This is an LFI episode and LFI is now part of PassivePockets.
I’m thrilled to have J Scott with us. He is an entrepreneur, investor, advisor, author, and partner at Bar Down Investments. He’s focused on buying and repositioning large multifamily properties. In the past, he has bought, built, rehab, sold, lend, and held over $150 million in property around the country. He holds strategic advisor roles in several companies.
He is the author of five BiggerPockets books on real estate investing, including the bestselling, The Book on Flipping Houses and the recently released Real Estate by the Numbers: A Complete Reference Guide to Deal Analysis. We are so pleased to have J not only on the show but as a member of the LFI community. He is an infielder. If you jump on the forums, you will find him there. J, thank you so much for coming. Welcome to the show.
Thanks so much. I’m excited to do this. I joined your community. I love the conversations. I have been looking forward to this. Thanks for having me.
I have been looking forward to it as well. The first question I always ask is, we want to hear about your journey. We know that you are an author. You have bought a bunch of real estate. How did you get into real estate? How did you find BiggerPockets? How did you decide you are going to write five books? If you can give us the full story of how you got to where you are.
The common theme in all of those was an accident. That’s the crazy thing. Starting at the beginning, I’m an engineer by education. I worked in the tech world for a long time. I was in Silicon Valley leading up to 2008. I met my soon-to-be wife in 2006. We decided to get married. When we decided to get married, we knew that working 80 hours a week in our tech jobs, she was traveling several weeks a month, it wasn’t conducive to starting a family. We knew we had to figure out the whole work-life balance thing and do something different.
When we decided to get married, we also decided to quit our jobs. We moved from the West Coast to the East Coast. We decided to figure out something else to allow us to have the work-life balance that we wanted. We fell into real estate. It was completely accidental. We were watching a flip show on TV and my wife was like, “Let’s flip a house.” We hadn’t yet quite figured out what we were going to do next in our careers.
We ended up flipping a house, the 2nd house, the 3rd house, the 10th, the 50th, and the 100th. Before we knew it, we were real estate people flipping houses. From 2008 until about 2016, we flipped about 450 houses. It was great. It was fun. I’m always a fan of scaling businesses. For me, it was a great challenge to be able to figure out how to go from flipping our first house to building a business around it.
I’m an introvert and it’s hard, especially a little bit better at it, but back then it was hard. People started to hear that I was flipping houses and everybody was starting to get back into real estate and I started getting a lot of requests from people, “Can I pick your brain? Can I take you to lunch? Can we have coffee and talk about flipping? Can you do a phone call with me?”
Meeting all of these people and doing all of these lunches wasn’t fun for me. It was stressful. What my wife suggested was, “All of them want to learn from you. They want to learn how to flip houses.” I was writing a blog at the time. She’s like, “You have got all this material in your blog. Why don’t you turn it into a book about flipping houses? That way, when people ask you to go to lunch or have coffee or do a phone call, you say, ‘No. I don’t have time to do that but here’s a book. Go read the book.’”
I thought that is brilliant. I love writing. I love teaching. I just don’t like talking to people. 2012, I sat down and wrote The Book on Flipping Houses. One of the chapters on estimating rehab costs ended up being like 300 pages itself. I said, “I’m going to turn that into a separate book.” I had these two books back in 2012. That’s how I became an author. With flipping and writing, it happened accidentally. I did it to avoid having to have lunch with people.
At the time, I had become friends with Joshua Dorkin, who was the Founder of BiggerPockets, which is now the largest real estate investing platform on the planet. Josh and I were friends. I said, “I wrote these two books. How about if I release them on BiggerPockets? I’m not a marketing and sales guy. I don’t want to sell them. I want people to be able to get them if they want them.” He said, “Let’s release them on BiggerPockets.”
He and I partnered up, and we released the two books. That led to BiggerPockets Publishing, which is now the largest real estate investing book publisher on the planet. That happened accidentally as well and that cemented my relationship with BiggerPockets. I have worked with them as an advisor. I hosted one of their podcasts. I had a great synergistic relationship with them over the past decades as well.
Your accidents were bigger than my accidents, but it is interesting that the only reason I’m in real estate was the accidental landlord. The only reason Left Field Investor exists is because I wanted to start a little dinner club but the pandemic stopped that, so we went online. Next thing you know, we got 1,300 members. The interesting thing to me is a lot of this, people stumble into but you have to actually then do something with it. That’s what you have done and started this amazing career that led to, now you are doing syndications at Bar Down Investments. Can you tell us a little bit about how did you get from flipping houses to syndications?
I flipped one house. I read your book. I didn’t read it well enough, obviously, because, we joke that we made hundreds of dollars on our first flip and you are supposed to make tens of thousands. The thing I learned is flipping is not for me. I’m a passive guy and I have learned that. How did you go from 450 or whatever the number was of flips to, “Now, I’m going to do something different?” Flips are very transactional. It’s different where now you are into cashflowing assets where before your cashflow is, “I flipped this house, now I got a bunch of cash, I got to go do it again to sustain it.” Talk about that transition.
