Episode 119 - Navigating Commercial Real Estate Investments: Distributions and Strategies

All right. What is up and welcome back to how to invest in commercial real estate. I, I was maybe a little too excited about that. It's so early and here goes Brayden. Yeah, we normally feel in the afternoon. So I'm hyping myself up a little bit, but it's ok. We are back for another super awesome exciting show. And today is actually an exciting day because everyone loves closing days. We're buying a piece of land in Princeton, Texas right next to all of our other pieces of land. Kind of interesting. This uh seller was a bit of a hold out. We literally bought everything around them. Um And then finally they have decided to sell and we are building a 1000 square foot nucky ho It is a sandwich shop found in like 1995. But anyway, they are blowing up. So we're gonna build them a pad right next to all of our other ones. Um which the first one we closed Princeton, what, a month or two ago, few, probably four months ago. It was, it was probably the beginning of the summer, but our Chipotle pad is set to be delivered in the next week or so. I mean, it's almost done.

Super exciting. We've already turned over our ground leases to seven brew and salad and go. So we should see them open up over the next few months. Um, so a lot of movement going on down at our site and bring some, some pictures and video for investors on that. Or have we already sent them out? Yes, I have sent them out to investors, but you're right, it would look good. So we can, we can throw them up here a little picture of the Princeton site. It was in the last, some pictures were in the last newsletter that went out. Yeah, we just went down there. It's looking good. But anyway, that is not the show today. What are we talking about? Brian distributions? Distribution? It's almost distribution time, two weeks, best time of the year. It only happens four times. All right. So what are we saying about distribution? Well, the first thing you gotta consider distributions when you're first setting up the deal, right? You've gotta, you've gotta put it in the uh the operating agreement and you've gotta, you've gotta tell the investors how it's gonna work, right? Yeah. So obviously we're investing in commercial real estate we're either developing or we're buying these existing deals for the cash flow they produce. So at some point, we're gonna have to evaluate what we're doing with this cash and typically for, for us and, and most people, we like to distribute that at the end of the quarter.

Right. So there's, there's four quarters in a year, we hold all of that and right around this time of the year, like Brian's saying, middle of September, right, middle of the last month of the end of the quarter, we're starting to review financials. We're starting to put together our thoughts and some quantitative data on how the property is performing. We've got a future outlook on, on kind of what's going um in the future. And then we also know that, you know, we set up this investment, so to speak with some sort of general expectation of what the heck we're doing, right? So we need to refer to that constantly when we're doing distributions constantly, right? Because in that operating agreement, there's the waterfall structure which just means, hey, once you guys make the cash, what happens to it? How does it get back to me, the investor? And that's in the operating agreement? That's in the waterfall structure. So at some point, this business plan that we pitch you is going to say, hey, we expect, you know, a 10 to 12% cash on cash paid out quarterly. So every quarter you could expect, you know, 2 to 3% paid out to you and, and uh check like a dividend.

Exactly. Yeah. And so then uh let, let's dive into that. So most of our deals, if their cash flowing deals are set up with uh a preferred to return to the investor. So what that means is if and when the property makes money in a given quarter, and we're gonna go distribute it to the investor is we, if it's profitable and if we are dis distributing, we have to pay the eight first and then after that's paid 8% preferred to return on the invested capital, then we split the remaining cash flow in some uh you know, percentage split with the investor. So let's say we pay an 8% preferred return and then we're, we're paying 60 or 70% of what's remaining to the investor. And then we're taking 30% or 40% of what's left over uh as our promote it's called. So, uh that's what we're talking about today. And so then let's, let me ask you a question if, if the property makes, uh let's say the property makes uh $100,000 in a year. Let's say the equity raise was uh a million bucks. Ok.

So that's, it's uh overall 10%. Um Are we paying, is that as, as easy as it is? We're, we're gonna pay that 100,000 out to the investor. So we're gonna pay 80% in the pre and we're gonna take that 2% that's left over and we're gonna split that 70% to the investor and 30% to us. Is that as easy as it is on paper, on paper. Is that easy? Look at your, look at your PNL and your, no, I, and hopefully it's that easy, but now it's not that easy. Right. Because on paper in a perfect world and then you're underwriting, uh, roofs don't go bad. They're always perfect. Uh, tenants pay you rent on time. They always renew for higher, uh, rent amounts. Right. Like we, we're underwriting a, a vast scenario of things that could happen and we're trying to boil all of that down to what we think we can pay out. Right. So that's what we're putting in the business plan. And that's what we're putting on the pitch deck is what we honestly believe we can pay out based on, on real life. And, and we might be a little different than, than some sponsors. We, uh, we have an account that we put money in upfront, right?

