This is the second in a series of episodes exploring the world of raising investment capital for those of you wanting to use other people’s money to get in and grow your self storage business.
Last week we had a quick look into who “investors” are and what they usually have their attention on, and the difference between investors and partners you may need.
In this episode, let’s explore the WHAT…what you will actually offer investors for their money.
Offering Structures
There are as many different ways to structure deals and partnerships as there are deals and partnerships.
So, it is very difficult, if not impossible, for me to tell you how or what you should be offering potential investors.
Let me share with you a couple of observations and what I currently see in the self storage marketplace.
As I stated last week, I do not relate to myself as an expert in this area, and I know without a great attorney who knows a lot about private placements, there is no way I could be where I am at this point.
I assume you are not raining money for a “blind fund.” In other words, you are raising money for a specific deal. I have seen that this is usually the way to go when you are now and doing your first few deals.
After you have a track record, it is easier to get investors to commit to giving you money to invest without seeing the deal after. However, I recommend you have deal-specific capital raises for your first few deals.
Yes, you can get people to commit to giving you money when you get a deal, but actually getting the money, let’s assume that happens when they say YES to a specific deal.
So, for now, we are deal specific in our raising.
Next, there are two basic ways to organize a deal am going to suggest you decide on:
- A deal that has a “liquidity event” for the investors before disposing of the property (selling it off), or
- A deal that has no “liquidity event.”
Said another way:
- Investors get their initial investment money back before the partnership sells the project, or
- Investors get their initial capital back at the end of the deal when the partnership sells the project.
Liquidity Event Deals
Why would you give investors their money back prior to selling the deal?
Many reasons. But the primary reason is that the sponsors (I am assuming you because you are creating the deal) usually get more ownership.
You do not have to distribute money based on ownership interest. We don’t. At least in the beginning.
Let me explain.
My attorney coached me as I got going that if I wanted to use other people’s money, and especially because I didn’t have a track record yet, they needed to feel very safe before they gave me money.
In my business strategy, I wanted to use other people’s money to create a portfolio of properties. Yes, I need some cash flow, but primarily I was getting in self storage to create a portfolio of properties. I wanted to use other people’s money to do that, and I gave up immediate cash flow for significantly more of the cash flow in future years.
So, what we told our investors was:
- We will give you a preferred return. In other words, the first 8%, or the first 10% of the cash flow goes to you.
- Then, between years four and six, you will get all your initial investment money back and any unpaid preferred return.
- We will get some fees like property management and developer fees on any construction, but almost all of the cash flow in years 1- 4 or 5 will be going to you to meet the preferred return requirement.
- However, you will own 30% OR 35% (depending on the perceived risk of the deal), and after your get all your initial investment money back (a “conversion”), you will continue to get 30% or 35% of the ongoing cash flow and final sales proceeds.
- The sponsors own 65% to &0% of the LLC shares, and post “conversion,” we get 65% or 70% of the ongoing cash flow and sales proceeds.
We are usually doing “value add” plays whereby we have created enough value that by year five or so, we can refinance the project and cash out enough to give investors their money back, thus causing the “conversion.”
My experience is investors feel safe in these deals because you can say, “Look, we don’t get any significant money out of the deal until you get all your money back plus a preferred return of x% while your money is in the deal. After that, you still get x% of the cash flow and sale proceeds, and you have no money in the deal.”
Investors feel safe.
Non-Liquity Event Deals
Another option, where the sponsors usually get more cash flow during the life of the deal but usually own less of the deal, is a structure where investors put their money in the deal, and it stays there until the deal is over.
I have seen structures where the investors won the majority of the LLC shares, the Sponsors are empowered to run the project, and they split the cash flow 60/40, 70/30, or even close to 50/50.
In both types of structure, where the investors either get their money back or not, they are not on the loans.
In my opinion, if an “investor” is on the loan and puts the cash in, you are their partner, and it is their deal, regardless of who found it.
In these non-liquidity event types of deals, there may or may not be refinancing and even some cash distributions for a refinance, but the investors are in the deal for the long run.
My experience is, investors usually want their money in a deal three to five years or so, so these deals tend to be shorter in nature than perhaps many of the deals where the investors get their capital back.
Preferred Return
In both cases, most of the time, investors tend to want a “Preferred Return” of some sort. They get, let’s say, the first 8% of cash flow to them or something.
This is fair because their money went into the deal, so they should get the first cash out.
Usually, the market dictates what the “preferred return” is.
When I first started, I looked at other storage deals, apartment deals and more.
I saw what someone putting money into real estate as an investor would be seeing. I assumed my deal would be one of many they saw.
So, I structured my deals to be slightly better than what I knew they would see if they compared because of unknown quality.
We will go deeper here when we get into what to say, but the preferred return was a big part of that.
Now what I offer as a preferred return has changed as the market has changed, but I tend to lean towards the liquidity event type of deals.
Use their money to control the property, create the upside value, pay them well for it, then refinance, put the deal into service, and let the cash flow and value go up.
The only real problem with this strategy for us has been that the values today are so high when it is time to refinance, we end up just selling most of them to maximize overall returns.
I guess in the world of problems, that is a good one.
Your Legal Team
Here is where I want to emphasize that a good lawyer as part of your team is critical. Don’t try to just sit around and figure this stuff out by yourself.
Get the direction and input from a good attorney who has done private placements before, preferably a local one who understands your immediate and long-term goals. If you don’t know who, start by asking your current lawyer who they would recommend.
It would be a rare place indeed where there are no lawyers close by that have not done this type of work before. I will leave the lawyer jokes alone here, but I am very tempted.
I believe you are only as good as your team, and in the money-raising business, your team starts here.
So, your assignment if you are going to go this route to get in or grow your self storage business is to see what other people are offering investors, put some ideas of your offering together based on your goals, and figure out who you attorney is.
I will see you in the next episode.
