The Hidden Housing Costs Almost Every New Investor Overlooks

Dave:
Hello, everyone. Welcome to On the Market. I’m your host, Dave Meyer, joined by three panelists today. We have Kathy Fettke. How are you, Kathy?

Kathy:
I’m good. I’m alive. That’s helpful.

Dave:
Are you referring to your heliskiing experience?

Kathy:
I am. My anniversary gift from my husband to take me up on the peak of some random mountain for our 25th anniversary. I survived it, even though the pilot didn’t want to go and the guide told us it was the most dangerous day they’d ever seen. And then the helicopter sunk into the powder and he said, “I don’t want to spend the night out here.” And I said, “I don’t either. This is not the anniversary gift I had in mind.” Anyway, we made it back.

Dave:
What’s up everyone? Welcome to On The Market. I’m your host, Dave Meyer, joined today by Mr. James Dainard, Kathy Fettke, and Henry Washington. How is everyone?

Henry:
Fantastic.

Kathy:
Good to see you guys again.

James:
I’m good. I’m back in warm California, so I’m, I’m happy.

Dave:
Are you still snowed in, Henry?

Henry:
There’s still snow on the ground, but luckily the roads are navigatable. Is that a word?

Dave:
Close enough.

Henry:
Nava-

Dave:
Navigable?

Henry:
Navigable.

Dave:
There we go.

Kathy:
Well, we had an earthquake.

Dave:
What?

Kathy:
Kind of exciting. I wasn’t there.

Dave:
In California? I didn’t even see that.

Kathy:
Right off of Malibu, about a few miles in, but I wasn’t there, so hopefully the house is still there. We’ll see. But if the earthquake didn’t take it, it might be the Santa Ana winds we had all week, so.

Dave:
Oh boy.

Kathy:
Glamorous California.

Dave:
I mean, it does… I know you’re saying it’s not, but it does seem pretty glamorous. I’m pretty into it.

Kathy:
In the summer.

Dave:
The weather at least seems really nice. I’ve been staring at, it’s like 4:00, 5:00, it’s pitch black out here, so that sounds pretty nice. All right, well today we’re going to get into a topic that we haven’t touched on this before, but a lot of the show, we want to help people understand current market conditions, and honestly, a lot of that is how you underwrite your deals, and how you make estimates into some of the costs. Sometimes we talk about rent, and income, but today we’re going to really focus on the cost side of your deals, and we’re going to talk about hidden costs.
So, what are some of the traps that investors miss when they’re underwriting their deals, or don’t know how to calculate? And I don’t know about you guys, but this is probably one of the more common questions I get. It’s like, I get the math, how to underwrite a rental property, but how do I figure out the assumptions for a rehab, or how do I figure out the assumption for holding costs for a flip? Those types of questions, I think, really trip up the investors, and they change a lot based on market conditions. So, that is what we’re going to talk about today, but first we’re going to take a quick break.
All right, so let’s get into it today, and we’re actually going to break this down into different strategies. So, as usual, James is going to represent the fix and flipping crew for us. Henry’s going to take the buy and hold position, and Kathy is going to look at syndications. James, let’s start with you, and just talk about fix and flip. Just generally speaking, at the highest level, what are the big categories of expenses that you think investors really need to know about when they’re underwriting their deals, and which ones do you think are the hardest to understand, and to underwrite correctly?

James:
Yeah, fix and flip is one of those businesses, because it’s a high return deal, there’s a lot of fees that can be associated with it. It’s also a high risk transaction, as well, because you are buying… There’s so many little things that can come up.
But the four main costs that I usually am watching when I’m buying any kind of fix and flip deal, or a short term investment, where we’ve got to close really quick, is closing costs and assignment fees. What’s your total acquisition? The lending, because a lot of times you got to take down these properties with construction lenders, which have a lot of fees that can be associated with that loan, as far as doc prepping, what kind of interest are you being… How they’re structuring their interest payments, and then construction, what are you missing outside the general scope of work?
And then lastly, it’s always seller concessions, because those things can be big effects at the bottom line in the ROI, when you’ve got to contribute to closing costs. So those are the four big things, and as an investor, you really got to dig into each one to make sure that you’re not getting feed to death, because those fees can really, really jeopardize your return.

Dave:
All right, great. I know nothing about any of this, so let’s get into that. You said the first thing here is closing costs, and assignment fees. So, what are some of the big costs associated with just acquisition there?

