TGCI 176: Understanding investor stack in a syndication.

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Episode 176: Understanding investor stack in a syndication.

Copy of EP #18 - 2 Guests

Summary

In today’s show, Pancham interviews Rajan Gupta – co-founder and principal of Mesos Capital. What is real estate syndication? How does it function? How are these properties being valued? What does our business plan look like? What kind of returns are you to the investors and what should they expect? We tend to get asked a lot about these questions so, in this episode, we’ll tackle it all for you!

Rajan has been a guest of The Gold Collar Investor Podcast multiple times yet he has never failed to provide his knowledge and comprehension on various topics. In this episode, he would share his insights about property syndication as he discusses how it works, where they focus their properties and how it is valued, and different offerings the Mesos Capital has in store for you!

 

Listen and enjoy the show!

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Pancham Gupta
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Rajan Gupta

Tune in to this show and enjoy!

Copy of Quote #00 - 1 Guest

Timestamped Shownotes:

  • 0:37 – Pancham welcomes back Rajan to the show
  • 2:20 – Overview of syndication and how it works
  • 3:34 – Single-family home valuation vs. commercial property valuation
  • 7:09 – Their business plan and the 2 key things for choosing an investment property
  • 9:38 – Major differences between Class A and Class B shares
  • 13:39 – How a preferred return operates
  • 16:11 – Identifying what Mesos Capital offerings is perfect for you
  • 21:51 – The benefits and risks of cash-out refinance

3 Key Points:

  1. A single-family home is valued based on the surrounding properties which are beyond one’s control while commercial properties are being valued by its income metrics. 
  2. Focusing their investment strategy on picking the location with high-growth markets and choosing Class B properties helps them increase the property’s value.
  3. Evaluating the kind of shares that would best fit you would be based on your liquidity situation, your tax situation, and the risks you’re willing to take.

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Read Full Transcript

Welcome to the gold color investor podcast with your host Pancham Gupta. This podcast is dedicated to helping the high paid professionals to break out of the Wall Street investments and create multiple income streams. Here’s your host Pancham Gupta.

 

Hi, this is Tom Burns, author of why doctors don’t get rich. You’re listening to the gold collar investor podcast with Pancham Gupta.

 

Pancham Gupta  Welcome to the another episode of the gold collar investor podcast. This is your host Pancham. Really appreciate you for tuning in today. I have invited my good friend and partner Rajan Gupta back on the show Rajan. Welcome to the show, man.

 

Rajan Gupta  Thanks for having me Pancham.

 

Pancham Gupta  So you know, Rajan, it’s winter time, what’s happening 2022 Is one month is already gone. It’s beginning of February. We’re recording this first and the first week of February. What are your thoughts on the market?

 

Rajan Gupta  Yes, the winter is about to end, the sun is out in the Northeast. Finally we can see this. And after six weeks, thoughts on the market, there is definitely some uncertainity coming with the Fed, intending to raise rates and SEC of liquidity multifamily prices doesn’t seem to acknowledge that what we have seen so far in the first half of the month of January, the deal, flow has definitely increased but prices have been on a certain a different level. So acquisition criterias, selection criterias have become tighter for us, which means more work to find a deal. But we are always like working hard to find the right product for us and our interests.

 

Pancham Gupta  Absolutely. Absolutely. So you know, this episode, I invited me in Rogen, we’re discussing something the other day and we were like, You know what, we get asked some of the questions a lot again, and again and again. And it’s about the syndication business, what is the syndication? How our properties valued, what kind of returns we offer to the investors, etc, etc. So we thought, you know, what, why don’t we just dedicate this podcast one episode to on just this topic? So here we are to discuss just that. And I want to kind of start by asking Rajan some questions about the basis like what is a syndication? And how are these commercial properties valued? So Rajan let’s start with that. If you’re talking to a person who’s never heard of syndication, how would you define that and also, you know, when it comes to commercial properties, they are valued very differently when it comes to you know, valuation as compared to a single family home, which most people are aware of how they’re valued. So you want to talk about like, start with syndication, and then how, how the commercial properties are valued.

 

Rajan Gupta  Sure. So think about syndication as a partnership. It’s like a bunch of investors or private individuals coming together, pooling their resources and time to do a project, it could be a real estate project, it could be a tech project, anything where you partner up. Now, these partners could be general partners who are actually operating are limited partners who are purely in their passive capacity investing their money. So everybody brings something to the table to get done a large project where the returns are commensurate to the resources and effort they put in. And that’s how we define a syndication go into your next question of how commercial properties are valued. So, we define commercial property anything which is like not just like retail or industrial or residential complex can be a commercial property, anything typically over five units, the larger the better, is defined as a commercial property in the residential space.

