Moses Kagan is the founder of Adaptive Realty which focuses on heavy value-add multifamily projects throughout the LA area.  I really enjoy his views on the real estate business which he shares often over on his blog.

In his most recent post, he discusses a concerning trend he’s seeing utilized by syndicators who raise capital via crowdfunding sites. In order to attract investors to their deal, syndicators must market deals with both current cash flow and high IRR’s. However, in today’s market, it’s nearly impossible to have both, so syndicators are over-raising capital to be used to make distributions during the renovation phase of the project. The overcapitalization hurts the total returns in the end, but operators don’t care because it’s what they had to do to raise money.

I agree with Moses 100%; intentionally over-raising equity to later be distributed to investors as cash flow is a concerning trend and feels awfully like a Ponzi scheme. Its bad practice and investors are ultimately the ones who are negatively impacted.

Having said that, it’s always good practice for value-add operators to over raise equity despite the cash drag. Value-add deals are unpredictable and typically require or could benefit from additional equity that is fully discretionary.

Unlike start-ups that can be burdened by the type and quantity of capital they, real estate deals are more flexible because operators can always distribute excess funds as cash flow. This should not be the intent. However, with returning capital as the downside scenario, I think it’s prudent for operators to raise more money than they think they need. Here’s why.

Capital reserves provide downside protection. While there are many ways to get hurt in value-add multifamily investing, one of the primary causes is going over-budget on the renovation. By maintaining significant reserves, operators can bridge any cost-overruns without having to eat into funds allocated for value-enhancing aspects such as amenity or unit upgrades. From a timing perspective, operators know within the first 6-12 months if they’re going to blow out their budget.

Additional capital enables operators to focus on making improvements that are accretive to the deal. When we capitalize a value-add deal, we raise enough capital to cure the deferred maintenance, upgrade and add new amenities, and renovated ~50% of the unit interiors. We typically don’t reserve funds for 100% of the unit interiors because it takes too long to get to all of them. The first dollars go to thinks like new roofs, plumbing repairs, and window replacements, while the last bucket of money goes into the units. Any money left over can be put toward doing additional unit upgrades.

Outmaneuver the competition. Capital provides agility. Prospects are typically choosing between 2-3 properties which are similar in terms of location, quality, and rents. Operators who have capital can make constant improvements that competitive, under-capitalized owners won’t be able to. For example, the addition of a pet wash station, bike room, or fire pit area can differentiate an asset. When deals are capital constrained, adding these types of discretionary amenities isn’t an option.  Furthermore, if a market softens, having reserves will allow you to offer more aggressive concessions knowing you have plenty of cash to cover expenses.

Maximize value prior to a refinance. When we execute deals, we aim to complete the repositioning and refinance the property within 24-36 months. We start by taking care of the deferred maintenance, then remaining funds go toward the value-creating aspects of the repositioning. Each incremental dollar in our budget can be put toward things such as unit renovations, which directly add value to the property. If valuations are high and rates are low, there is oftentimes and strong case for refinancing early and returning funds to investors. It’s a win-win.  

Excess funds can be returned to investors via cash flow. If the renovation is completed under-budget and the excess reserves aren’t needed, they can always be returned to investors via distributions. This is never the intent, but there’s no harm in returning capital if it’s no longer needed. Investors will be happy to see some cash flow, while the deal is well-positioned for long-term success.   

When capitalizing a deal, always raise more capital than you need. Most of the time you need it and you’ll never be disappointed that you have it.

What do you think?