Assessing Risk: The Importance of Structuring Real Estate DealsMay 12, 2023
Today, we will be discussing the basics of raising money for self-storage revenue. Investing in self-storage can be a profitable venture, but it can also be daunting to raise capital for it. However, by breaking it down into quadrants, it becomes easier to structure the deal and offer it to potential investors.
The Quadrants of Structuring a Real Estate Deal
When structuring a real estate deal, there are four main quadrants to consider: Risk, Labor, Return, and Opportunity. Let’s take a look at each quadrant and focus on the main principles of each one.
In the risk quadrant, we have three different types of risk: the Risk of Investment, the Risk of Missed Opportunity, and the Risk of Ruin. Investors should only be taking on the first type of risk, which is the risk of their investment. By doing this, they will be limited to losing only the capital they put into the investment.
In the labor quadrant, we consider who will be managing the investment and doing all the work. This is important to consider because real estate investing is a lot of work. It is important to clarify who is doing what and how they will be compensated for it.
In the return quadrant, we consider the profitability of the investment and how it will benefit our overall goals. This is important because it determines where our cash flow comes from, who gets the cash flow, and how it is distributed.
Finally, in the opportunity quadrant, we look at how the investment opportunity stacks up against other opportunities that the investor may have. If the investment opportunity is low risk and high return, then more investors will be interested in investing in it.
Fees and Equity Splits
The quadrants are weighed against one another through two main methods: fees and equity splits. Fees are charges made by the sponsor for their work. Equity splits, on the other hand, refer to the percentage of the investment that is owned by the sponsor and the investors.
For instance, in a self-storage deal, the sponsor may not be putting their money into the investment but may be taking on all the work and risk. In such a scenario, they may charge fees for their work and take a larger percentage of the equity, such as 30%.
It is important to note that equity is only the sponsor's share of the profits, not the investors'. When a sponsor brings in a partner to help finance the deal, that partner will also get a percentage of the equity. The investor will still receive their share, but the sponsor's equity position will be reduced. The same applies to labor or work done after the deal is done. The ongoing work is different from upfront work and is rewarded through fees.
There are various ways to structure a deal when the investor is concerned about getting a good return, especially if the deal is not as profitable. In such cases, the sponsor may offer a preferred return, which is a common practice. This means that as an investor, you will receive a guaranteed return on your investment before any equity or returns are divided among other parties. This ensures that you will earn a return on your investment regardless of how the deal performs.
The Importance of Risk Assessment
Risk is an essential consideration when structuring real estate deals. For instance, self-storage deals have a lower risk of ruin than other types of real estate investments. As a result, investors are likely to take less risk when investing in self-storage facilities.
Consequently, a sponsor needs to ensure that they limit the investor's risk to the risk of their investment. By doing this, investors are less likely to lose their money if things go wrong. A sponsor should also assess the investor's risk tolerance and invest the funds appropriately.
Asset and Property Management Fees
There are two types of fees prevalent in real estate deals: Asset Management and Property Management fees. Asset management fees go to the company running the asset. They may handle financials or report back to the investors. Property management fees cover the work done on the property.
After the fees have been paid, the profits can be distributed among the investors. The return depends on the equity splits between the sponsor and the investor. When a return is paid to investors, the equity given determines how it is divided. If investors have an eight percent preferred return, they will receive it. Then, after that, it is split among the equity given. However, the details in the contract are essential to understanding and working through the process.
Opportunity Equity Splits and Fees
Opportunity equity splits and fees depend on the deals' opportunities. A deal with lower risk and high asset performance could lead to tremendous opportunities. In such cases, sponsors receive equity and a more significant share, allowing them to take a bigger chunk. The investors still receive a return on investment, but the sponsor's share is more significant, giving them more to split up.
When structuring a deal, investors' perceived risk is a critical factor to consider. The higher the risk, the more the investor will need to feel comfortable giving money. It is important to remember that investors want to be protected and may not want risk. Therefore, they may settle for a lower return. Sponsors need to find the right balance to create a structure that works for both the investors and the sponsors.
Finally, when it comes to raising money for self-storage, investors should consider structuring their real estate deals into four quadrants: risk, labor, return, and opportunity. Assessing and limiting the investor's risk, determining the equity splits and fees, and assessing the opportunity are crucial in structuring a self-storage investment deal. Risk assessment is critical to ensure that investors' risk is limited, and equity splits and fees are essential components to consider.
The return on investment depends on the equity splits, and opportunity equity splits and fees depend on the opportunities available. Different structures can be applied to meet different investor preferences, but it is crucial to find the right balance to create a structure that works for both investors and sponsors.