We, we don't rely on this $100,000 a year to pay for things normally. Right. We'd normally say, ok, we've got a reserve of this much. Hopefully we can pay out the whole $100,000 over the course of the year and everything works perfectly. But, but um, there are sponsors who kind of rely on some of the income to, to build up that, that reserve is that so, so that's a great, great point. And, and the two differences there are focusing on the, the difference between your profit and loss statement and your, your balance sheet and your cash flow statement, right? A profit loss is how much you're actually profiting by owning that business, right? And you may profit that $100,000 but at the same time, you may have $100,000 new roof that's on your balance sheet, right? So, yeah, you profited $100,000 but you had to reinvest that back into the center of that year. You actually couldn't do a distribution that year. So that's very probable. Yeah. So, but, uh, again, to that point, if we knew that we had, let's say we bought uh a property and, and the roof was old, we would probably reserve for either repairs on that roof knowing we were gonna need to do that over the next couple of years.

Or we might say, hey, we know we got to, we've got to uh, fix the entire roof or replace the entire roof and we might reserve that whole amount. Yeah. So I, I think the biggest thing here is you've got to be developing forward looking statements and beliefs about the property based on, on realistic expectations, right? Like roofs, hhv. AC units go bad. Uh, uh, mechanical things of any nature need, need replaced, right? Your parking lot is gonna need, replaced. Your plants are gonna die. You're gonna have move outs, you're gonna have to pay somebody to get you new tenants. You're gonna have to pay for that new tenant. So hopefully you were a judicious investor and in your due diligence, you identified some of these things and said, hey, maybe it's a good idea to come to the closing table with a little bit of extra cash just in case some of this shit fails before I have the opportunity to make any money from that investment. And then it puts me having to put more money in that investment because I, I didn't anticipate any of these things going wrong. First of all, if you didn't anticipate anything going wrong, you're probably an idiot, right? Everything is gonna go wrong and I I it just will.

Yeah. And our goal is to always try to streamline the cash flow to the investor. And so like you, you said, Brian, we're, we're trying to identify everything uh ahead of time that we're gonna have to spend in Capex. And we also, you know, you, you need uh an operating budget and like an uh an amount of operating capital in the account to handle the ups and downs of a of a monthly financial statement. So, you know, the rent is gonna come in at all different times. The bills are gonna get paid at different times. And so your, your cash is gonna be going up and it's gonna be coming down, it's gonna be going up and coming down and we don't want those types of scenarios to affect uh if possible the distributions. We would love to just send the investors exactly what we told them, the property was gonna make every quarter, they feel better about their investment and it's easier for us. So, uh in order to do that, we try to uh raise that money ahead of time, we try to look at a five year window and say, ok, what are all the Capex expenses we're gonna have uh on this and then, you know, maybe we anticipate losing a couple of tenants and and what it's gonna cost to backfill those.

So we add that to the cap budget. And then we say, ok, this size of property, we wanna maintain $50,000 of operating capital in the account at all times or it could be 100 if it's a bigger property. And so all that's adding up to this amount of cash. And what we try to do is re raise that along with the equity requirements of the deal. That way once we own the property, we, if the property makes that 100,000, we can deliver that 100,000 to the investor because we're protected with our Capex and our operating budget already in a perfect world. That's the scenario. Yeah, so more specifically, right, you can make that 100,000 on the balance sheet, you can have all or you can make that 100,000 on your, on your profit and loss statement. You profited 100,000 but on your balance sheet, you still have the same problems, right? Your HV AC units went out, you had to do some roof maintenance, whatever it was. So you had maybe 50,000 of stuff go wrong that needed repaired. But because you thought of that right, you had that money in, in cash and savings in your rainy day fund, whatever you wanna call it, you can afford to reinvest back into the property on, on your balance sheet, on your cash flow statement, right?

And still distribute that $100,000 profit because you actually profited that $100,000 and you were smart enough to know that something was going to require an investment to continue this cash flow. Like your money machine requires maintenance. So Joe, let me ask you, um let's let's go with the perfect storm and I'm thinking of village South where uh precision bought that. Uh and I invested in that a long time ago, right? The property is getting older. But, but now um my uh distributions are increasing. What was your thought process on actually increasing distributions over the course of owning that property above and beyond what you thought it would pay, what you, what you thought it would pay? Yeah, that, that's a, a classic example of just the property doing uh even better than projections. So you, you got better uh leases is that, so you're making a few things happen there, first of all just to, just to cover it is an older property, but we did reserve when we purchased the property for, you know, kind of roof structure parking. And so that was all taken care of and we're, we're paying out, I think it was 12% to the investor for a long time.