James:
Well, one of the biggest fees, hidden costs that I see happen all the time is in wholesaling. And because a lot of times when a wholesaler… When you’re buying an assignment deal, or you’re buying any deal, you have your own closing costs, which are typically going to be your title, and your escrow fees. And if you’re an investor, a lot of times you can negotiate a better rate, because you’re doing numerous transactions. So that’s the first fee I’m always going after is how do I reduce my transaction fees, escrow, title, I work with one title company, they give me a way better rate, they reduce my cost when I’m doing the same transaction.
The other thing I have to watch out for is when you’re buying an off market wholesale deal, you are buying the terms that the wholesaler structured with the seller as a negotiation. And part of that negotiation, sometimes, even when we’re wholesaling or working with a seller, a seller just sometimes wants to know what their net number is. Like, “I’m walking away with $10,000 or $20,000,” or whatever it is.
That usually means that the contract’s structured with the buyer paying all the seller’s closing costs. And so, there’s a huge fee that can creep in at the end. I’ve been see… Especially the last two years, it wasn’t as big of a deal until these last two years, is you would go to buy a deal from a wholesaler and they say, “Hey, it’s $200,000.” “Perfect, wholesaler. I’ll take that deal.”
I’m calculating, as a buyer, that I got my standard escrow, and title piece. But then, when they’re saying 200,000, or they’re saying, “Hey, I locked this property up for 180, I want to make 20 as my assignment fee, you’re buying it for 200.” But then if they structure that you’re paying the buyer’s closing costs, that can get rolled into the deal, and that can be anywhere between three, four, $5,000 that can get added onto the property.
And if that’s not specified in that assignment agreement, you could get stuck paying those costs, because if you’re signing an assignment and saying, “Hey, I’m just assuming this guy’s contract,” it’s up to the investor to verify what’s inside that contract. And so you can get stuck with those fees if you’re not watching that.
So, how I like to always structure my off market deals is instead of a purchase price, I do total investor acquisition. So, that means when I’m buying it from the wholesaler, I’m going, “Hey, I’m buying this for 200,000,” but that uncovers all the costs in there, and then that way if there is additional costs, that comes out of the assignment, not my pocket.

Dave:
So you’re saying that there is a chance, using your example where it’s, the house is at 180, the wholesaler wants 20 grand for an assignment fee. You’re saying that there are scenarios where you as the investor could buy it for 200, and then you would have additional costs on top of that, that could be unexpected?

James:
Yeah, because when you’re buying a wholesale deal, you’re not actually buying a property. You are, on the next transaction, you’re buying the rights to the contract on that property. And so however that contract’s structured, if it’s not clarified on if that’s being deducted from the fee, yes, you are going to be responsible for any buyer’s closing costs, because you’re now assuming that contract, right?

Dave:
Okay, that makes sense. Okay, that’s a very good tip. Yeah, I never would’ve thought about that. And so, is that something that wholesalers… What you were suggesting, the total acquisition fee, using that as the number for your negotiation, it sounds like, is that something wholesalers are familiar with, in your experience, and they’re comfortable reconsidering the way they structure their deals, or their presentations to you, around your preferred metric?

James:
Yeah, a lot of times I’ll have a little bit of issues when I’m working with maybe a newer wholesaler, just because they just also didn’t think about it either. So if they call me and say, “Hey, this price is 200 grand,” the price is really 205 if I’m paying all the closing costs. And so, I just have to educate people a little bit, like, “Oh, next time will you let me know it’s 200, and I’m paying all sellers close… So I can calculate it correctly.”
The clarification question I always ask is, “Is there any other cost outside of it?” And then, “Is this my total acquisition fee?” And if I do that, it can kind of narrow the price down, if they say yes, and then the contract states later, they’re responsible to cover the difference at that point.

Dave:
Okay, cool. Thank you, that’s super helpful. So, the second thing you said where there’s some hidden costs that you might want to make sure you’re calculating, is with lending and hard money. There are some well-known fees and costs associated with getting a loan, but what particularly about flipping, and hard money do you think people need to keep an eye out for?

