The Capital Structure Progression of SBRE Entrepreneurs

 
Matt Burk
February 2, 2016
The Capital Structure Progression of SBRE Entrepreneurs

SBRE entrepreneurs come from various places. If you are one, you may have worked as or for a mortgage broker, real estate lender, developer, builder, loan servicing shop, attorney, and/or in many other environments in and around the real estate business. At one point or another, you decide it is time to go out on your own and do deals. It is a cliché, but you can only do one deal at a time, and SBRE entrepreneurs often start out with just one deal. In order to fund that first deal, many will put up their own money to do it, combined with borrowing the rest as needed. You may have enough capital to do one or two or three deals or even more depending on the financial point from which you are starting. Quite often, however, you quickly reach the outer edge of your personal resources and must start taking in capital from others in order to do more deals. Usually this is from what I refer to as FFR (friends, family, and relatives) who know, like and trust you. Depending on the depth of your FFR, this can carry you a significant distance early in the life of the business and allow you to do several deals or even more.

As your SBRE business and reputation grows, you will often have access to more and more deals that meet your criteria which you could acquire and fund if you just had the capital. As more capital is tied up in existing deals that perhaps have yet to go full cycle, you may quickly reach the edge of your FFR capacity and must now go out to people you do not know as well and/or with whom you do not have the same level of inherent trust built. This may require you to provide more analytics and rigor in your presentation to potential investors as they want to better understand the strengths and weaknesses, the potential risks and rewards, of the deal, and generally this is something most SBRE entrepreneurs can figure out how to do reasonably well. After all, real estate deals is what you do, so providing some support of your recommendation to do it is relatively easy. If you are driven, ambitious, determined and even halfway competent, gaining additional investors to do individual deals and matching those investors with those deals is not particularly difficult.

I know many SBRE entrepreneurs who have actually scaled their business quite some distance with this one-investor-one-deal-at-a-time model. If you are a good real estate underwriter and are providing solid returns, generally your investors will tell other investors they know about it and you will be able to expand your pool of one-off investors significantly, allowing you to do more deals using this model. This seems like a good thing and it is in some ways. It is at the same time sowing the seeds of stagnation in the model and great difficulty later in transcending it because you are conditioning your investors on how the model works. Typically they are quite content to pick and choose which particular deals to which they can say yes or no. But early on, you are not too concerned about this because your business is growing and you may just choose to live with the annoyances of the model, which are also growing, since it is working more than it is not and you do not yet know of any better way.

As your SBRE entrepreneurial enterprise grows, your success is at the same time giving rise to a new prerequisite in your business – the obligation to accurately track, account for and administer the financial performance of the assets and the capital accounts for your investors. In the beginning, simple tools like Excel and Quicken can handle the fairly rudimentary calculations and do not require particularly specialized or financially talented people to perform these functions. This usually isn’t what the entrepreneur especially enjoys doing or is particularly good at, but it doesn’t seem like a big deal and is more or less an afterthought at this early stage. Rarely is it an area that is carefully architected and built when the business is rather small. Therefore it often gets built on a foundation not designed to support the height of structure you may have in mind for your business if you are especially ambitious.

As your business grows and deal sizes get bigger, the next step of your progression is often to place more than one investor into an individual deal. While many investors can write a check for $50,000 or $100,000 or $250,000, far fewer can or will write one for $500,000 and even fewer for $1,000,000 or more. However, as your reputation, your business and your ambitions continue to grow, you may have opportunities to do deals that you believe meet your underwriting criteria that are getting larger and larger and it is simply harder to find investors with deep enough pockets and/or enough confidence in you to invest $1,000,000 or more in one deal. The first, most obvious, least difficult, and least regulatory burdensome option to do these deals is to combine 2 or more investors together into a single deal and provide each with a fractional or participation interest in that deal prorated to their level of investment.

While there are more moving parts to this structure and potential legal and regulatory requirements depending on the type of deal, the state one is operating in, the residency of the investors, and other factors, it is still not particularly difficult to arrange and close deals using this method. A big part of why this is relatively easy to effectuate is that the investors still have the ability to say yes or no to each deal they look at and thus have veto power over their participation in any given deal. Allowing the investors to pick and choose deals is central to your capital raising ability and its impact on your success is large, but often not underappreciated. For now, at this stage of the progression, the SBRE entrepreneur has figured out how you can raise greater dollar amounts in each deal and thus do more and larger deals. This development – multiple investors in one deal – also significantly increases the annoyance for you since you now have to deal with many of them instead of one as well as track everything accurately.  The logistical and operational challenges are exacerbated as the number of investors per deal grows. You now find yourself, for example:

  • Providing the same deal information to multiple people multiple times

  • Answering the same questions and handling the same objections from more people trying to get multiple decisions to participate or not

  • Replacing last minute fallouts while holding your counterparty (borrower, seller, etc.) at bay

  • Dealing with a different combination of investors in different deals, some of whom may be in more than one

  • And many more

To further complicate your life, you now have significantly increased the intricacy of the details necessary to accurately track, account for and administer each deal with multiple investors in them, not usually your favorite thing to do or to manage. This area of your business quickly becomes more complex and demanding of your time and brain power to develop.

Often your success now attracts more deals and more investors who want in on the action in the structure you have created. Momentum carries you further downstream and you close more and more deals using this structure, making good money in the process, but aggravating you ever more due to the inefficiencies of the business model in what has turned into an unwieldy capital structure to which you gave birth. You start to think, or start to think more frequently, that there has to be a better way to do all this that does not require so much brain damage to get deals closed, so much work on each transaction in dealing with multiple parties, each with a different combination of people, and so much convoluted tracking on the back end. You start to think about a pooled investment fund and how that might work for you. But what does that really look like and what does it really mean? We shall see. 

Photo of Matt BurkMatt Burk is founder and CEO of Fairway America, LLC, and SBREfunds.com, and Chief Investment Officer of Fairway’s two proprietary nationwide small balance real estate (SBRE) asset based pooled investment funds, Fairway America Fund VI, LLC, and Fairway America Fund VII LP. Fairway is the nation’s premier consulting, advisory, and investment firm in the SBRE private pooled investment fund space, providing a full spectrum of practical, real world products and services (including capital) needed for true success for SBRE entrepreneurs all over the U.S. Matt is a highly regarded adviser, consultant, and mentor to dozens of SBRE fund managers and author of a widely read blog followed by serious SBRE entrepreneurs and investors. For over 20 years, Matt has led Fairway’s deal underwriting as well as capital raising efforts in Fairway’s seven proprietary funds and individual trust deed investments, resulting in more than $250,000,000 in capital raised from accredited investors through more than 1,000 SBRE deals. He is currently working on multiple SBRE fund consulting engagements nationwide, authoring a book on how to raise capital for and effectively manage pooled investment funds, and dedicating his efforts to create greater awareness and drive more capital to the many high caliber and deserving SBRE entrepreneurs around the U.S.