2016-ish rolls around, 2017 rolls around, and I am completely burned out from flipping houses. I like to think that I was a pretty good business owner, pretty good at scaling the business. There are a lot of headaches that come along with flipping houses. No matter how well you might systematize or create processes around the business, it’s a very high-touch business. It’s a relatively low-margin business. It can get very frustrating and stressful.
No matter how well you might systematize or create processes around the business, real estate is a very high touch business.
Around 2016 and 2017, I decided I was done with flipping houses. I thought about leaving the real estate industry for a while. I took some time off and said, “I’m going to reevaluate what I want to do next. Do I want to go back to tech?” I was doing some advisory work for some tech businesses. Did I want to become a full-time advisor? I didn’t know.
I took some time off and a weird thing happened when I stopped flipping houses. All of this cash that I had in all of these deals came and ended up in my bank account. Suddenly, I had all of this cash. I guess I knew I had, it was on my balance sheet, but I had never seen it all in one place in the last several years because when you are flipping 5, 10, or 15 houses at a time, all your cash is out there. I saw all this cash come back to me. While I’m trying to figure out what I want to be doing for my active efforts moving forward. I had this challenge of figuring out what I wanted to do with all this cash.
I decided, “I know real estate well. I like real estate well. I was a big fan of multifamily as an asset class come 2016 and 2017. Why not invest it passively? Why not start investing in syndications?” 2016 and 2017, I started investing some of that money in multifamily syndications. I started investing in some other syndications. I quickly realized, and you are not going to like the answer here for anybody out there that’s a passive investor, don’t listen. I don’t trust other people with my money. I’m a control freak. I probably overestimate my skill at investing in real estate. I’m going to be a better custodian or a better fiduciary of my money than somebody else will.
While I found some good syndicators to invest money with, I was never comfortable doing big investments or a lot of investments because, again, I’m a control freak. 2017, what am I going to do with my money if I don’t trust other people to be investing it for me? That’s when I decided, “There’s no reason why I can’t stay in real estate.” I can’t move to the multifamily or to the commercial side and use syndication as a vehicle to invest my own cash but in deals where I’m the custodian, I’m the fiduciary, or I’m the guy in charge.
2017, I decided I wanted to move into multifamily. I used that as a vehicle to stay in real estate, but also as a vehicle to invest my own funds passively. I started thinking about how do I learn this business because single-family wasn’t that tough and there weren’t a lot of risks because I was using my own capital. I wasn’t partnering with other people. I didn’t have equity investors, so I didn’t have to worry about losing anybody else’s money. If things went south, it was my own money.
With syndication, that all changed. I’m now a fiduciary for other people and I need to understand this business better than, as far as I’m concerned, anybody else if I’m going to trust myself investing other people’s money. I reached out to a friend of mine, her name was Ashley Wilson. At the time, she was doing multifamily as well. I reached out to her and I said, “I will make you a deal. I have a proposal for you. I will come and work for you for a year. I will be your coffee boy. I will dedicate my time. I will dedicate my knowledge. I will have access to my network. I will put money in. I will put whatever you want for one year. You have got me. I’m not going to do anything else. All I ask in return is, let me shadow you in your business for that year. Teach me multifamily.”
She thought that was a great opportunity for her. I obviously, because I proposed it, thought it was a great opportunity for me. For the next year, we worked together, and I got to see every facet of the business. She’s the best asset manager I have ever met, so I got to see the operations side of the business. That part of the business that a lot of people don’t even think about, I got to be exposed to.
I helped her because I had the ability to raise capital for her deals and helped her there. I’m the numbers guy. I helped them with their underwriting models and helped put together some analysis models for locations and helped with due diligence. It was a great partnership. After about a year, what we realized was we had a tremendously complementary set of skills.
There were things that I was good at that she hated doing. There were things that she was good at that I wasn’t good at. Between us, we were this superhuman real estate investors, if you put our skills together. At the time she said, “Let’s work together.” She had a company called Bar Down Investments. She said, “I’d love for you to come and be 50/50 partners with me at Bar Down.” I jumped at that opportunity, and we have been working together for years now.
A little bit of an accident, you intentionally said, “Let’s trade your knowledge for my network and all the things you brought.” You partnered up, and then all of a sudden, accidentally, you found a new way to go forward. That’s awesome. It was an intentional accident. You did something with intention and it resulted in something good for you and that seems to be how things are progressing.
I like to say that I go out of my way to put myself in situations that could turn out well. If you are constantly putting yourself in situations where opportunities could arise, eventually they will. Trust me, I put myself in plenty of situations where no opportunities come off those and I move on. Eventually, good opportunities will arise and I haven’t been scared to jump at them.
We are going to get back to the multifamily stuff, but I’d like to start with the economy. Everything is uncertain now. There’s a lot going on. There are supply chain issues, inflation, and interest rates. There’s a war in Europe. There was a pandemic that threw everything. A lot has happened over the last few years. What does all that mean for investors? Is uncertainty more of a problem than the high-interest rates? How does all that work together, in your opinion?
That’s actually a good word, uncertainty. There’s a lot of it. The nice thing as investors is, especially if we are not flipping houses, if we are focused on buy and hold, if we are focused on the right type of investing, the nice thing is that investing has a relatively long time horizon. Our time horizon’s going to be 3, 5, 10, or even 20 years or more.