James:
Especially nowadays, so the lending hard money space has changed. It has the been one of the biggest industries that’s changed over the last 24 to 36 months. Hard money, when I was buying as a new investor, was just like it… I mean, it was really hard money. We would go to a lender and say, “Hey, we got this property. They want us to put a certain amount down.” They’d verify the loan to value, and I could have my cash in 24 to 48 hours. And it was a very simple process at that point.
And then, you kind of knew what your fees were, which typically with a lender, when you’re using a construction or hard money loan, which most of the times you need to do with a fix and flip, you got to add value to these properties. They’re going to be higher rate and points. So the first things you always want to look for is what’s the points on the loan? And what points are, is it’s the origination fee, with the balance of that property, which is going to be the purchase price, and the construction component.
The next thing you want to know is, what is the interest rate? Which is going to be, typically with hard money right now, it’s going to be 10 to 12{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}. And based on that rate, you want to make sure that… There’s a couple things that you want to watch out on the interest, and the rate. The thing that I’m always looking out for, is if I’m doing a construction loan, are they charging me interest on the full balance of the loan, or only the drawn amount?
That can really make a big difference on a long project, because some lenders do finance, because they say, “Hey, I’m reserving you the cash, and so, if we’re reserving the cash, we’re charging you for the interest.” Now some lenders don’t do that.
And so, those are really important things to do, because again, it can be thousands of dollars on your interest when you’re reading your loan sheet. In addition, too, you want to know if there’s any kind of prepayment penalties, right? Because like what I was saying earlier was when we had hard money, it was like cash guys giving us money. Now there’s banks in the space, and banks come with different types of terms.
They’re used to prepays, they want to keep their money out on the street, because if you are a short term investor, and you’re getting a 12 month hard money loan, and you’re selling that deal in eight months, and there’s a prepay, that’s going to affect your deal, and return down. So, sometimes there can be a one to two point prepay.
Other times there can be motivation, where, like we have a hard money company called interest funding. We actually incentivize our borrowers to pay us off quickly, because we like to get in and out of loans. It’s safer for us. And so, you want to be also asking what the benefits are. And then the biggest thing you got to check out for in your lending is just those hidden little doc fees, because they just rack up.

Dave:
But can you negotiate out of those? It’s like, they always keep it at a level where it’s annoying, but it’s not worth actually arguing about. Do you actually go after your lenders for those things?

James:
I will, because there’s also the cat and mouse game all these lenders play, and it’s like, “Oh, I only charge one point, and I’m this rate.” But then you look at their doc schedules and their fees, and it’s almost the same as a two point lender that may have a lot more reduced fees. So, you do have to look through them all, because when you’re paying $350 to $500 per fee, and there’s four to five of them in that deal, that can turn into two to three points.

Dave:
Yeah.

James:
And if you’re doing that on 10 deals, that’s going to add up dramatically over a year. And so, just always be watching. There’s always the construction doc fee, the underwriting fee, then there’s a construction draw fee that could be like $500 per draw that you have. Then there could be a… What’d I get? I got one recently, I’m like, they charged me a $100 to generate a payoff. I was like, “You got to be kidding, I’m paying you off, and you’re going to charge me $100?”

Dave:
Money collection fee.

James:
Yeah, money collection. Yeah, I’m paying… Yeah, they’re trying to make it sure I’m not paying them off.

Dave:
You’re paying them to take your money.

James:
Exactly. That one I felt really good about. But all these fees add up, and you really got to watch for them. And a lot of investors will… That’s their first thing, is, “What’s your rate and points?” And they get fixated on this, but you want to look at the whole big picture. What is the total cost of all of these? How they’re structuring their interest payments, what kind of doc and prep fees, and then really compare apples to apples at that point.

Kathy:
Sounds like it would be a good idea to be a lender, then.

James:
Being a lender is one of the best businesses there are.

Kathy:
Clearly.

James:
Being a hard money lender, it is the best business to operate. I will say that. Because you don’t have to do all the hard work. The investors are doing the hard work. You just got to make sure you verify the asset, and you’re good.

Kathy:
And just charge a bunch of fees.

James:
Reasonable fees. If it’s [inaudible 00:13:07] .

Dave:
Okay. James, so far we’ve talked about closing and costs, and lending, construction. I feel like this is obviously a big one. There’s probably so many things to it, but what’s your top tip here, for helping people avoid any hidden fees, or costs with construction on a flip?

James:
The biggest one that I always say is, is the bid fixed, or is it time immaterial, or just an estimate? Those are going to be the big variances on those hidden fees, because I have had clients, and it’s happened to me too, where you get submitted a bid, and you have to read that fine print. Are these allowances that are being listed on your estimate, or is it fixed? And if there’s verbiage about there being an allowance, or it’s an estimate only, that contractor can raise their price at any time, at least in Washington state. So, that’s the big one with construction, to make sure you’re narrowing that scope, that it can’t be increased just because costs go up.