Uh But what happened is we got in there and, and started filling vacancy and then a lot of the renewal leases uh just because of the dynamics of the deal, we were able to increase the rents 30 40 50% on some of those leases. So the income continues to go up and above what I projected. And so as that happens, and as long as we're protected on the Capex and operational side, we're gonna increase those distribution percentage. And I think we got all the way up to like 24% a year prorated on their, on their money because le let's dive into that, right? Because it's so fascinating and that's not because this property did anything extraordinary, right? That, that's you guys being judicious sponsors and saying, hey, here's this property. It's got, you know, really under market rents. We think we think we could push some of these as much as 10 or 20% but nobody's gonna build a model that, that says, hey, I'm gonna go increase everyone's rent by 20%. Like that's probably a very aggressive assumption that you can do that.

So any, any good real estate investor at this point is saying, ok, I see upside here, but let's look at the downside, maybe, maybe I can't fill all that rent, maybe, or maybe I can't raise rent that much. Maybe I can't fill the vacancy as fast as I thought. What if I just put 34 5% income growth on my model? What would that do? Ok, that would look good. It'd give me 12 13%. That's all, that's all you need. You've identified room for upside and then on, on the tail end of that, right? When you're negotiating these leases, you know, you have to get rent growth. You know, you have to fill vacancies. If you know, you only have to get 3% rent growth, you're not going to your tenant and just asking for 3% right? You're, you're going and asking for whatever you can. If it's, if it's 20 if it's 25 if it's 50 you could double somebody's rent if you could, right? You would, you don't just say, oh, I only need three, yep, 3% increase. No, of course not. So, a good underwriter is underwriting market rent growth, right? They're, they're kind of coupling that with a little bit of property specific rent growth.

But at the same time, you're thinking like, and that's what kind of pushed us out of multifamily, right? Is it was hard to go in and buy these five cap multifamily deals and say, yeah, I'm gonna grow rent by 10% every year for the next five years. That's the only way the model works. Yeah, like you're insane pass. But a lot of people did it and a lot of people made a ton of money but you just, you, it's hard to predict that. So don't go in trying to make the model as good as possible and, and make it, you know, oh, I'm gonna pay out 30% cash on cash. If you put this in reality, on the model, half of the people would have been like, there's no way in hell, dude. Pass. You're insane. Yeah. So think about that is we have to sometimes dumb down uh return expectations just so people will believe us and invest with us. But the point I wanna make for investors is that's a really good one is there's not a lot of investments that you go into where you're totally satisfied with the amount that they're promising you, but that there's a real chance that it doubles. Just ask yourself about the investments that you've made and say, ok, they're promising me 10 12% that's higher than the market that's higher than treasury bonds, that's higher than a lot of stuff I can invest in.

And oh, by the way, there's a real likelihood that it'll be double or triple that you ever heard of Bitcoin? Yeah. And so that literally is what we can offer investors. Now with that good news is that we have investments that that will likely far exceed uh what we have uh promised the investor and that happens all the time. We have many more of those, but we do have a few examples where the best case didn't work out like Village South instead of getting 10% rent growth, we got 2030 40% rent growth. Well, uh I'll give another example colonial which there are investors probably listen to the podcast that are on that, that deal went the opposite direction. Everything that could go wrong did go wrong and is still going wrong. And so that's presented a lot of challenge for us. Uh You know, given that we wanna pay out uh distributions but we haven't in over a year. And so the reasons for that is we lost, we've actually turned over almost the entire building of tenants. Uh during COVID, we lost most all of the tenants besides like two or three. That's expensive. Not only do you lose the rent and lose the triple nets when they, when they move out?

But then it sits vacant for months and then in order to get a new tenant in, I've got to pay leasing commissions. I've got to pay tenant improvement dollars. I have legal expenses reviewing the leases. So the, the costs compound. Uh a great example of a great looking P and L but a horrible looking cashless a Yeah. And uh you know that this is a good asset that we paid out for a year or two. But then we hit the struggles and we even had a lot of cash uh that we with like 400 grand in that we, we've never had to do a capital call. We raised enough money for a worst case scenario. But the problem is when the worst case scenario happened, it drains all of the operational cash. So now the deal is essentially at more risk than it was in the beginning. And so could we pay out some of the money that we're collecting? Yeah, I mean it on paper, it's profitable. But the last thing I want to do is pay out the remaining operating cash or profitability that I have and then have more things go wrong and we have to do what's called a capital call. And so for the investors that don't know what a capital call is, it's when the investment runs out of money and it's at risk of making mortgage payments or missing paying bills.

