EP26: Geek Out on Syndicated Finances: Rob Beardsley's Take on Loans and High Interest

Preservation of capital is always the most important thing. But for the last couple years the market has somewhat gotten away from that and people got more focused on higher leverage and higher returns rather than trying to focus on downside protection. So I think that has shifted in a big way and now the best way to move forward is really to focus on that downside protection aspect and making sure that you feel comfortable holding deals for what could be longer term. You know, last few years people were able to buy and sell very quickly and make very big returns in a short amount of time. And that's just not normal real estate investing. Normal real estate investing is a slow game and it is a get rich slow business.

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Hey, hey hey. Welcome back to Think Outside the Stocks. Another episode and we have Rob Beardsley from Lone Star Capital back with us and we had this conversation with him last time, just couldn't have enough of it. He has extensive, extensive expertise in the underwriting and capital structure in the deal. So we thought we will have him back. Rob, welcome back. Thank you so much for coming back again.

Yep, no problem. Happy to be here.

Thank you so much. We have so much to talk about today. So just you know as, as I like it this stating the three facts about our speaker last time we gave a great introduction about Rob. Rob, as we all know that he's from Lone Star Capital and he's actually managing acquisitions and capital market. So fun fact about him that he has written over 50 articles about underwriting the deal struct, you know, the capital market and many, many things. He actually has another book coming out which is the structuring and raising Debt and Equity for Real Estate. So that's another book. So we talked about the last underwriting book with him. This actually Rob is my personal favorite. Incredible amount of information in Here. So that's interesting facts about him. Rob, again, you know, today's focus is about passive investors and especially in this market, how do they navigate through this conditions that we have? We have that multifamily has been a great asset class for them to invest in. Today we will try to address that fear in their mind. Today we'll try to address also some part of what is this partnership structure, this splits the, you know, the structuring part which you specialize in. What do they want to keep in mind from your perspective, your expert perspective? What should they keep in mind?

Yeah, diving right in. You know, I know you mentioned what should we focus on in the current environment? So just so that everyone understands where we see the current environment. You know, we've seen a very dramatic increase in interest rates which has led to a shakeup in the market. Transaction activity is way down, values are down, and the future is uncertain. People aren't sure about rent growth, they're not sure about collections, they're not sure about where cap rates are going, which, which is where our property value is going. So with that uncertainty causes people concern and some people are on the sidelines waiting for more certain times for them to invest again, which is perfectly reasonable for us. And the way we look at it is preservation of capital is always the most important thing. But for the last couple years, the market has somewhat gotten away from that and people got more focused on higher leverage and higher returns rather than trying to focus on downside protection. So I think that has shifted in a big way and now the best way to move forward is really to focus on that downside protection aspect and making sure that you feel comfortable holding deals for what could be longer term. You know, last few years people were able to buy and sell very quickly and make very big returns in a short amount of time. And that's just not normal real estate investing. Normal real estate investing is a slow game and it is a get rich slow business. And that's what we're going back to, in my opinion. And so investors need to adjust their expectations and understand that deals can still be very good if you buy and be prepared to hold for longer term, which could be something like five to seven years where there's still strong returns, but it also provides more importantly that downside protection. And for us, we've been doing long term debt, fixed rate, and that makes us feel really comfortable investing in today's environment because we can weather a storm and we're not totally dependent upon timing in order to earn our returns.

Great Great perspective. Rob, so few things that you mentioned here, right. First of all, that cap rate changing. So when it comes to the single family homes, right. Most of our passive investors who are basically landlords, right. They are seeing greater fluctuation in the single family market. So at least one good thing we like about multifamily, that the market fluct in terms of like what is the property value next to you that doesn't impact directly the multifamily environment, but what it impacts, as you mentioned, the cap rates. Right, the cap rates and the net operating income that kind of still has that control, that okay, if it goes up and down, the values can get adjusted with that. Right. You make a very great point here about the capital preservation and about going back to that basics about having just a long term play in mind. The multiple. The real estate is about holding it, going it in right investment and holding it right. Time for the perspective. You know, I get asked many times that is multifamily still a right investment in this current market? And you focused so many bits and pieces on that, right? So let's go back to it and talk about the interest rates environment that you talk about going in and what happened, you know, what happened last couple of years, that whole fluctuation about going into different lending products. And when you are saying that you are focused on the fixed rate, how important is that? So can we go back look at it that what happened, what people actually created a product that was not sustainable. And now what with the fixed rate, how you plan to mitigate that risk?