Dave:
What structure do you prefer, James, for your contractors? Is it fixing the bid?

James:
Oh, we fixed bid everything. I want to know price per square foot, or fixed bid, and if they can’t do that, it makes me a little uncomfortable.

Dave:
Okay, cool. And then last thing you said was seller concessions. Very popular topic these days. So, what are you doing to make sure you’re accounting for seller concessions right now?

James:
As the market cools down, you want to look at what demographic you’re selling to. If it’s a first time home buyer right now, we might pack in an additional 2{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} to 3{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} in closing costs, because that buyer might be asking for that on every deal. In 2008, ’09, and ’10, there was limited financing, limited buyer pools, and it was a lot of motivation for first time home buyers. And so, it was almost always on those deals we were going to have to pay 2{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} to 3{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} in closing costs.
And so you want to make sure you know who you’re selling to, or what product you’re selling. Like if you’re a new construction builder, and the rates are high, you might be buying down the rates. So these are all… If you’re paying three points on a $300,000 flip that you’re selling later, that’s $9,000, which can be anywhere… A lot of times, 25{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} to 50{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} of our profit on the smaller deal.
And so, watch out for those closing costs. So, how we kind of protect ourselves on that, when we’re running our analysis and our underwriting, we’re calling every broker, and then we’re reading through the MLS to see if there was concessions costs given when they sold it. Because if the comparables are all saying they had to support those closing costs, we have to factor in our pro forma.

Dave:
You have a good rule of thumb, James, for how much people should set aside when they’re underwriting a deal right now, for seller concessions?

James:
What I’ve been doing, because roughly is, we have 6{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} broker fees, and then we usually have about 2.5{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} in closing costs, to 3{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}. So, I add an additional 1{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} minimum to each deal. So typically when I’m selling a property, I knock 10{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} right off the top. If I’m selling it for a million bucks, I’m going off a net of 900, because that’s going to be all my closing costs right off the bat, plus a little bit of wiggle room. So, that’s how I underwrite things really quickly in my brain.

Dave:
All right. Well, there are some good tips for underwriting right now, in the fix and flip space. Henry, let’s move on to you, and talk about buy and hold. So, what do you see as the big buckets of expenses that need to be accounted for, and what are some of the major areas that you find investors underestimating, or miscalculating, when they do their underwriting?

Henry:
Yeah, man, so buy and hold. I think most people understand the high level buckets. So we’re talking about maintenance. Everybody knows stuff breaks. So, you need to be budgeting for maintenance out of your properties. Everybody understands that there is going to be property management of some sort, so there’s a budget for that. There’s capital expenses, there’s vacancies, and then everybody else knows there’s your debt service, and your principal, your interest, and your insurance.
So, those are the main buckets that people are typically aware of. But what I found is that people like to skimp on some of these. They’re like, “Ah, it won’t happen too often. I’ll just leave that out of my underwriting. Vacancies are really low here. Stuff rents so fast, so we’re not going to budget for vacancy.” Or, “I’m going self manage, so we’re not going to budget for property management.” So, I think people leave a lot of that stuff out.
But even within some of these expenses, there are hidden costs in the hidden expenses. So when you think about vacancy, everybody understands vacancy. Yeah, people will move out, and then when they move out, I have to re-rent it, and so I need to budget for that time that somebody is not living in my property.
But when you really break down vacancy, there’s a lot in there that people don’t account for. Yes, vacancy means when somebody moves out, you need to pay the mortgage. But what people don’t think about is, what about vacancy when tenants don’t pay rent, right? Because maybe a tenant doesn’t move out, but they’re just not paying you rent for whatever reason, and you’re going through this series of back and forth with a tenant. You’re still having to cover the mortgage for that timeframe, and they still live there.
So, I think vacancy is much deeper than just, “Somebody’s moving out, and I’m re-renting it.” Also, what about eviction costs, right? You’re a landlord, at some point you’re going to do an eviction, or two, or three, or four. It depends on how good you are at tenant selection. But no one budgets for evictions on the front side, and I think evictions are part of vacancy.

Dave:
And expensive.