There’s a lot of uncertainty, and that’s actually the interesting thing when it comes to real estate. A lot of times in a lot of investments we make, we can forecast how well those investments are likely to do in the short-term because we typically have a lot more certainty short-term than we have long-term. The nice thing is, in real estate, we have more certainty the longer we go out.
If you look at real estate in historical terms, we tend to see trends over 10, 15, or 20 years. Real estate only goes up over 10, 15, or 20 years. It might go down over the next month or the next year or the next five years. Given a long enough time horizon, we tend to see real estate appreciated, and typically we see it appreciate right about the rate of inflation over time. The other nice thing about real estate is we get to use leverage. We get to use loans.
Another thing that happens over time is we pay down our loans and our LTVs, our leverage decreases over time. Deals get safer. Additionally, we get to, essentially, dollar cost average into our loans. I might take a high-interest loan today to get into a deal but at some point over the next years, interest rates are likely to be lower. I can get into a lower loan. Whatever cashflow I’m making now, I’m probably making even more cashflow tomorrow.
The one commonality amongst all real estate deals, whether it’s today, tomorrow, or ten years from now, is we are going to get the tax benefits. I know people think tax benefits can change, they can go away. The nice thing is one of the most popular vehicles for our Congress people, for their retirement and for their investments is real estate, and they make the tax laws.
What we have noticed over the last years is that some of the best tax advantages come to real estate investors and that’s because that’s a vehicle of choice for the people that make the law. We are going to get tax benefits. The nice thing about real estate is, there could be a lot of uncertainty now but if you set your time horizon many years out into the future, what we have is more certainty and much higher likelihood than any deals we do now. Assuming, we don’t make bad decisions, decisions that crush us in the next years. Assuming we don’t make bad decisions in the short-term is likely going to benefit us down the road.
With that, how should passive investors be thinking? If they continue to deploy capital, as you said, as long as they are making good decisions now, it will probably pay off. You hear a lot of people talking about, “I’m going to wait it out.” For me, it sounds like that’s the one thing I pulled over from my stock market days is I don’t want to time the market, so I’m going to dollar cost average into deals. I’m going to continue deploying capital.
How should investors determine if they should continue doing that to deploy capital? How do they decide what operators and asset classes to focus on now? Most people are new to passive investing over the years. Over the years, it was hard to make a bad decision because everything went up. We are not there now. How do passives make those decisions? How do they analyze that?
A couple of things. Number one, historically, when we have looked at investment opportunities, we tend to look longer term. When I look at an area, for example, when my team says, “Let’s analyze a location for investment.” We are going to look at longer-term trends. The big three things we look for are population growth, employment growth, and wage growth. We want to know that over the next years, we are going to have more customers who are making more money because they have good job opportunities. We look at these long-term things.
If I see that an area has long-term growth potential, again population, wage, and employment. I’m probably going to say, “That’s a place I want to invest.” To some degree, that’s 60% to 70% of the analysis I’m going to do before I go into an area. If you have those three things, you are probably going to have an area that’s right for opportunity.
These days, not only should we be looking at the long-term trends for these deals that we are doing but we need to look at the short-term. I mentioned earlier that if you can get to the 5, 7, or 10 years, your deal is going to do well. The key is making sure that the deal doesn’t implode in years 2, 3, or 4. What I would suggest to anybody looking to do deals right now is to focus your risk mitigation. Still focus on the population growth and the long-term trends, but also spend a lot of time and effort focusing your due diligence on short-term risks. Making sure that operators are thinking about those risks and have plans to mitigate those risks.
I’m less concerned about if I go into a deal, I’m going to ask fewer questions about, “You have modeled cap rate expansion of 0.1% per year instead of 0.15% per year. Why?” I care about that. I want to see bigger numbers. That’s going to concern me less than the catastrophic risk you are taking out of a floating-rate loan. You have got a one-year rate cap which means that you have this insurance policy that’s going to expire in a year. What is your plan if interest rates go up in the next year?
That’s going to be something I care much more about than how you modeled your rate cap expansion or population growth because that’s the risk that’s potentially going to sink the entire deal. That’s not going to cause the deal to lose 5% or 10% or not do as well by 5% or 10%. That’s the thing that’s going to cause the deal to, “I’m going to get a capital call.” Potentially the deal’s going to get locked boxed by the lender, which means the lender’s going to go in and control every dollar that’s coming in and going out. Worst case, the deal gets taken back by the bank.
Those are the big catastrophic risks. Those are the ones that you want to make sure that the operator is thinking about and has plans to mitigate. I’m always going to ask questions about what are those short-term risks. Are the short-term risks in weather? Investing in an area that has hurricanes or tornadoes? How do you mitigate that? Do you have the right insurance in place? What types of loans are you taking? What types of debt are you putting on the deals? What are you promising to investors in terms of returns? What’s your mitigation if you can’t deliver that? What’s your DSCR look like? How much room do you have for vacancies to go up? If vacancies go up 5%, what’s your breakeven occupancy number? If I see an 80% breakeven occupancy, that’s going to scare me.
If I see a 50% breakeven occupancy, I know that in a worse case, if we have a bad 2023 and 2024, the property is going to survive long enough to get into the next phase of the cycle. That’s a long way of saying that as an LP right now, be focusing on the short-term risks, and make sure your operators are focused and have mitigation plans for those short-term risks.