Sure. So a couple years ago, interest rates were very low and the market was under the assumption that interest rates would stay low. The Fed had guided the market saying we intend to keep rates very low, stimulative and allow the economy to do its thing. And what that gave people the confidence to do was borrow short term floating rate debt because they were under the assumption that those short term rates would stay low. So there's really no value in fixing. You could stay, you could stay floating, have a really cheap interest rate and you could borrow at high leverage because the capital markets were wide open. So we weren't immune to that. We were borrowing cheap debt that was floating and it was really allowing our deals to look really good on paper. And for the deals that had the right timing, they performed really well. However, once interest rates started rising because the Fed ended up recognizing that inflation was a problem, they ended up raising rates dramatically. That put a big strain on our portfolio. With floating rates as well as properties across the country because all of a sudden your debt service is doubling and tripling. And that is the reality that we find ourselves in. And so, you know, the people who have good operations, have sophisticated, are sophisticated and have investors that are willing to make a capital call if necessary, those people are going to do just fine because the underlying real estate is still performing really well. But for people who are maybe struggling with their property and they're maybe not as sophisticated to navigate their lender relationship or navigate a refinance or something like that out of a floating rate into a fixed rate or doing some sort of refi, that's going to be a problem. And then we're already starting to see some of these cracks in the market or problems and in the space. And so not to go too far off track, you know, you're asking, is multifamily still the right place to invest? We're not ever going to say that, you know, we think that our deals are the best or that you should only invest with us. You know, what we're focused on is multifamily and that's what we think is best. But at the end of the day, our investors come to us to invest in multifamily. You know, when, when an investor comes to us, they're already convinced that multifamily is the right place to be. They're just picking us as the best place to be in multifam family. So the feedback that I'm getting from our investors is by and large still very positive because if you look at around the world, there just aren't that many options to invest. It's not like there's asset, you know, there's very few asset classes that are safe. You know, when interest rates go up, most, most financial products or investments are correlated to interest rates. So the stock market's being affected, real estate's being affected, venture capital has been very much affected. So it, it really is based on the investor's risk tolerance. And so for me, I am a bit more risk averse and multifamily is one of most stable places to be, especially in a recessionary environment. So that makes me feel really comfortable about investing into multifamily today. Even though the potential for super high amazing returns that investors somewhat got used to before are most likely not going to happen again. I still think for decent to good returns, multifamily is a really good place to be.

Great evaluation, Rob. And I'm going to go back to some of the component that you said. Right. First of all, the syndicators who walked in into that variable rate and now the cost of the debt servicing that has gone up. So essentially you're either paying the interest only product or you're paying the principal or interest product. But if you have that fluctuation right now, suddenly your money going to your lender is more, more than you originally projected in your finances, in underwriting, as we say it. So now suddenly that's basically what's taking away from the cash flow. So not necessarily that the property performance has gone down, the property performance is sustainable. And that's, that's essentially the fundamentals that I really like about multifamily. And you point to that too, that the fundamentals of multifamily as an investment, that's not changed, that's still the same. People still need place to stay, people still are paying the rents. The rent growth is kind of in parallel with inflation. Should the money coming in the net operating, coming in, in the property is still good. But the money going out, especially in the lender's pocket is now more because of that fluctuating interest rate that they have gotten into. Right. So in this case that's again coming back to either the investments that are existing, sustaining in them is more important. Right. As you rightfully point out. So that you know, what are other investments doing, right? The stock market, what is that doing the, you know, VC or any other front for that sake, Right now we are in that recessionary environment, people are losing money, losing their hard earned money. And your focus is that capital preservation. So at least kind of sustain this kind of a war zone and hold on to what you are doing, keep on performing in terms of the properties, sustain that capital, sustain the capital preservation phase and, and maybe you'll see the longer term. So in worst case, if you predict it to be in five years, maybe a year longer or you know, maybe another year, but investors have gotten used to that 2, 3 year exit and you know, 20, 30% IRRs, but that won't be the case. And again, in alignment with the market. So, so great points there. So let me ask you that, that question that when you are thinking about now moving into the properties, what is the criteria, especially when it comes to the death, how structuring it, what are the key points that you are keeping in mind that is helping that focus of the capital preservation?

