When my Harvard Extension students ask me why I love real estate, my first response is that it’s truly unique among investments: Search the globe and you will find no business which is more accessible to individual investors. Starting with a single rental condominium, an investor can quickly build a steady stream of cash flows and a portfolio of appreciating assets.
What first-time entrepreneurs frequently lack, however, is capital. How can an average person with modest savings purchase a $400,000 rental unit, let alone a multi-million dollar property? The simple answer – and the most oft repeated cliché in the business – is OPM: Other People’s Money.
Successful entrepreneurs create vehicles through which other people can invest their capital and earn a healthy return. Arranging the pile of money, also known as the “Capital Stack,” is both an art and a science. Familiarity with the different capital providers, how to find them, and how they think is an essential skill for real estate entrepreneurs.
Lenders, who provide the vast majority of the money needed for real estate investments, are the most conservative of all capital providers. They insist on being paid before any other capital provider and they’ll provide no more than 80% of the dollars required. In exchange, however, lenders provide the cheapest capital an entrepreneur can find.
Successful real estate entrepreneurs study how lenders use credit scores, income ratios, cash reserves, collateral value, and other personal characteristics to establish the borrower’s creditworthiness. In sizing up a potential investment, entrepreneur’s instinctively think about how their largest capital partner, the bank, will look at the deal.
But what about the remaining 20% of the needed capital? That must come from someone who is comfortable with being paid after the lender, receiving uncertain payments, and, consequently, taking on much more risk. “Money Partners” – friends and family, wealthy individuals, or sometimes real estate investment funds – contribute most of the remaining capital for a project.
In exchange for taking on additional downside risk, Money Partners require much more upside potential – generally in the form of a large share of the profits. Crafting the arrangement by which profits are split between the entrepreneur and the Money Partner, call the “Cash Flow Waterfall,” is another immensely profitable area of study.
The ability to assemble a sufficient capital stack from a variety of sources is one of the most essential skills in real estate investment. Those who take the time to learn it find themselves in an ocean of investment opportunity.
Teo Nicolais is a real estate entrepreneur who loves to teach. The real estate investment courses he teaches at Harvard Extension School are among the largest and highest ranked in the entire program. He applies what he teaches in the classroom to his own real estate investment company, Nicolais, LLC in Denver, Colorado and is a proud member of the Apartment Association of Metro Denver. See his upcoming class, Raising Capital for Your Real Estate Investment and the others in the series offered by the Apartment Association.