 

Pancham Gupta  So Rajan before you actually go explain how a property which is a commercial property, which is five or more units, like you said, Can you quickly touch on how a single family home is valued, let’s say is, you know, most people are familiar with it just so that we can then directly compare it to how it is different for commercial properties.

 

Rajan Gupta  So a single family home is purely a supply demand phenomena. It has nothing to do with the buying capacity of the people in that area or the economy and financial environment plays a role in it, but in the end, it’s basically how many people want to buy in that neighborhood and how many homes are available if the supply is large houses go down in value, if the demand is large houses go up in value, there is yes certain houses that look nice, the owners have maintained well would show up nice and would have a decent bit of higher value than the other houses in the neighborhood. But other than that is mostly valued on the phenomenon are the criteria which is beyond one’s control.

 

Pancham Gupta  Right so you know, in other words, they are valued based on the comp of the what the next door house or the next on the street house was sold for if the properties are similar in size and number of bedrooms and bathrooms. They will get valued based on how much the property your neighbor’s houses sold for really and you know, which is called comparables or comps in short, short form, and which Rajan which you mentioned exactly depends on the supply demand phenomena there. And it doesn’t really matter what kind of income those properties are producing, let’s say if you Rajan have a house and you are doing Airbnb out of your house and you’re producing a million dollars in income from that house, your house is when you go out and sell it is not going to sell for a lot more in value than the neighbor’s house, just because you were producing a million dollars in income, it’s going to get sold for sell the car, right. So that’s how they’re valued. So now let’s go to commercial properties, how they are valued version.

 

Rajan Gupta  So commercial properties are like a business, there is an operational component to it, there is a financial component to it. Like any other company, two companies making the exactly same product could have a stock value, which is very different. So commercial property is typically valued by the net operating income, which is the income that you basically produce from the property before taxes. And then the multiplier, which in the stock world is the key in the real estate world, we call it a cap rate, capital or a multiplier is an indication of the financial environment. And the net operating income is something which the operator or in our case, like general partners, to some extent control, you get up the rents the NOI goes up, you get the expenses lower, the NOI goes lower. So a commercial property is purely valued as a business like EPS multiplied by p is the stock value. Similarly, net operating income divided by cap rate is the value of the commercial property.

 

Pancham Gupta  Right. So basically, at the end of the day, the banks, they lend on these properties really, after looking at the income, just like they would do a next door 711 or Dunkin Donuts, they will look at what the income level they’re producing, and what’s on like, going cap rate, and then that’s how they would value it. So now you can see the difference really, between a commercial property and a single family home is that one is based off the purely income metrics, that if the income is higher, the value of the property goes higher, right, and if the income is lower, the value of the property goes lower. So just quickly touch on this Rogen like as part of our business plan when we buy these multifamily apartment complexes. In the southeast, we have certain markets that we go into. And we pick those markets after a lot of data analysis and figure out where the people are moving to where the jobs are going, whether they’re landlord friendly, and all that. So what is usually typically our business plan looks like. So yeah,

 

Rajan Gupta  so like you said, like, the first most important thing is picking your markets. Right. I think we have done a bunch of podcasts in the past on that like high growth markets in the southeast. Infrastructure is one key thing jurisdiction is another key thing after COVID especially on how to choose a property, we look at two primary reasons one is like criterias. One is we are picking a class of products in these very high growth markets where the demand drivers are just amazing. Pick up like something like Wilmington, or Leland where we have two syndications we did in 2021, population growth of over 30%, year over year. So the demand is just like outrageous, and you have organic rent growth. The second is like we pick up like Class B product, but it between 85 and 2005, where with certain degree of cosmetic rehab, or value addition, on the amenities and exterior, we jack up the wrench, and as we discussed, like five minutes ago getting the rent sub getting the value of the properties higher. So those are the two primary things that we are focusing late part of 2021 and 420 22, which is stick to your growth markets and stick to the product, which is either way, or could we get very close to a and then increase the value add.

 

Pancham Gupta  Right so in really other words, our goal as part of our business plan, whether it’s class a Class B whether whatever market they are in, at the end of the day, our goal is to go in and increase the net operating income on the property. And you know, obviously, if the NOI goes up when the value of the property goes up, and if the obviously the market has been going up. So cap rates are also going down. And that kind of helps as well in the increase of the property. So that’s our business plan, usually four depending on wherever the property is. And after we have increased the property value, we would either sell the property or do a cash out large cash out refinance, where we will pull out the equity give it back to the investors investors would still be in the deal, and they will still enjoy the cash flow and the increased value of the property being the equity owners in the property. So that’s great. Rajan let’s talk about from the investor point of view, like what kind of returns as me so capital offerings, we have done bunch in the last year and we have we are planning to have a lot more this year as well. Can you define like from an investor point of view who’s never done a syndication now they understand what syndication is they understand the difference between Single Family and commercial properties as a passive investor, right? Can you explain the different offerings that we have like class a share? What is the class a share? What is the class B share, so that they’re aware of exactly the return structure?