The next thing I would tell LPs right now, especially new LPs, is diversification. Diversify. When I say diversify, I mean diversify across investors. If I have somebody that comes to me now and says, “$500,000, do you have a deal? I can put it in.” The first thing I would tell them is, “You shouldn’t be putting $500,000 with us.” Not because I don’t trust us, I think we do a great job but what types of deals are we going to do? We are going to do deals that are highly correlated to each other. We are going to do deals in the same locations, the same types of properties, and the same asset class.
If multifamily in Houston goes down the tubes, good as an operator, as I might be, I’m not highly diversified in my portfolio. That means investors who only invest with me aren’t going to be highly diversified. Diversify across operators. Diversify across asset classes because a lot of asset classes are not necessarily negatively correlated but less correlated. There are times when multifamily is going to do poorly but self-storage might do well. There are times when retail might do well but self-storage might do poorly diversify, so you have some negative or some less correlations across asset classes.
Diversify across locations. One of the big things that we see during downturns, recessions, and economic booms, typically in most areas, rising tide lifts all boats. During recessions, we don’t see that. We see certain areas get hit harder a lot more so than other areas. That’s because recessions play out differently and certain industries tend to get hit harder. If one industry gets hit hard, let’s say hospitality gets hit hard, it’s going to hit certain cities a lot worse than it’s going to hit other cities. Make sure you are diversifying across areas.
Diversify across exit strategies. Have some deals with new construction, maybe have some deals with value add multifamily. Have some deals that are long-term stabilized plays. Have some deals that are, we cash you out early and then you get “infinite returns” after your money’s been returned to you. Have those different exit strategies that you have diversified across.
Diversify across return structures, maybe invest in deals that generate a lot of cashflow. Invest in other deals that generate a lot of tax benefits. Invest in other deals that are going to generate large total returns on the back end. Diversify across the types of returns and when you are going to be getting those returns. Lots of ways to diversify. Don’t just think about, “I’m investing in a multifamily and a self-storage. I’m now diversified.” It’s a lot more complex than that.
We talk a lot at the show about diversification. Generally, operator, and asset class market, but you added exit structures, return structures, and other ways to diversify. That’s brilliant because that means you are covered no matter what happens. That’s the point of diversification. It’s to make sure that no matter what happens, you are going to be okay. That’s phenomenal stuff right there. I do want to back up quickly. You mentioned DSCR and break-even occupancy. Just to make sure that all of our audience is on the same page, can you explain what those are and why they matter?
DSCR stands for Debt Service Coverage Ratio. It’s probably one of the most important metrics that a bank is going to use. It’s basically a ratio of how much money your property is generating, to what your mortgage is every month. Let’s say your property is generating $100,000 a month and your mortgage is $100,000 a month. Your ratio is now one.
It’s not a very good ratio because if your income drops by even a dollar, you can’t pay your mortgage. Typically, you want to make some multiple of whatever your mortgage is in net operating income every month so that the bank is comfortable that you can pay the mortgage and you have money left over as your risk mitigation should your income drop.
What the banks want to see is somewhere between 1.15 and 1.25. As an investor these days, I want to see a minimum of 1.25. I want to know if income can drop by about 20% and if the deal is still going to be able to pay the mortgage. That’s DSCR. Breakeven occupancy is the same thing, but looking at it from another aspect, how much vacancy can I have in a deal where I can still pay the mortgage?
If there’s an 8% vacancy in the property, if I have 8% of the units that aren’t paying either because there’s a physical vacancy, people aren’t living there, or economic vacancy, which means people live there but aren’t paying their rent. If we lose 8%, does the property barely pay the mortgage, or can we lose 30% of the tenants and we can still pay the mortgage?
For breakeven occupancy, we want a lower number. We want to know that as few units can be occupied as possible and we are not going to lose this deal to the bank. I like to see that it depends on the deal these days. It depends on where or how much renovations are required, but generally somewhere in the 65% to 75% for a breakeven occupancy for a lot of these multifamily deals.
I want to change the topic a little bit. I think it’s still related to interest rates. Investing passively in debt is becoming more popular. More people are talking about it, “There’s a debt fund. Let’s get into that. Here’s some preferred equity. Maybe we should invest in that.” Some operators offer a different share of class that has a higher yield but no upside. Can you talk to us about which of those are you looking into? Are you looking into those? Do you think it’s a good time to invest in debt right now? Talk about preferred equity in general.
When we talk about investing in a deal, we have this thing called the capital stack. A capital stack is all the money it takes to put a deal together to get a deal done. Let’s say, I’m buying a deal for $20 million. My capital stack might look like I have $14 million worth of bank loans or debt, and then I have $6 million worth of what we call equity, which is basically investors putting money into the deal. That’s my capital stack, $14 million in debt and $6 million in equity. Every month, I have a bunch of money coming in and I’m paying a bunch of bills. I’m paying my property taxes, insurance, maintenance and property management, and all that stuff. I have a bunch of money left over at the end.