Yeah. So even though we're big fans of value add, where we can buy a property with the opportunity to raise rents, do renovations, improve the operations, reduce expenses, maybe increase occupancy, we love value add. And that's how you can really do very well in multifamily. With that being said, typically when you buy a value add opportunity, you're buying a lower in place cap rate rate. And that's pretty simple because if you're buying a property with a lot of opportunity, let's say the opportunity to raise occupancy and raise rents, the existing income at the property is low. So if you are buying a big value add, it might be at a 4 cap. And the problem with a 4 cap today is it's very difficult to finance. Bridge loans are very expensive. So for us that's not really an option. And then if we want to finance a 4 cap with a permanent long term loan, that's going to be constrained to a very low leverage point because lenders look at the in place income when it comes to permanent debt and they're just not able to lend you at a decent ltv. So that doesn't get us excited either because we don't want to do deals at too low of leverage. Obviously we don't want to be at too high of leverage because that's risky. But we don't want to be at too low of leverage because there's just less positive leverage involved in the deal, making it harder to achieve strong returns. And also the tax benefits are diluted across a larger portion of equity. So for us the sweet spot is finding something with a bit of value add where we can create some upside, but also strong in place cap rate that makes the deal more financeable. That's the sweet spot that we're focused on today. Not easy to find. But that is, that's our, that's our goal. And what that allows us to do is to put on modest leverage, 60, 65% loan to cost leverage long term basis on, at a fixed rate, which reduces our risk dramatically. And then we couple that with a more favorable prepayment penalty schedule. And this is actually something that investors, passive investors, don't think about enough in my opinion. And they need to be asking this question more, which is what is the loan's prepayment penalty? Because it's great and easy to get into a super attractive loan at let's say a low interest rate. But how easy it is to get out of that loan. And that might be expensive, it might be so expensive that you're stuck in that loan and you're not able to get out. And if you want to take advantage of a hot market and sell or refinance, you may not be able to. So for us, we want to match that carefully matched long term debt, but also retain some flexibility. And what that means is we have to pay the lender a slightly higher interest rate in order to have that flexibility. And that's again not easy to do because the incentive is to have the lowest interest rate possible, show investors the highest cash flow possible, but we have to balance the pros and cons there.

Great thoughts, Rob. There. So for the listeners who are coming in, we talked about the cap rates at length last time. Cap rates essentially define what the value of the property is going to be based on the net operating income. So Rob is talking about the cap rate being consistent, the fixed debt that they are trying to see manage that risk. Right. So another good aspect of the fixed rate. Right, Rob, that the rate cap, that's kind of additional cost. Right. Can you talk about the rate gap and how, you know, having a fixed rate actually kind of reduces that risk of the cost?

Yeah. So a big part of floating rate debt is that lenders most often require the borrower to buy a interest rate cap. And that puts a ceiling to your interest rate exposure. So your floating rate can float, but if it crosses a certain threshold, there's a cap in place that puts a limit to how high it can go. And this cap is not free. You have to pay and it can be very expensive for this interest rate cap. And these caps don't last forever. If you have, let's say a three year loan or a five year loan or a ten year loan that's floating, you'll be responsible for purchasing a new rate cap every single time the existing one expires. So you might buy an initial rate cap for two to three years and then after that two year period it expires, you have to buy another one and then another one, another one. And this is kind of, this can. What we've seen is since interest rates have gone up so dramatically, we're now kind of in this loop of having to buy cap and then start reserving and saving up for the next one. And then, you know, when are you going to get out of this loop? Right. We just don't know. There's a lot of uncertainty. And that's just the reality of floating rates. They're uncertain. And so floating rates can be very beneficial because they afford maximum flexibility. And historically speaking, over pretty much any period of time, floating rates can be, have historically been cheaper. So it's just more volatile, it's harder to sleep at night. And that's why we love the fixed rate now, because we've just found it so much easier to deal with, we're removing a variable from the equation and we're able to provide investors more consistency. The reality that we've discovered and matured into is the fact that we're not necessarily in the business of providing investors the highest returns possible. We're in the business of providing them the most consistent returns and letting them sleep at night and providing them confidence. That's most important to us. And the fixed rate alleviates that floating rate volatility and the need to buy that interest rate cap and then have to reserve an escrow for the next interest rate cap, right? If your loan is fixed, it's fixed for the term and you don't have to worry about interest rates until your loan expires, right? You still have interest rate risk, but it's not during that existing loan. It's when you go to refinance out of the existing loan and into something new.