Henry:
And expensive, and it’s going to vary from state to state. So you should do your due diligence, know what an eviction costs you, and budget part of that into your monthly expenses for your property. You also have utility costs during vacancies. So, if your property is empty, and you’re having to renovate it, right? Well, you’re not only covering the mortgage, but you’re covering the utilities, and those utility expenses aren’t things that people think about as part of what you pay for as a landlord. They say, “Oh, well, my tenants are going to pay for the utilities.” Yeah, they will when they live there. But what happens when you’re doing a 60-day renovation on a property? That utility expense goes back to you. So, you’re carrying utilities.
And so, it’s not just tenants moving, it’s much more than that, because you’ve got tenants moving, you’ve got renovations, and a lot of times people who are going to do this buy and hold method, or especially the BRRRR method, they’re not considering all of these holding costs on the front side. You’re buying a property that needs a renovation. So, all of these expenses start hitting you from day one, before you’re ever making any money. And so you want to underwrite that into what you’re offering for a property, and be able to budget for it on the front side.

Dave:
So, how do you do that practically, Henry? Because a lot… If you use the Bigger Pockets calculators, or a spreadsheet, usually there’s a line item for vacancy, and it’s usually a percentage of rent is what most people do. Is that what you do, or do you recommend adding sort of another lineup? Do you jack up the vacancy number?

Henry:
I don’t think that it matters, as long as you add it in there. So, if you just want to increase your vacancy percentage, right? So some people, as a rule of thumb, just use the vacancy percentage of a market, so you can find your market, and understand, “Hey, in Northwest Arkansas, we have 5{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} vacancy, so I’ll budget 5{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}.”
Well, 5{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} typically probably isn’t even one month’s rent. And so, I prefer to do it more on, how long do you envision a property to be vacant when you have to turn it over, and then add a little padding for these other things that we talked about. So, in my opinion, it needs to be at least one month’s rent, plus these additional things. And so, just use your best judgment, based on what these things cost, and add a little bit to that. Or you can have separate line items if you’re super detail-oriented.
Another thing to think about is a lot of people do not budget for property management. They say, “Well, I’m going to self-manage.” And I know that sounds great, and I think most people should self-manage where it makes sense, but you have to understand what your goals are as a real estate investor.
If your goal is to buy one property a year for five years, and then at the end of your journey you’re going to have five properties, okay, self-managing might be something that’s reasonable for you. But if you’re planning to scale this business, if you want to get to your financial freedom by generating enough cash flow from your rental properties, it’s probably going to mean you’re going to do more than five properties. And yes, right now managing your properties seems like a good thing to do, because you want to learn, because it saves you the money. But at some point, you are not going to want to do that if you’re growing, and scaling, and you want to be able to still cash flow your properties when that happens.
And so, if you’re not underwriting your deals with 10{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} property management in there, I think that you’re hurting yourself, because if you’re buying something that doesn’t work, if you add that 10{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}, well you’re buying a really slim deal, and then you’re going to lose your cash flow, if and when you decide you don’t want to do that. Also, you don’t know what life brings, right? You don’t know what opportunities are around the corner for you. Maybe you get a different job, maybe you have to move. There’s all these things that could unexpectedly require you to hire property management, and you haven’t prepared to do that, and I think that’s a big one that people miss that’s easily added to your underwriting.

Dave:
I think that’s such a good point. I mean, this is an oversimplification, but in a lot of ways, the only way to really lose money in rental property investing, is forced selling, like if you have to sell at a bad time. The housing market generally goes up. So, if you can hold on through bad times, you’re going to do well.
And I think property management is one of those sort of traps where you can get sucked into forced selling. Like you said, if your life changes, if something happens, and it doesn’t pencil out with you not managing, you could sell what might be a great deal, because you just… Like long term, because it just doesn’t work with your lifestyle anymore, or you can’t find a property manager to do it effectively. So, I think that’s a really good risk management strategy, is to make sure, even if you’re self-managing and intend to do it forever, to continue to underwrite with those. Very good tip. Any other ones, you think?

Henry:
Yeah, one final one to think about, that I think a lot of investors don’t think about it, because they don’t really consider it at an expense, but it kind of turns into one. So, a lot of landlords don’t… they’re not diligent about rent raises. I buy properties all the time from landlords, and their market rents are so low, and you’re essentially leaving money on the table by not keeping up with market rents.
I’m not saying you need to be at the market number every single time, but if you’re not increasing your rents with what the rent rates are in your area, essentially you’re charging yourself an expense every month, because you’re leaving money on the table from the rents that you could be getting, especially if you rented it to another tenant.
Now, I’m not saying be irresponsible, and raise rents on people without considering who your tenants are, what situations are out there, but you need to have some sort of systematic process in place to ensure that you’re keeping your rents up with the market, and with inflation. Because if you’re not doing that, then you’re paying an inflation expense, and you’re paying a rent expense by not charging those things.

