AMA - Should I Buy Them Out?

On today’s show Matt asks,

I have been invited to come into a new construction project for an 8 unit apartment building as an investor. The hard construction cost is $1.2M and the total value of the project is about $1.8M after lease-up. We should be able to return the majority of the equity on refinance.

The investor who wants out made an initial investment of $250,000 and has been with the project since inception until now. They are asking for $310,000 for their 50% share of the project. The project qualifies for a 10 year tax abatement.

I’m hearing that construction costs are falling and am wondering if we should find a lower cost general contractor to complete the project.

I’m going to need to raise money from investors for the equity participation in the project which is proving difficult in today’s environment. Some of my investors are dentists who have been hit hard by the pandemic. Any thoughts on the project and the investment?

Matt,

This is a great question. There is no question that raising money in today’s environment is more difficult than it was even 6 months ago. Some investors are sitting on their cash waiting for deeply distressed bargains to appear on the market.

I’m familiar with the location of your project and I think you should be conservative in your underwriting for the investment. Assume that rents will be lower than the current projections. There has been a lot of new construction in the area and the numbers of unemployed will put downward pressure on rents. Assume that rents fall 10% compared with today for a building that will complete a year from now. If the numbers still work, then pull the trigger.

I understand that the current partner in the project wants to get bought out. They also want a profit, which is perfectly fair for value creation. But the value hasn’t been created yet because the project isn’t complete.

I would make a counter-offer to the current investor that they can get their initial capital back immediately.

The profit portion would deferred until a later milestone in the project. It could be paid when the building hits break-even leasing, or perhaps when the building achieves its certificate of occupancy. It doesn’t make sense that a partner cash out of a project and expect to collect a profit before the project itself generates a profit.

I think you can make a compelling argument that the partner’s profit be deferred until the project is complete.

If the investor objects that their profit isn’t secured, you can offer one of several solutions. You could offer a shareholder pledge. This would put shares of the company in trust and they would automatically transfer to the investor in the event that you default on your commitment to pay the profit at the agreed point in time.

You could also secure their profit on title with a mortgage. This mortgage would need to be approved by your construction lender, or it would be an un-recorded mortgage, only to be recorded in the event of default.

You also asked about getting a new bid on the project. We’ve seen labour costs reduced in several markets. This is the result of millions of unemployed people across the country.

We believe that putting people to work who have no work is an awesome thing to do. But you need to be careful as well. Most problems in projects are the result of making a bad hire. Since you’re not local to the investment, your risk is higher of problems not being caught in a timely manner.

That means you need a lot more formal process in place for management of construction funds, construction materials, and quality control. Don’t just hire a new general contractor because they gave you a low bid for the project. We’ve done lots of shows on the perils of the hiring the wrong contractor.