So as you rightfully point out for the passive investors to look at, the first thing that you mentioned is the yield term. And then the second thing that you mentioned is this rate cap, right? So this is, you know, the prepayment penalty and the rate cap. These are the two things that the question they should ask for and they don't pay enough attention to, right? When they say that this is a great rate that they have gotten into. But asking that right question that how much is it costing you to get to that great rate, that's really important, right? We talked about not to fall for the shiny numbers. And when you talk about being conservative about projecting, this is really important. When it's important for passive investors not to fall for still, you know, that 20% IRR, for example, and ask these right questions that. Okay, let's look back. Last episode we talked about the underwriting assumptions, the conservative underwriting assumptions. And this time we are talking about what is your debt structure? Because these are the two things that's going to impact. We saw that the variable rate that we just discussed, the variable rate, that is one reason to dry out the cash flow. The another reason to dry out the cash flow is this, the rate gap. Because the rate cap was not expensive and that has gotten what, three, five times or more? Much, much more than that, Much more than that. So yeah, that's, that's the tricky part. So passive investors ask those right questions, right? So with that, I think I would love to talk touch base another topic with you. It's about structuring, right? So we're talking about money as a whole for the listeners. We talked about the money that's coming from the lender first and how to structure that. And again, Rob's specialty, in addition to underwriting, is that structuring. Right. But that structuring does not stop there. That structuring actually comes back to the deal and doing that partnership structure correctly. And we saw all the different types of structuring. Right. Rob? There is very simple, straightforward, you know, partnership splits. There is like a waterfall model. There is different classes. So let's talk a little bit about that. But before that, let's talk talk about what is a capital stack and why should passive investors be focused on where their position in the capital stack is?

Yeah. Yes. I mean, a capital stack or capital structure is just the way that the money comes together to do a deal. So you could do a deal with no debt, you could do a deal with a little bit of debt, you could do a deal with a lot of debt. So debt is the foundational layer of your capital structure, and then from there, everything builds off of it. So as an equity investor, it's very important to understand the capital structure because. And your place in the capital structure, if, if there is debt, you want to understand it well and you want to understand the fact that you are subordinate to the debt. Right? That's what debt is, that the lender gets paid first and equity investors get paid second. Then there's things in between. There's things that are kind of a mix between debt and equity, such as mezzanine debt or preferred equity, which sits in the middle of the capital structure, in between debt and in between common equity, that again, if a common equity investor is coming in, they need to understand, oh, there's a lender involved in this capital stack, and there's a preferred equity lender or a mezzanine loan or something that also gets paid first before common equity, which enhances the, increases the risk of the deal. And as a common equity investor, you want to be cognizant of how much risk you're taking and to see, does this deal profile projected returns and its risk? Are they in alignment with my capital, with my investment strategy? Right. So that is really important.

So let's, let's step back and talk about these positions. Right. It's almost like first in, first out. So the first one, the lender comes in, lender gets paid first. Let's talk about the mezzanine piece. Can you explain a little bit about that?

Sure. So mezzanine debt is very similar to preferred equity. And they can be structured very similarly. So basically it's like I said, it's a mix of debt and equity, whereby they're paid first before the common equity, but they're paid after the lender. And mezzanine debt is structured as more so like debt and there's usually stronger terms. Whereas preferred equity is technically an equity investment, but they have more rights in the operating agreement where they say we get paid first. If you don't pay us, we maybe can remove you as the manager, or we have default interest and we can dilute the remaining equity to make sure that we get our returns. So it's. You have to be careful with that kind of stuff. So on our end at Lone Star, we've actually never borrowed preferred equity or mezzanine debt. Not to say that we wouldn't. It's just we haven't found a need for it in the past. There are opportunities where we think it makes sense to do so. However, we have actually lent out preferred equity, which is a very cool experience and a great place to be in the capital structure. So that was something that we did for a little bit. But again, our main focus at Lone Star is really owning and operating properties ourselves, not necessarily being a lender, but we know that business quite well because we were that lender and we did lend preferred equity in the past.