Who is the very first person that I’m going to pay every month with that leftover money? The first person’s going to be the bank. It’s going to be the lender. It’s going to be the debt. They are going to get the first check. I know that if they don’t get the first check, they have the ability to come in and take that property away from me.
If I have any money left over, that money is now going to go to my investors. Hopefully, I have money left over. Hopefully, my investors get stuff. For some reason, my investors don’t get anything, they can’t take the property from me. Unfortunately, they are going to be upset, they are not going to be happy with me, but they can’t take the property. The investors are in a worse position than the bank because the bank is getting paid first. Whoever gets paid first is in the best position. Whoever gets paid second is in the second-best position. We all understand this.
This is the reason why when I borrow money from the bank, I only have to pay them 6%, 7%, or 8% interest. That’s a pretty low number. They are not asking for a lot in return but they don’t have to because their risk is very low because they get paid first. Whoever gets paid first has the lowest risk and they generally make the least amount of money. Investors only get paid after the lender does. They get paid later. Just because they get paid later, they are taking more risks.
If for some reason, this property doesn’t do well and we have to sell it, the banks going to get paid first. Investors only get paid if there’s money left over, so they are taking more risks. They are taking more risks, they require a higher return. That’s why banks might only make 6%, 7%, and 8% interest, but investors want their 12%, 14%, or, 16% IRR. If they take more risks, they make more money because they get paid later. That’s what a capital stack basically is.
Why are people investing in debt these days? It’s because they like the idea of taking less risk. They like the idea of being that person that’s going to get paid first. In return for getting paid first, what they are willing to give up is high returns. People come in and say, “I will invest in debt. Pay me my 8%, 9%, or 10%. I realize I’m getting less money but I’m a much lower risk.” We have this thing called preferred equity. Preferred equity is this place right in between debt and regular investors.
It’s a little bit higher risk, it gets a little bit higher return than debt, but it’s lower risk and lower return than regular investors. The reason why it’s a higher risk than debt is because it gets paid after the lender. The reason why it’s lower risk than the regular investors is because they get paid second. They get paid before the other investors. The other investors now get paid third. They sit in the middle and because they get paid second, they take a little bit less risk. They make a little bit less money than the other investors, but they take more risks than the lender and they get paid a little bit more than the lender. That’s called preferred equity.
Preferred equity and debt these days are a lot more popular because people are worried about the economy. They are worried that a deal could go south. They are worried there could be a major financial issue and a deal could blow up and get taken back by the bank. People know that if they are getting paid first, they are taking the least risk, and because the economy is risky right now, they like the idea of less risk. A lot of people are putting their money into these things that are lower risk like debt and preferred equity, even though they are having to take a lower return for it. People are trading risk for return. Does that make sense?
People are trading risk for return.
Yeah, that’s phenomenal. That’s a great way to explain it. The next question would be with the preferred equity. Sometimes you see that in a deal that you are investing in before the purchase. The deal is there. There’s a preferred equity position. Now, we are seeing that maybe preferred equity might come in on some deals that because of interest rates rising so fast, the deal is in a little bit of jeopardy. Instead of maybe doing a capital call, you have some preferred equity come in there. Can you talk about how that works and how that affects current LP investors on that deal if preferred equity comes in?
As an investor, I don’t want the group to be able to bring in preferred equity later at their own discretion. Remember, if it’s the lender and the investors, the lender gets paid first, and the investors get paid second. If the group can now bring in a preferred equity investment, now preferred equity gets paid second after the lender. As a regular investor, I’m now getting paid third. My risk went up because I’m no longer getting paid second. I’m now getting paid third. Bringing in a preferred equity group without my consent, investment is now a lot higher risk.
I always want to make sure that when I go into a deal as an LP, that I know exactly what the capital stack is going to look like, and I want to make sure that the documents are written in such a way that I can’t get disintermediated. I can’t get another group of investors that get priority over me because that puts me in a riskier situation any new outside without any new upside. I got no benefit out of that. I just got the downside.
Coming into a deal, knowing that there’s going to be preferred equity in the deal from the beginning, that’s different. Now, I come in knowing I’m going to get paid third, but I can demand returns that are commensurate with that. I can say, “I’m only going to do this deal that has preferred equity if I’m getting at least a 15% compounded return.” As opposed to, “Normally, I might take 13%.” I have a little bit more risk, I’m going to demand a higher return. Maybe I’m going to come in and say, “I want to invest in that preferred equity investment.”
I don’t want to be a regular investor in this deal. I want to go in that preferred equity. Now, I’m in the lower-risk position, even if it means I’m getting lower returns. Coming into a deal, I won’t necessarily not do a deal if there’s preferred equity. I will want to make sure that I have a higher potential for returns because I’m at more risk and I do want to make sure that a group can’t add preferred equity without my consent after the deal’s already been done.
Does that typically have an upside? Is it more like debt? Are they going to participate materially in the upside?
Most preferred equity is a hybrid between debt and equity. In fact, it’s actually closer to debt but we never call it debt because if there’s a lender in the deal, a lender doesn’t want to see more debt in the deal. In the mortgage, it basically says you can’t have another lender. We don’t call it debt. We call it equity, and we treat it like equity but in a lot of ways it’s like debt.