 

Rajan Gupta  Sure. So before we jump into the offerings, let’s look at like how we structure our deals like when I say structure like the financial capital stack assumingly, we buy a property, let’s say the notional value is about 40 million, the first thing to do is like secured debt on the property. This is where your lender comes in typical loan to value ratios of about 70 to 80%. So let’s say somebody comes in lenses like about like $30 million on the deal. So you have like 30, millions of the capital start going out, then you have like about 10 million plus some rehab budget closing costs and everything, let’s say 12 million to raise from the investors. Typically, we structured the investments in two tranches. Class A is the tranche that sits lower in the stack, they have lower risk, they said right above the lender, these investors are typically those investors who want a higher yield than what banks are offering or other fixed income instruments are offering. But they still want like a lower risk. They don’t want to be nakedly exposed to the equity side of the investment. So in that case, they come as a class A investor, which sits between the debt and the common equity. Typically, we try to keep this exposure to about like, at most like 10 or 15% of the total equity stack. So in the example we are talking about if your total equity stack is 42 million 30 million instead, this guy would range somewhere between 1,000,002 million. As an example, these investors typically get between eight to 10%, as a coupon, paid monthly annualized coupon paid monthly, after the debt has been paid, the probability of them getting their coupons are very, very high, nothing is guaranteed in a syndication, so we cannot use that word, but the probability of them getting their coupon is very high right after the senior debt guy. And until these guys have been paid their coupon of eight or 10%, the common equity guy doesn’t get paid anything. Similarly, on a capital event, like punch of described, either sale or refinance, after the lender is paid, these guys are paid 100% of their capital back before the common equity guy or the Class B guy gets the first dollar. So to summarize, these guys are willing to give their upside happy with an eight or 10% coupon have a very low risk, and the probability of getting their cash flows and getting their capital back is very high close to one. After this the next section of their tranches. The common equity guy, we call it the Class B shares. That’s about like 80% of the total stack. In the example we said like about like nine to $10 billion. Again, like these guys have like in finite upside with us, they own the deal. 7030 different deals have different structures, but typically in our historical structures, our class B owners own the deal 70% general partners own 30% and there is an IRR hurdle. After the class A guys are paid, any cash flows are distributed to the Class B guys are common equity guys, until they get a 7% pref. So the chances of them missing their pref are actually pretty decent in today’s environment. But they catch up on the backend. And they also participate 70% On the upside of the deal. So again, these investors, they want to take on more risk, they believe in the investment philosophy around multifamily and missiles in general. So they are exposed to the risk, but then they have 70% Upside when the deal sells or refinances up,

 

Pancham Gupta  right. So Rajan, can you explain what preferred return is I know you mentioned that class B investors, people who buy Class B shares, they have no 7% preferred return. And their chances of making that pref during the first second or maybe even third year is lower in this market. But they catch up at the backend, right? What does that mean?

 

Rajan Gupta  So preferred return means that they have a preference over the cash flows. Let’s put it this way. So for example, you invest in $100,000, your preferred return is 7%. Which means like until you get 7%, nobody else or the general partner is not going to make any dollars. So you have a preference of 7% on the cash flows before you start splitting the cash flows with the general partners. That’s preferred. Catching up on the backend means let’s say again, in the example you have $100,000 invested for three years, you’re supposed to get 7% which is your preferred about $21,000. But the deal did not generate enough cash flow are all the cash flows were distributed to the class A guys and you got paid only 4000 in year one 5000 In year two 6000 in year three. So you have $3,000 missing from your profit from your one 2000 In year two and 1000 in the last year, about $6,000. So when the deal sells After the senior lender and the class A guy stayed, you will get the $6,000 paid first, before the cash flows are spread between you and the general partners. Preferred is a way to basically indicate, hey, we want you to get your money back. Plus, we want you to get your 7%, or the preferred back before the general partners start making the first dollar.

