Stack of cash

plywood

If you are a small developer, by the time you approach someone to invest in your project you should have the fundamentals of the project worked out.  You should know how the building will make more money that it will  cost to build and operate.  You should have confidence in your budget for what the hard and soft costs for the building should be and how long it will take to build and lease.  You should have a good working theory on what the terms of the construction loan will be and how much equity will be required.  You should know how much cash you are asking the investor to put at risk, when they will get that cash back and how much of a return the project can pay the investor as consideration for putting their cash at risk.

That is when the investor's cash becomes like plywood.  Like plywood, capital is one of many things you need to build the project, which is available from a wide variety of sources.  You should take care to use the right sort of plywood for the the task. Make sure you have communicated clearly with the lumberyard about the amount of plywood you need and when you need it.  You should also be very clear on the particulars of what you are willing to pay for the plywood and when you will pay for the plywood.   It's the same with capital.  You want the right capital, good terms and good communication.

Frame the investment in the project as a business transaction.  The investor is not making a loan, they are investing equity in the project and they will own a piece of the project until such time as the commitments you make to them are satisfied.  Their capital is at risk.  They could lose all of it if the project spins out of control and the bank, (who did make a loan) takes over the project and sells it to recover the money they loaned for construction.  In consideration for taking the risk of losing their investment you are offering to pay the investor a Preferred Return.  They get their initial cash investment back and they get stipulated rate of return on top of their investment before anyone else gets a distribution of the money the building makes.  They get paid first.  That's the prefered part.  Once the investor's principal and Preferred Return has been paid out, a common deal structure is for the capital partner (investor) and the operating partner to divide the cash flow that the project generates.  This split of the cash flow and the proceeds if the project is sold is established in the Partnership Agreement or the LLC Operating Agreement.  A higher preferred return can be paid if the capital partner is being paid off and removed from the project and the operating partner hangs on to ownership of the project and the cash flow, or if the project is being refinanced or sold after rents and operating expenses can be demonstrated over a year or two and the property is considered "stabilized".

Investors will be comparing your project to other things they might invest in.  They will weigh the risk and the return of your project while considering their other options for putting their capital to work.  As the Operating Partner, it is the developer 's job to design the deal.  It is important to be disciplined when you design a deal structure and to think about that structure being used for more than just one project.  After a couple projects you will see that it is much better to have a fairly standardized approach to what you offer to an investor, rather than building every deal around an agreement that has been highly customized to the investor's needs.  Consider the kind of capital and investors your project requires and go find that capital and investor on purpose.  Make sure the interests of the project and the interests of the investor are aligned and that expectations are well communicated.  The Operating Partner has the authority to replace the Investor's capital at any time, provided that the returns laid out in the agreement are met.  You reserve the right to change plywood vendors when needed, provided that you pay what you promised.

Many thanks to Chuck Marohn, Jim Kumon and the good folks at StrongTowns.org for putting together the registration set up for the August Boot Camp.

www.strongtowns.us/smallscale-duncanville

We are quite grateful for their help on this, which arrives just in the nick of time.  So for everyone who posted "I'm in " on the Small Developer/Builders Facebook Group or commented to that effect here on the blog, or sent me an email, text or voice mail, now is the time to get signed up for real.

Later this month we will also be launching a website repository for site plans, pro forma worksheets, etc. so that everyone who has asked for various versions of spreadsheets and step by step help on how to figure out if a building can make money will have a place to go to find the downloadable files.

When I ask folks who want to develop small projects what they are worried about, it's often that their lack of know how is going to create a problem that is so big that their project will blow up and they will lose all their investors' money.  That is a legitimate fear.  The best way to address it is to stay in the safe zone and build your know how until you are ready to ask someone for money.

Safe Zone Stage One - Work it out on paper One of the core skills a developer needs is the ability to understand how a building makes more money than is required to build and operate it.  The best way to figure out if you understand your project thoroughly is to write stuff down.  Get your plans and ideas on paper so you can test them and communicate them to other people.  Do your market study so you understand what people are paying in rent for space that is comparable to what you want to provide.  Test your idea for what you want to build on several potential sites.  Build your pro forma from scratch, (even if you have access to someone else's template) so that you understand how the rents, the hard construction costs, the land cost, the soft costs, the operating expenses all interact in a building that makes money.  Dig into the hard construction costs so that you understand what the most expensive parts of the building are and what you can do to spend your construction budget where it will have the greatest benefit.  If you see a project you like, try to reverse engineer it on paper. (-this is a little like learning how to draw by tracing over another drawing).

Safe Zone Stage Two - Take your paper to your mentors, peers, and colleagues Once you are confident you can describe your project costs, likely rents, likely operating expenses, and your preferred deal structure with your investors, and you have your project down on paper, you are ready to go get other people you trust to look at your work.  Better to learn that you have missed something from your mentor or your colleague than from a potential investor or construction lender.  Find people who will be tough with you because they want you to be successful in your enterprise.  Be sure you do the same for others when they ask. Sit down with your mentor or peer and lay out the project for them.  How does the project make money?  How much equity are you asking your investor for?  When do they get their principal back?  What is their return and when do they get it?What kind of debt financing are you trying to get? How is the cash flow after debt service going to be divided? What are the risks in the project?  How are you planning to address them?  What parts of the proposed project need to be described in more detail? Do you have a one page summary of the deal -or are you expecting an investor to read 23 pages of spreadsheets and site plans and figure it out for themselves?

Find someone who will play the role of your potential investor and practice your pitch on them.  Have someone else observe and critique your effort.  These should be people with enough experience in real estate that you know you are gaining real ability and confidence through the exercise.

Next Time : Leaving the Safe Zone in Stage Three - Taking your paper to your potential Investors and lenders