The reason it’s like debt is most preferred equity has a fixed return. Unlike debt, the fixed return isn’t coming all monthly. Full disclosure, we run a preferred equity fund where we have investors invest in our fund and we invest in deals as the preferred equity. What we typically get is returns for our investment. Our preferred equity investment is we typically get 6% per year in fixed income. Half a percent a month, and that’s like the lender.
We get paid that every month. We have recourse if for some reason we don’t get paid that 6% per year. When the deal sells, we get another 6% per year on the back end. In total, it’s a 12% average annual return and there’s no compounding there. If the deal does exceptionally well, we don’t get more money. If a deal does poorly, we don’t get less money, and because we get paid second as preferred equity, we are going to get all of our money and all of our profits before the other investors will even get their money back at the end of the deal.
How is that taxed, that preferred equity? Is that taxed like equity? Do you get the depreciation and all that?
Like any other piece of the equity stack. It’s a fixed return, but from a tax standpoint, it’s taxed exactly the same. Preferred equity participates in depreciation, bonus depreciation, and cost segregation. All the tax benefits are exactly the same way as regular equity does. All that’s obviously negotiable but all the deals I have seen participate exactly the same way. The only difference is they get paid second instead of third and they have a fixed 12% return as opposed to the unlimited upside if the deal does good.
I want to pivot again here. I know we are all over the place, but there are so many questions I have for you to stay on one topic. This might be a long one, but we talk a lot about financial freedom and building wealth as passive investors. For someone new or even someone who’s been doing this for a while and we talked about diversification. How do we figure out a strategy for which asset classes to invest in? How much in each? Which operator? Which markets? How are we looking at that capital allocation and how do we scale that investing business as a passive investor? That’s probably 4 or 5 questions mixed up in there, but if you could try to touch on that, that’d be great.
It’s a tough question. Anytime you talk about asset allocation, Benjamin Graham wrote some great books on asset allocation in the equities markets. Stock investor, you have probably read those. It’s a difficult topic to cover comprehensively and I’m certainly not an expert, what I like to think about is, again, there are different planes of investing. Different ways to look at things and to look at from five perspectives. We talked about them earlier but I will repeat them again.
1) Diversification across locations. 2) Diversification across operators. Make sure you are diversifying across operators. Asset class is a big one. Again, a lot of asset classes aren’t necessary. I want to be careful with my terms. I don’t want to say negatively correlated which means if one loses money, the other’s going to gain money but are correlated in a way that one might do well if another one tends to do less well.
I like to ensure that I have investments across a lot of different asset classes and we can talk about what some of those types of returns is another one. Am I getting cashflow and tax benefits from some deals? Am I getting long-term big return numbers from some deals? I like to balance that. I’m not getting all great tax benefits because here we are in a situation where it’s hard to get cashflow these days. A lot of syndicators are saying, “Come invest with me for the tax benefits,” because that’s all they have. I don’t want to invest everything for tax benefits. I still want to find some cashflow deals even if they are in different asset classes.
Finally, I’m very big on investing in different timeframes. We talk about dollar cost averaging in the equities world in the stock market. You can’t dollar cost average as well in real estate but you can approach that. You can do that to some extent and you do that by investing over periods of time and investing in deals that are going to last different periods of time. I want to constantly be investing. I want to be investing in something every couple of months and for everything I invest in, I want to have different time periods.
I might invest in something that’s likely to be 3, 5, or 10 years. Maybe something that I’m going to hold until I can pass it on to my kids because he’s going to be paying me cashflow for the next 30 years. Diversification across time spans as well. Those are the five areas that I look at when I think about diversification in syndications, real estate, or equity in general.
How do you put that into practice? I know we talk about, “You got to get into different asset classes.” You don’t have control over which deals show up at which times. It’s complicated and I know this is very individual. You don’t have to talk about yourself specifically, but just generally. A self-storage deal came across my desk yesterday and tomorrow a multifamily deal, and then a mobile home park. I’m thinking, “I have a multifamily. I have self-storage. I better go jump in that mobile home park deal.” How do you figure that out with all the competing timeframes that you are dealing with?
Let’s be clear. When I say diversify, when I say that these are also my criteria for due diligence. All of these things are important but there is one of these things that stick out more than the others and that’s the operator. A good enough operator can overcome location risk and asset class risk and other risks and things going on in the deal. A bad operator isn’t going to overcome any of those things.
Number one for me is always going to be the operator and how I decide on a good operator because here’s the problem. I have learned this because I’m an LP investor but I’m also a GP investor. What I have realized is deals are complicated enough that if I wanted to obfuscate a deal to a point where none of my LP investors knew what was going on or understood the deal, I could do that. Underwriting for these things is as much an art as it is a science.
I could manipulate my underwriting to the point where I could hide issues in a deal that I promise you no investor. I hate to say this because I don’t want anybody to ever think I would do this but I’m pointing out, it’s possible. Smart GPs can obfuscate issues in the nuances of underwriting. I know that I’m not smart enough if I’m going to do a deal with somebody in Omaha, Nebraska. I don’t know enough and I will never know as much about Omaha, Nebraska as that syndicator should. They could be hiding something about the location.