And so I have to go back to the investors. And I said, I know the original investment was a million dollars raised, but now I got to raise an additional $500,000. Who's with me? And there's gonna be some people that are gonna say, ok, I got the money. I trust that this, I'm not loading gold onto a sinking ship. I'm gonna give Joel uh more money and then everyone else is, but there's other people that are gonna say, you know what? I don't feel so good about this. Joel told me he was gonna do this and now it's not doing that and now he needs more of my money. Like I don't want to get more involved in one of the worst assets they have. I want to get in one of the better assets they have. And so if they say no, now what you have is you've got a dilution of ownership of anybody that doesn't want to participate. So now they're gonna get less by really no fault of their own. And anybody that uh sends in more money is gonna get a bigger share of the deal because now the overall capital is a million and a half. OK? And that's not ideal. I don't want to do that. We have never done that. Not ideal. Uh And so when uh that's why we raise money upfront for this stuff, but it's also while sometimes we, we don't pay distributions, that's exactly why we suspend distributions.

We, we have an obligation, a fiduciary obligation uh to the investor, but also to the deal because if the deal fails, the investor's investment uh fails. And so bigger than next week's distribution is their capital. And our goal is, is always number one is to preserve uh investor capital. And so, uh if the count is low. And if there are struggles at the property, whether it be vacancy, whether it be roof, like we're having to repair the roof at colonial for the second time. Uh is, is we have to make sure we have enough money for all of that uh no matter what. Uh And, and so that's why we suspend distributions because we want to build up that, that capital account to where the deal is safe. And as soon as we get it back operating profitably, and we have enough cash that we think will sustain us, that's when we resume distributions. Uh So that's all going through our head every single quarter with every single property because we always want to make sure we get the investors their money. But we, we definitely don't want to put the deals at risk or have capital calls where we dilute investor ownership.

Yeah, the, the biggest thing is there's always something on the horizon. It's identifying what's next on the horizon and maybe how far it is away because there's, there's always something there like the roof is, is 10 years old, the HVC units, you know, we've gone over this list so many times now, but I'm trying to get the point in 10, 10. Uh How many leases are, do you have rolling in the next one or two years? Exactly. There's always something. So you want to try to meet your return expectation but you, you always want to acknowledge what's on the horizon and, and what's coming, right? And if, if people were just naturally good at this, you know, they would inherently have more money. So it takes a specific person, you know, a, a financially disciplined person to be able to say, yeah, we made hundreds of thousands of dollars this year. We can't pay out anything. Yeah. And I'll give, I'll give us one example to close the show. So I, I've mentioned my struggles investing online with third party uh sponsors before. Uh, you know, it was a good learning experience. Uh You know, I thought, well, man, I'm, I'm making money for my investors. These guys are bigger, they have more experience or professional. They're online raising money.

Surely they're gonna do a better job than I do. I'm nobody from Oklahoma. And uh one of the deals particularly was a hotel deal. It was kind of two or three hotels in like Colorado Springs. I'm thinking Colorado's a great market, put a bunch of money in the first distribution came out fine. They paid a decent amount and then COVID hit and the hotels kind of shut down there for a little while. And what was amazing to me is literally the very first quarter after COVID hit, they're doing a capital call. Oh, wow. And so they, they didn't have enough money for, uh you know, a rainy day. They, they paid out distributions the, the couple quarters before and then all of a sudden they're out of money and that's a terrible situation to be in. And it didn't give me confidence that they were, were, you know, financially astute enough to manage that investment. Now, have they lost my initial investment? No, they, the, the hotels are hanging on. They're doing fine. They're not paying a distribution right now, but it was just that they did a capital call, not just to spend distributions, but they did a capital call immediate.

It means that they didn't have any savings for a rainy day or even, you know, a rainy few weeks. So anyway, uh that, that's a big part of our business. And so when you guys invest with us know that we're doing everything we can number one to protect your original investment, we never wanna lose money. The second thing is we want to maximize those distributions, but we want to do it in the safest way possible that we don't put the deal at risk or risk doing a capital call. Uh That could dilute some investors uh ownership and leave them with a bad taste in our mouth. So great point really quick. What uh did you do the capital call? Win? Oh, no, I, I didn't do it. And uh and this for the same reason, I think investors shouldn't do it when I asked for the capital call is, is that, hey, why don't, why didn't you have enough money? Uh ahead of time to deal with this problem. And what makes me think that you're gonna figure this out if we just give you a little bit more money because I could just give them a little bit more money and then the next quarter or two, they're like, yeah, we're out of money again. So it just didn't give me confidence.

I'm not saying there's not a, ever a situation where you wouldn't do a capital call. Uh We're gonna try not to do it with our investors. Of course, there may be a, a scenario in the future that it just mandates it, but uh we're working really hard uh to not do that and hopefully we don't agree. All right. So that's all on how do we determine distributions? All right guys. Well, we will see you next week on how to invest in commercial real estate. Right.