You can get all the details here.

It is very easy to add a user worksheet.  All RealData products have an “Add User Worksheet” feature in the RealData menu.  Just add your own worksheet and begin adding your own formulas which link back to our product.

In our Learn section, we have an article on expanding our popular development program, On Schedule, to accommodate long term rental income when analyzing distressed, partially-built development projects such as housing developments and condominium buildings.

Support is included with the purchase of RealData’s products.  If you would like advice on creating your own extension to your copy of our software, open a support ticket or give us a call.

And so…  what’s it’s all about?  An why did I think anyone would read it?

I’d probably describe it best as being two books in one.  Quite a few readers of my first book, “What Every Real Estate Investor Needs to Know About Cash Flow…,” told me they wanted to see more examples of the 37 key calculations I discussed there. That’s an entirely reasonable request; most of us learn better from examples.

So, I began with the idea of creating a workbook of sorts.  For each of my 37 metrics I created a series of sample problems that the reader could work through.  And, of course, I provided the step-by-solution for every problem.

I would humbly submit (all right, maybe not so humbly) that this was a good idea, because to master anything you have to roll up your sleeves and get involved with it.  You can’t just read about these concepts, you have to practice them if you expect to internalize them as part of your approach to investing.  And that, by the way, is how “Mastering” got into the title.

It’s one thing to master these concepts, but it’s yet another to understand how to integrate them and apply them — and that’s why I wrote the second part of the book, the case studies.  I took four different type of properties — a single-family rental, a development project, and apartment building, and a commercial property.

What I tried to do here was to take real-life situations, where you have to deal with asking prices that may be realistic or not; where you encounter seller representations that may be accurate or not; where you have to make judgments and forecasts using imperfect current knowledge.

One of my goals in this part of the book was to show you how to play, “What if…” with your forecasts so as to give you a sense of the range of possible outcomes for your investment if things like rent projections, interest rates, resale costs varied.  Also, in a departure from some of my usual topics, I tried to show how to look at a re-hab project — specifically, how to estimate an appropriate price for a property that you plan to re-develop into an income-producing investment.

Part 2 of the book can stand on its own, so if you’re comfortable with concepts like NOI, cap rate, discounted cash flow and IRR, go ahead an read this part first.

You’ll find more about this book, and my others, here.

This is a place that welcomes beginners, experience investors, and real estate professionals alike.  If a topic is pertinent and meaningful to you as a real estate investor, developer, appraiser, consultant, or educator, then it belongs in this blog.

So we may talk about where we think the real estate market is headed.  We’ll certainly discuss  nuts-and-bolts topics, like, “What exactly is a profitability index?” and “What’s a back-door approach and when do you use it?”

We want to tell you about useful resources as soon as we discover them (and so you won’t have to wait for our not-so-rigorously scheduled newsletter).  We definitely will talk about technology.  Do you know about the hidden gotchas lurking in Excel 2007?  And there are plenty of useful tips we can give you about using our RealData software to best advantage.

We’ll do our best to keep the conga line moving, but urge you to jump in with your comments.

Welcome aboard.