So you were on the positive side of that, that experience. Right. For passive investors, the moment you start seeing many layers in this structure, the capital stack, start asking those questions, you know, especially if there is a lending position and then there is different class of investors and sitting in between, they are the one that are going to get priority if something goes wrong. Right. So that's one important aspect. Thank you for pointing that out. Now let's talk about the actual structure and let's start with very simple, right. Most of the times I'll get question from my passive investors that how do you get paid? Right. And you know, one great thing about my business syndication business is that we are pretty transparent about it. We, we pretty much say it in our webinars and that tell us, tell them what is that fee structure is going to be for us. Right. So essentially the syndication is the process of these two groups coming together, one with the subject matter expert and one with the passive investors with the capital. Right. It doesn't mean that the syndication team does not put money in it. They do also put money into it, but they have that expertise. Right. So let's talk about in the structure. First thing first, that how is the structure Defined for the fees that syndication team is going to get paid. And the partnership model for the passive investors, how is that structured? In a very simple structure. And then we will go a little bit complex, step by step.

Sure, yeah. I like to keep things simple. So you break up sponsor compensation into two categories, fees and performance compensation. So fees are pretty straightforward. Typically deals will have an acquisition fee, which is a one time fee at closing. And then there's an asset management fee which is ongoing. And so that asset management fee helps pay the sponsor an ongoing basis for managing the investment. And then sometimes there's a disposition fee, sometimes there's refinance fees, but those are the kind of the main fees. Then on the profit participation or the performance compensation side of things, that's where you have profit splits and where you have waterfalls. The most typical structure, especially kind of on the more institutional side, is one in which has a preferred return. Preferred returns are really important because it gives investors a priority on their return before there's any share of the profits with the sponsor. And so we have our structure set up with an 8% cumulative and compounding preferred return, which means investors earn a compounded 8% return before we earn any profit. And more importantly than that, even our preferred return is subject to return of capital. So investors not only get an 8% compounded return, they also get all their original investment back. And that 8% is annual, right. It's compounded on an annualized basis. And then investors are owed 100% of their original investment. Then once that occurs, which means they've gotten all their money back, their risk is off the table, they've earned a minimum 8% return. Then after that we start to share the profits on a 7030 split with 70% of the profits going to investors and 30% going to us as the sponsor. And that is, I would say, very typical structure and kind of the industry standard. Anything that deviates too far away from that to me starts to be a red flag. Right.

And keeping it simple like you said, right, keeping it in simple, passive investors are going to be able to understand it more. So just going back to what you mentioned, the split, the partnership split, right? You're talking about 70, 30. So that 7030 partnership split, every dollar that's coming to in terms of the income, in terms of, you know, refinancing, when it also the sell of the property, the 70% is going to get get to the passive investors and the 30% is going to get to the GP team. But in this process, it's not just that 70%, the preferred treatment that you're talking about is that 8% preferred. So unless the 8% is given back to the passive investors, the sponsor team is not even starting to get that 30% on their money. Right. So that's really a preferred treatment for passive investors. And if you don't have a pref return in your deal, look for it. And that's, as you said, so that's the first red flag going back to the acquisition fees. Right. So there is acquisition fees. What is the typical range that they should look for? I mean, of course, it depends on value add and how much work that property has. But what, what is the fees that typically they should look for?

Well, I would say that there are some differences based on the size of the deal and based on the asset class. There's some asset classes that are just, just the terms are different or the fees are higher. But in our space of multifamily value add, the acquisition fees are usually somewhere around one and a half to 2%. And the asset management fee also is about one and a half to 2%. And then. Yeah, so those are, those are the typical fees. A disposition fee is less common, but It'll be sometimes 1% of the sale price. And refi fees also, again, are less common, but can be 1% of the refinance loan proceeds.