I’m never going to know enough about self-storage or as much about self-storage as a syndicator that’s doing something in self-storage. If they want to hide something about a deal that I don’t understand enough about self-storage. No matter how smart, I’m not going to be able to find it. I recognize that to some degree, I am going to need to put my faith in an operator that they are doing the right thing, that they are as smart as they say they are, and that they are being forthcoming with me about all the details of the deal. How do we do that? The way I like to do that is I focus on referrals. I will never invest with an operator no matter how good that person looks to me.
I might know somebody or I met somebody and I have hung out with them for a couple of months. I’m still not going to invest with them unless somebody else that I know and trust has invested with them for a long period of time and can vouch for them. I have realized this can make it hard for syndicators to break into space. If you are a new syndicator and all of your investors have these criteria that they need a referral, you are never going to get your first investor.
Don’t invest on an operator unless they have already earned your trust or the trust of someone you know for a long period of time.
Unfortunately, that’s the hard thing. Maybe your first investor should be your friends and your family but I’m going to take referrals as more valuable than my looking at the underwriting, my walking a property, my looking OM or a PPM. All of that goes out the window. At the end of the day, the biggest thing that I’m going to use to make my decision is somebody that I know and trust saying, “This is somebody you know and you can trust.”
People have heard me tell this story a million times, I’m not going to go through the whole thing. I had three phases of how to find sponsors. The first one was bad, the second one was okay, and the third one is exactly what you said. I don’t invest with a sponsor unless they are referred to me by someone that I know, like, and trust, and that person’s already invested in the deal. I do the same due diligence I used to or even probably better now, but I start with that referral and I’m 100 ahead.
The next logical question is, if someone refers you to an operator, how do you vet that operator? How do you make sure? They came from someone you trust and they have invested with them, so you are fairly confident that you know you are on the right track, but how do you vet that operator for yourself?
I want a list of investors who have invested with them, and a lot of them don’t like turning that over. I don’t ask for a list of every investor. I say, “Give me five investors.” They’d give me five, and then I say, “Give me five more.” Again, I don’t want anybody to think that I would ever hide anything because I wouldn’t. Certainly, as somebody that has some loyal investors, if I gave you my list of top five investors, they would never say a negative word about me because they are my super fans. They have been investing with me for a long time. They made a lot of money with me. I’m the first to recognize. Anybody that’s been in this game for a little while has at least a short list of investors, their biggest fans in the world.
If you are investing with me, you want to talk to my second tier, you want to talk to the folks that have been investing with me that have seen the works. That saw the deal that we did back in during COVID where we didn’t pay distributions for most of 2020 because we were concerned about COVID. You need to hear about that and how we handle and communicate that. Did we give information? Those are the investors you want to hear from not the guy that happened to invest in the last deal I did where everything went perfectly.
How do you find that? You keep asking for more. “Can I get a list of five people? “You don’t call those people but then you go back and you say, “Thanks. Can I get a list of five more?” Hopefully, they will give you five more. If they do, you go back again and you say, “Give me five more.” By that third list, those are the people you want to talk to.
Most likely, they are still going to say good things, but they will be the folks that have dealt with warts. We all have warts. We have all had things that have gone wrong in our deals. I always hear, “Nothing ever went wrong.” You are either lying to me or you are not the investor I need to talk to. I want to talk to the guy that says “Something went wrong. Let me tell you how they handled it.” At the end of the day, that’s what I care about.
I wish I remember who this was because I would give full credit to them. I was talking to somebody and they did the same thing you do. They asked for those referrals but they asked for specific investors who invested in the sponsor’s most challenging and difficult deal. They say, “Also, I want to talk to the two investors that you had deals that did not invest again with you.”
That could be for capital reasons but it could be for other reasons. You are digging into trying to get to exactly what you said. You are getting to the people that had a struggle because if you never had a struggle, I don’t know if I want to invest with you. I want to know how did you deal with the struggle and how did you come through it. That’s a great way to do it.
Things are always going to go wrong. I don’t care what you do when things are going well. None of my investors call me when things are going well. It’s when something happens that they are going to call me. They need to know how I’m going to react, how I’m going to communicate, and how we are going to think through mitigation. That’s what I care about as an LP myself.
Down to time here, but as a passive investor, what asset classes are you looking at right now?
When I think about diversification, I think about outside of real estate as well. I invest in a lot of things that are outside of real estate. In real estate, I’m investing in multifamily. Most of my multifamily investment is in my own deals, so I invest alongside my LPs. I do invest in a few other multifamily deals. Self-storage notes are something that I like. Those are the three big asset classes that I look at.
Diversifying your investments includes investing outside of real estate as well.
I do a lot of Angel investing or I invest in businesses. Everything from funds. I’m looking at a carwash fund right now. It’s an asset class that I like because it’s hard to find cashflow. That’s a good cashflow type asset class right now. I invest in racehorses. As far as I’m concerned, as much negative correlation as I can get across all these asset classes, the better I’m going to do.
It all boils down to the sponsor, the person running the deal. I don’t necessarily have to understand an asset class well if I trust the sponsor. I invest in a lot of things, but in real estate these days, it’s probably notes, self-storage, and multifamily. I feel like there’s the most negative correlation or the least correlation among those asset classes, and all three of those, I tend to like going into a downturn.