 

Pancham Gupta  Right. So it’s really in other words, the way I like to put it differently is that there is an alignment of interest when it comes to investor capital and general partner like limited partners and general partners, they have the same destination, think of this as a plane, we are going to a same destination where pilots are really the general partners, and all the passengers are the limited partners and we all riding in the same plane have the same goal, same destination, and the interests are aligned the same way. So if the Class B guys do not get their 7% preferred return, then the general partners, they don’t make any money, right? It’s very different from, let’s say, a 401k plan or any mutual fund where doesn’t matter if it goes up or down, they get their percentage fee. Alright, so that’s Class A and Class B. And you mentioned 7030 Rajan, can you explain what does that mean? How do we structure and, and also, I want to touch on, like, you mentioned the psychology of the investor who is investing in class a share or Class B share, right? The Class A share guy doesn’t really is okay, giving up the upside, right. And he really cares about the coupon, which is think of that as a fixed coupon or a CD in a bank, where they’re getting that monthly every month, and they do not share the upside, and Class B shares, they really want to share the upside is more risky, compared to Class A, from the money point of view, what kind of capital would make a lot of sense for Class A or class B, for example, like if someone has a 401k, or self directed IRA money? Right? From your point of view? Is there a particular class, you would prefer a over b? Or let’s say if they have money sitting in their life insurance, you know, cash value, they want to invest that? Or let’s say they have money sitting in their personal account, right? Their own funds, they want to invest that? Would you say there is any preference from that, given where the capitalists coming from between Class A and Class B?

 

Rajan Gupta  Yeah, that’s a very good point to bring up. To me it like boils down to your risk appetite. But like one of the big distinction between the two classes is like a large portion of investors come in these investments because of the tax benefits. Plasma investors, like again, like we, for all our syndications, we do accelerated depreciation, so you get a large write off in year one, the write off depends on a deal to deal and whether you can use it and to what extent depends on your personal tax situation, your CPA would advise you more, but generically, class B, investors get that depreciation. And the class A investors are purely treated like debt or a preferred investor who gets their eight or 10% coupon, but do not get the depreciation, which means the cash flows that they’re getting will be taxed in an ordinary way, like their income is taxed. So again, there are certain instruments like you’re coming from a solo 401k, which are not exposed to right away taxes, or you’re coming from a self directed IRA could determine your choices. In the end, it comes to like your personal tax situation and risk appetite, I would say under two factors that would determine whether you go in ARB. But like, given your liquidity situation, your tax situation, your risk appetite, those are the few factors I would say that could like steer you towards you towards like one or the other class, one thing was adding would be, which a lot of investors have missed in the past is, you could basically do a combination of both. So if you have a lot of liquidity lying around, and you want, you’re happy with that 9% 10% coupon, but you don’t want to pay ordinary income taxes in that year, you could do a combination of both A and B. Typically, the depreciation from B would write off your income from a as well for a few first years, a few years of the operations on the D

 

Pancham Gupta  right now that’s a great point. And you know, listeners if you’re not familiar with bonus depreciation, or you know, what are all the tax benefits that real estate offers, and you’re confused by any of the things that Rajan just mentioned, or you know how it really works, you can go to the gold collar investor.com forward slash show for that is the episode where I discuss with our CPA about all the benefits of tax benefits of real estate and how bonus depreciation which is the large right of Rajan is talking about works for these investments. how they apply to Class B shares. So definitely go check that out if you’re not aware, and there are other things that we discussed in that episode. So definitely something that I would listen to. So going back to this Rogen, is there anything as that you would want to add, when it comes to class A or Class B shares are the actual 7030? You want to quickly touch on that, like, what does that mean? The split? Yeah,

 

Rajan Gupta  so 7030 is like an assembler partnership way how Class B investors and the general partners which is musos shares the equity or the profits. So let’s talk about Class A, in a capital stack is purely treated as debt or a preferred component, they do not share any upside, they do not have any equity. So after both the senior debt guy who’s your lender and classes paid, anything left over is split 7030 between a Class B, and the general partners, which is me SOS, which means like every dollar that a deal makes 70% of that goes to the investor 30% comes to us. But of course, every deal is different. Certain deals have an IRR hurdle, which means like after the investors make a certain amount of money 13 or 14%, the split becomes like 5050, or 6040. To add to that, like, a lot of people are confused or have a question around refinances and capital returns. This is the equity that never changes. For example, you put in $100,000 in a deal, there is a large refi, like certain times the NY goes higher, so we are able to refi and cash out people. And both A and B get their money back. Class B investors still have 70% in the deal, which means that going forward, they would still own 70% of the deal, they would still have a right on 70% of the cash flows. So that’s what 7030 actually means.