Right. Now let's talk about the waterfall structure. So sometimes it's a very simple format that, okay, the passive investors are getting 8, whatever the pre. Percentage, 7%, 8%. They're getting that 70, 30 split. There's an acquisition fee, there's an asset management fees, and there might be some capital transaction. Now the, the additional layer to it is now the waterfall. How does the waterfall work and how actually it might benefit in the good interest of passive investors?

Yeah, so a waterfall is just simply the outline of the partnership structure and how profits essentially flow through the different hurdles and splits and stuff like that. So like we discussed, the most important piece is the preferred return. So as a passive investor, I want to know what are the mechanics of the preferred return? Are my interests aligned with the sponsor and am I getting a market rate deal for me, if the preferred return doesn't compound, that's not very attractive because I want my sponsor to be penalized if they don't pay me the preferred return. Right. If I get 8% distributions every single month, well, I'm very happy. That's fantastic. But if I don't, I want the payments that I'm missing to be accruing and compounding. And what the compounding is, is it's actually the dollars that you're not being paid are earning interest on themselves at 8%. And that's great too. Right. That's just nearly just as good as earning the 8% into your bank account every month. So I like a compounding preferred return over just a simple accrual. So that's important to me. It's not necessarily a deal killer, but I like that and focus on that. Everything else in the waterfall is just kind of negotiable or just whether you think it's fair or not. Right. Some people think 7030 split is too high of a split for the sponsor and they want to look for a situation where they can find an 8020 or a 75, 25 or maybe 7030 is fair. Right. So it really just depends on what the investor is looking for and how has options. Maybe they have a friend who, you know, is, is offering them different terms. So yeah, that's, that's my opinion on the waterfall.

And how does it change when based on the performance? So sometimes a passive investor can see that after a particular threshold it's, you know, the split changed maybe 50, 50. How is that structure and why, why is it important for them to take a look at that?

Yeah, regardless of the structure, it's important that investors look at the deal's returns on a net basis after all the fees and after the profit splits are taken into account. Right. Because it's not helpful to an investor if the deal is presented as the best deal in the world, but the fees and the profit split eat away at the returns. Right. And it's. What's the point? So it's important for investors to analyze deals on a net return basis, which is, is not hard to do. And sponsors usually show investors, hey, these are the returns on a net basis, so they can see what those projections look like. But to answer your question, yes, you know, it is more common these days to have a secondary hurdle. For example, our typical deal structure includes a 5050 split of the remaining profits after a 15% IRR. So that's really simple. When the deal returns a 15% internal rate of return to investors, any profits above that are split 50, 50.

Yeah. And then that's not necessarily a bad thing. Right. Because that actually is that motivation for the sponsor team to kind of outperform and keep on sticking to their projects, what they have done. So it means that if they do actually reach to that 15%, they have done exceptionally well. And there's a little bit More reward for them in there. And that helps passive investors too. Right. So now moving on from that little bit simple structure, we had a layer of the split, little bit complexity in it. Let's talk about the classes, the classes of shares. Sometimes it's just one straight class and sometimes there is a class A, class B and class C. And the class C typically is what we just talked about, that pref and this partnership splits and the change based on the performance, what is the time that the classes A and B are coming in and getting structured in the deal?

There's a few different ways to approach multi class or dual class deal structures. So, you know, three, four years ago, the dual class structure became very popular where the class A investors were actually paid first before class B investors and they earned a fixed rate of return that was around 9 to 10%. And they didn't participate in any of the upside, but they had the security of the position in the capital stack and they got all their return out of yield. Right. So they got good cash flow and then the class B investors had to wait for those class A investor to be paid first. And then they got paid, but they got more upside because they didn't have to share the profits with the class A investors. So that was an interesting or it is an interesting structure where people who are more cash flow focused and more risk averse can enjoy the class A structure or the class A tranche. And then people who don't really care about cash flow as much and really want more risk and more return, they can invest in class B. And so that was, that was more popular. I don't think it's quite as popular anymore. But that is one way to approach kind of a dual class structure. Another thing that's kind of completely different but still can be referred to as class A and class B, which actually our deals have them. It's a simple allocation of difference in minimum investment. And so for investors who invest more with us, our class B tranche is open for $500,000 and greater investments. We actually improve the deal structure in the investor's favor by offering them a 9% cumulative and compounding return and a 7030 split thereafter with no 5050 split above any other hurdle. So it's just 7030 for the rest of the returns. And so that's a little bit of a better structure which actually has more downside protection because the promote is subordinate to a 9% pref rather than an 8% pref. And so the higher the pref for an investor, right. They're not necessarily guaranteed returns, but it's their minimum return is now higher, which puts them in a better situation.