The last question I always ask is, what’s a great podcast that you listen to?
I have been on so many. This one seems awesome. Anybody who’s reading this, go back and read every other episode. Here’s one I love. It’s not real estate. It’s called the All-In Podcast. It’s a business podcast. I come from the venture capital world. It’s run by four guys: 3 are venture capitalists, 1 is an Angel investor. They talk about all things business, macro, and investing. It’s a lot of Silicon Valley talk. If you want to get a well-rounded view of the economy, technology, and business, it’s an amazing podcast.
They are entertaining. It’s not just the knowledge, they are also fun to listen to, which is a double whammy there. This has been phenomenal. Thank you so much for being on the show. If someone wants to get in touch with you or learn more about Bar Down Investments, what’s the best way to do that?
www.ConnectWithJScott.com and that will link you to everything you need to know about me. Feel free to reach out to me by email, I’m always happy to connect.
Thank you very much. Again, thank you for your contributions to the community. We are so glad you are an infielder and a part of Left Field Investors. Thank you for sharing your knowledge on the show as well. We enjoyed it.
Thanks. Appreciate it.
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I enjoyed that conversation with J. He gives his knowledge, and that’s why I love having him in the forum of the infielders. We are getting a ton of knowledge from him and we got a ton in this show. I love the fact that he wrote a book so he wouldn’t have to talk to people. He said he’s an introvert and his wife had a great idea, “Just put it all in the book and you won’t have to go to all these lunches.” I love how that kickstarted everything.
As he is an introvert, BiggerPockets has a publishing arm. Amazing stuff. He talked about flipping and high touch, low margin. Every time you flip one, you’ve got to go find another. There’s no recurring income there. I get that. It would be exhausting after doing 450. I was exhausted after failing at one. I get it.
It’s interesting how he puts himself in a situation and things turn out right. You have to put yourself out there and you have to take chances. When you do, you are going to find things happened that you weren’t expecting. Good things. That’s what you want to do. You are talking about looking long-term while making sure risk mitigation is the primary. You are looking at the long-term but you are mitigating risk in the short-term as well. That was good advice.
He started to talk about diversification, and I couldn’t stop smiling because he named the first three things we always name at Left Field. Diversify by an operator, asset class, and market, and then, he added a couple more. I have always been thinking you want to keep diversifying. He diversifies also by an exit strategy, return structure, and other ways. You’ve got to always be thinking, “How can I make sure that no matter what happens and where it happens, I am protected? I have different buckets of investments. Some are going to do well and some might do less well at certain times.”
It’s also interesting that he is looking at debt now, and a lot of people are because there’s less risk at what you give up, there is a little bit of higher returns. That makes sense. When we are talking about investing with new operators, I love when I get confirmation. When we talk about community personal finance, that’s one of the things we are addressing these days. Alternative investing is hard, but when you do it in a community and when you do it with others, it gets a lot easier.
Part of that is the confidence. It’s the same thing I remember when Steve Suh told me he was the same operator that I was, I got confidence, and that’s what you get. When J was talking about you only invest in a new operator if somebody that you know and trust has already invested with him, that’s the same philosophy we have. That’s the confidence I get.
Somebody is smart who knows what he’s doing, well-connected to the industry and operator, an awesome passive investor, and he says he’s finding new operators the same way we at Left Field Investors are, that gives me confidence that we are on the right track. I’m pleased with that. He also said another thing too. If you trust the sponsor, once you get to that point where you are trusting the operator and you have confidence in them to do a good job, you might be okay getting into an asset class with them that you don’t know quite as well as maybe you think you should because you are trusting the operator.
I love that philosophy because I can’t be an expert in everything. What I need to do is be an expert in finding quality operators, and then trust them to do their job. A ton of awesome content from J. We are certainly going to have him on again. I’m going to be reading the forums every time he posts because that guy brings the knowledge every time. I’m appreciative of him. That’s all we have for now. We will talk to you next time in the Left Field.
Important Links
- Bar Down Investments
- BiggerPockets
- The Book on Flipping Houses
- Real Estate by the Numbers: A Complete Reference Guide to Deal Analysis
- All-In Podcast
- www.ConnectWithJScott.com
- J@JScott.com
About J Scott
J Scott (he goes by “J”) is an entrepreneur, investor, advisor, author. An engineer and business guy by education, J spent much of his early career in Silicon Valley (California), where he held management positions at several Fortune 500 companies, including Microsoft and eBay.
In 2008, J and his wife Carol quit their corporate jobs, moved back East, got married, started a family and decided to focus on real estate and investing. In the past fourteen years, they have bought, built, rehabbed, sold, lent-on and held over $150M in property all around the country. J is also a strategic advisor and mentor to several companies, business owners and entrepreneurs.
J is partner at Bar Down Investments, focusing on purchasing and repositioning large multifamily projects. He is the former host of the top-rated BiggerPockets Business Podcast and is the author of five books on real estate investing, including the best-selling, The Book on Flipping Houses. His books have sold over 350,000 copies in the past nine years and have helped investors from around the world get their start with real estate.
J and his family currently live in Sarasota, FL. J can be reached at j@jscott.com and you can connect with him at www.ConnectWithJScott.com.
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