 

Pancham Gupta  Great. Yeah. So awesome. Is there anything else you think that we need to talk about? I know people like I’ve gotten this questions in the past where people don’t know what the cashout refinances, I will quickly touch on that. That’s really basically you know, even if you own a single family house, you bought it for 500,000, now it is $1.5 million, given the market has gone up. Now what you can really do, you can pay off your old lender, and get a new loan, basically buy the house, again, from yourself, think of it that way that you’re buying this house, you own this house, but you’re again, going to a new bank or the same bank, and you’re asking for a new loan on this based on this new appraised value of 1.5 million. So let’s say the loan is 75, or 80%, you get that new value, new appraised value to 80% of that, and you take that amount, you pay off your old lender, your old loan, and whatever the difference is, that is the cash out amount that you would get in your bank. And that’s what really the cash out refinance is now at this point, you have debt of much higher value than what you had before. So your payments are higher, depending on whether the interest rate was lower or higher, you know, it could potentially be higher. In our case, we did one refi, where our payment actually was pretty much the same, even when we did a large cash out refinance. So depending on the rate where it is. So that’s what really the cash out refinance is and that’s what we try to do when we add the value increase the net operating income, the value goes up, and we do a cash out refinance, and the investors, when that cash out comes out, they get that money back. We did get split prorated among all investors, and they are still owners of that property just like you own your home 100%. Even after you get a new loan, your equity percentage did not change, it was still 100% Before the cash out and still 100% After the cash out the same way. All the investors, their equity percentages are exactly the same. It’s just that the cashflow will change now because the debt has changed.

 

Rajan Gupta  One thing to add there a very key point is like in a single family example, a bunch of you gave, if you go back to the bank and refinance the house at 1.5 million, your personal debt obligation has gone up, you owe the bank $400,000 when you bought the house for 500. If for some reason the house goes underwater or you’re not able to make payments, the bank can come after your personal assets, or you’re personally liable for that 400,000. Now that number has skyrocketed to 1.2 million. Yes, yes. Being responsible investors, you get access to that extra seven $800,000. And I hope you invested like wisely to cover up that delta. But you’re still liable personally for that 1.2 million in commercial real estate, especially if you’re a passive investor or LP as a class B shareholder. You are not liable for any debt. So let’s say we buy that multifamily hypothetically for $500,000. That debt is 400. In a couple of years, we refinance it at 1.5 Getting 1.2 million back. That cashflow goes back to you. But your personal debt obligations have not gone up. Yes, our debt obligation on the property has gone up. But for some reason, if the market turns or the property is not able to generate enough for the debt, you are not personally liable for that debt.

 

Pancham Gupta  Right. Exactly. Exactly. So it is an amazing strategy when it comes to cash out refinance on the investment side, because see, like all the upside of the property, you’re still keeping all the tax benefits is it’s for you to keep still right. All you have the equity ownership. So and the cashflow, none of that is you know, bank is not taking any of that away from you. And there is literally no personal guarantee you have to give and doesn’t come on your credit score. So that’s that I guess that’s pretty much what the you know, we have going on, you know, me, Susan, this is how we kind of structure and you know, after you listen to this episode, if you have any questions, do not hesitate to reach out. There is one more offering that we offer, which is a missiles Income Fund. I want to mention just that that, you know, remian Rajan actually did an episode dedicated just for that Mrs. Income Fund. It’s a low risk, high yield alternative that we have provided, which is much more diversified. It’s very similar to Class A shares that Rajan had mentioned, but it is much more diversified now. Like it is not just one tied to one property, but it’s tied to many, many properties. It’s a fund. So if you’re interested in that alternative, definitely check out show 94 It’s the gold collar investor.com forward slash show 94 You can listen to all about Mr. Singh Kham fun there. So that’s pretty much it. Reach out if you have any more questions, Rajan anything you want to add to before we sign off?

 

Rajan Gupta  No, I think I hope this could be valuable. We’ve been getting these questions from multiple people, not just like new investors, old investors. So I think this would be helpful and I hope to like launch a few offerings this year and have all of you join us

 

Pancham Gupta  Thank you Rajan for your time here. Thank you for tuning in today and listening to our structuring how the capital stack equity stack for the investors look like for Mesos Capital syndication. If you have any questions do not hesitate to reach out to me or Rajan at our Mesos Capital email or to me at my podcast email p@thegoldcolorinvestor.com. Again, it’s P as in Paul at the gold color investor.com Thanks for listening, signing off. Talk to you next week.



Thank you for listening to the gold collar investor podcast. If you love what you’ve heard and you want more of pension Gupta, visit us at www dot the gold collar investor.com And follow us on Facebook at the gold collar investor. The information on this podcast are opinions. As always, please consult your own financial team before investing

Copy of EP #18 - 2 Guests

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