Yeah. At least they're going to get that money paid first before sponsor team is going to start making that money. So you make a good point there. Right. We have that different classes of investment and I often look at my investors and I ask them that what is really purpose that you want to go into this deal? For example, if somebody is very close to the retirement and that cash flow is important for them, they might look into that class A which might be a little bit less IRR than what the class C will get it. But at least it's getting that consistent cash flow which is important for them. So that also helps kind of improve the investment faster returns in the class C also because now we have somebody who is maybe just taking that 8 to 10% IRR versus what the Class C is getting. You know, that 12%, 14%, whatever the IRR is is projected for them. So that's an interesting point. And of course, you know, if somebody is coming in with that big investment chunk, it's kind of nice to have that rewarded that. Okay. They're going to make a little bit more preferred treatment on that investment. So thank you for explaining that. My last question is going to be about, you know, the different type of investment. So we talked, so we talked about the lender, then we talked about the equity partners. But equity partners also there different categories to it. Right. Can you explain those? You know, the money, the chunk of money coming from different type of investors and it could be ranging from the partnership to, you know, just, just a regular accredited investor, for example, or even sophisticated. So can you explain that different categories of investors that are coming in in the deal?

Yeah, yeah, we, we look at investors as accredited investors or high net worth investors who are individuals investing in real estate, but aren't necessarily real estate professionals. They don't invest professionally or for a living. Then there's professional investors who maybe are high net worth individuals and they do this and this is kind of their main focus. Or they could be setting up a fund, a fund of funds model, or it could be structured as a cogp. And then also there's the institutional world, which includes family offices, includes private equity firms and larger pools of capital. So there's a big diversity of investors out there and it's important for a sponsor to kind of figure out who they want to work with, how they want to go about working with them and being intentional with attracting them the right way. Right. Because the way that you might communicate with a retail investor and a credit investor is not the same that you'd communicate with a, you know, $2 billion fund. Right. It's a different level of sophistication, different level of due diligence, different. A different level of sales and work. So that's something that really gets, gets me excited. And I love to work with different types of investors. And I like working with small investors, big investors. And all of our deals have a mix and sometimes we have a very large investor mixed in with some smaller investors. Sometimes the deal is just all syndication and it's just many small investors. So that's our kind of more diverse way of approaching our investor base. Some people really just focus on only one style, but we like to, to work with different types.

Yeah. And that kind of diversity helps the deal. Right. The helps mitigating that deal as well. So thank you so much for explaining that. With that, I always like to ask what are the three things that you would advise the passive investors, especially in this structure and how the money is coming in to ask the sponsors. And we did kind of mention couple of things trickling in in the conversation. But just to summarize it, what are the three things that you would ask the passive investors to focus on?

Yeah, to summarize, I think a really good thing to focus on are loan prepayment penalties, especially because real interest rates today are potentially on the higher side and they may come down and that will actually exacerbate yield maintenance prepayment penalties. So understanding prepayment penalties and figuring out what that looks like for the deal, that's really important. Number two, we talked about preferred returns and we talked about compounding preferred returns as well as preferred returns that are subject to return of capital or not. That's also important and helpful to understand and be comfortable with as a passive investor. For a third thing, I would probably bring it back to debt and point out the two really important factors about debt, which are the leverage point, understanding that more leverage versus less leverage. Right. As well as the term of the debt. How long is the debt for? Is it for two years? Because that's kind of risky because you're going to have to deal with a looming maturity or is it a 10 year loan which has a long time to really mitigate risk. Right. So looking at longer term, lower leverage, those are ways to mitigate downside. But again, mitigating your downside isn't free. It might result in the deal having slightly more conservative or lower return projections. So as an Investor, you have to look, look at that and say, can I live with potentially slightly lower returns in exchange for these downside protections?

Right. Thank you so much for summarizing it. That's so listeners, if you are listening to this episode, it might sound a little bit complex because your focus is passive investment. You don't want this to be so complicated. But just by spending this 30, 40 minutes on this episode and even going back to the past episode, 30, 40 minutes, it's going to give you immense amount of knowledge to ask those right questions. So I encourage you to go back, listen to the previous episode and listen to this episode again. The first time around, you might just get familiar with the terms that I use. But take a pencil pen down and just note down all this top all these questions, all this important aspect of the debt structuring and the underwriting in last episode that you can focus on so you can ask that educated questions. It is really, really important. At this time when we are looking through this trifecta of the inflation, the interest rates and the recession and you're just sitting on the sideline with your money, eroding your money to inflation, just think about what you can do and ask these right questions. Rob, that has been immensely grateful to have you. I'm going to ask you just in the next, next, you know, just couple of more questions about wrapping up this episode. The segment, my favorite segment, how do you, Rob, think outside the stocks? I asked that question to you last time and great answer, great insight into how do you actually diversify? Today I'm going to ask a different question in that segment. How do you measure what you invest in? Because what gets measured gets managed. Right? Right. So for most of our investor investors, sometimes they put money at different places and they're not measuring, they're not kind of looking at their portfolio as whole because they're just in different places. How do you actually measure that and do you have any tips for the investors to manage that?

Yeah, I do a few things. So on a monthly basis, I track all my income and then I track, I put a certain amount of my income every month into another separate, separate bank account, which is my investing account. And then from there money goes and is invested and I take my funds for investing and I break it up into allocations. Certain percentage for real estate, certain percentage for venture capital, certain percentage for the stock market. And so I, that way I don't really have to think too hard about it. Right. It's just already broken up and say, okay, I've got $10,000 ready to go to put into the stock market. Okay, great. Buy some stuff.

Stocks.

And so that keeps it pretty simple from an allocation standpoint. And then to keep track of it all I just maintain and update my personal financial statement and schedule of real estate owned as I have to do for our lenders anyway. So I just manage and maintain my personal affairs.

Do you use any tools for that or just simple old Excel?

Just Excel. I love Excel.

Yeah, that's a good friend, right. For many of us. Us. Thank you for sharing that. What are you known most for within your inner circle?

Interesting. I would probably have to say my focus and yeah, my focus. I just, you know, I don't. You're not going to see me wake up one day and say I have interesting idea and it's just a brand new venture. You know, I, I pick my lane and I stick to it and I've, you know, I've got my strategies and, and that's what I focus on.

That's excellent. So that's kind of a subject matter expertise that you are creating over and over again. I love that one advice for passive investors that are starting out.

Think sponsor first. Just build up sponsor relationships. Take your time vetting sponsors because at the end of the day if you're looking at it's very time consuming to be deal driven which means that you are looking first at deals and then evaluating sponsors. That's extremely time consuming and requires you to be an expert. It is better to be sponsor driven and find a handful of sponsors that you trust trust after vetting them. And that way you can do deals from a smaller pool of deals because you're only looking at deals with those sponsors. And then you can pick the deals that fit your criteria, make you feel comfortable of those of those sponsors that you already trust. That way you're not having to do deal diligence and sponsor diligence for every single deal that you're doing. It's saving you a lot of time.

Yeah, it's kind of upside down. Thank you so much for that value. You. I think that's very, very interesting point that you know, when even I look at partnerships I look at the sponsors first before even they have the deals. Right. I start looking at if this value system is going to match first of all and are they putting that investors in the, in the first seat. Right. The first priority. So that what you just said, that's just such golden words. That's so important. The next question I have, what is that one advice you got that kind of changed your path.

Interesting. I've gotten a lot of good advice, but I don't know if I or, you know, when I heard this, but I would just say that the best thing is to not accept typical timelines and not accept the traditional path and to think whatever your goals are, you should just look at them and say, well, how can I, if that is a year goal, how can I do that in a quarter or a month? Right? And just trying to compress time windows is really, it requires opening up your mind and having a paradigm shift. But it is very, very valuable.

That's, that's great. Such a, such a great advice. So, Rob, with that, we have come to our end of our episode. We had another great, great conversation and thanks again for your insight. We hope this 2023 has a great success year for Lone Star Capital and you. And thank you so much again for joining.

No problem. Thank you.

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