Dave:
Opportunity costs are costs. I mean, if you are losing out on an opportunity, that costs you something, that is an inefficiency in your business that you need to take advantage of. So yeah, I mean, that’s hard to underwrite for though, right? You’re just like, you can’t be like, “Oh, I’m going to be bad at running my business, so I need to add this [inaudible 00:25:18].”

Henry:
And a lack of business acumen.

Dave:
I guess if you’re just really self-aware you could do that, but I’m not that self aware. You learn those ones the hard way.

James:
And that’s why we hire ho property management, right? If you don’t have the heart to raise rent on people, factor for the property management expense, let them do it. So, just put one of those in there. Either rent raises, or property management cost.

Kathy:
Absolutely. Couldn’t agree more.

Dave:
All right, well, any other last thoughts? I think we’ve covered now buy and hold, and fix and flip. Kathy, I have you going last because I know you have to go to the airport, so if our listeners just hear Kathy run out the door, it’s because she has to make a flight, but she’s here with us for now. So, let’s ask her about syndications, and what the big costs… I assume we’re, we’re going to do this as a LP, as someone who invests, a limited partner in a syndication. What are some of the, as a passive investor, some of the costs that we should be thinking about?

Kathy:
Yeah, and just to explain to some people who maybe don’t know what a syndication is, somebody, an investor finds a deal, and needs more money, doesn’t want to go to the bank, so they bring in passive investors, other investors who don’t want to do the work, just want to invest. So, the person who found the deal is generally called the sponsor, and they’re the GP the general partner, and then the investor is the LP, the limited partner.
So, I can really speak to both sides, because I’ve been on both sides, and there’s hidden fees on both sides, because it’s a partnership, and it’s flexible, meaning if the deal goes really well, then everybody generally makes money. If it doesn’t, that’s when people get upset, right? Because there’s not enough money to trickle down to everybody.
So, as an investor, it’s really important, first and foremost, to look at the fees, because the sponsor may say, “Hey, we’re going to split this 50/50.” Now, the investor generally gets like 80{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} of the profit, but it’s 70, 80{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} depending on the deal, and the sponsor gets 20 or 30{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}. But I’ve seen people flip it. I mean, there’s all kinds of ways these are structured.
But let’s say it’s 80{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} of the profit, and you’re like, “Whoa, this is great. I’m going to get 80{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} of the profit and do none of the work.” Well, what if within the documents, there’s all kinds of fees that you didn’t account for, and those fees eat up all the profit during the process of the deal, such that there’s no profit left, and you get nothing? So, this is really important to understand.
On the flip side, if you’re the sponsor, if you’re the syndicator, and you don’t charge any fees, which I’ve done, when I first started syndicating 12 years ago, I didn’t want to charge fees to the investors. I just wanted it to be fair, and even, and I’ll just do the work, and we’ll just split it all at the end. But I also gave an enormously high preferred return.
So, that’s the next thing, is the preferred return is who gets paid first, who gets preference? And it’ll outline that in the documents. Some documents don’t have any preferred return, everybody just gets their money pro rata. It’s better for the investor to have preference, to get paid first, before anybody else. That’s a preferred return. So, in the beginning, I was giving my investors a 15{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} preferred return per year.

Dave:
Whoa, I want to go back in time and invest in this.

Kathy:
Man.

Dave:
Because no fees, 15{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} pref, that sounds great.

Kathy:
It was crazy. But this was 2010. I mean, we were getting stuff for 10 cents on the dollar. There was so much in it that everybody made money, except if things go longer. So if you project you’re going to get through this deal in two years, but it goes three, or four, due to things that are really maybe out of your control completely, well, the investors are still getting that pref, they’re getting paid first. They’re getting that 15{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} before I get anything.
So, in some of those deals, I didn’t charge any fees, I gave an enormous preferred return, and by the end, I didn’t get anything. So I did all the work, didn’t get the profit, but the investors did great. So in a syndication, it needs to be equal. Everybody needs to make money.

Dave:
Absolutely. Yeah. I think that this concept of the capital stack, basically the order of which people are getting paid, is really important. And that’s not just for syndications too. Sometimes this happens in partnerships on smaller deals, as well. If someone… You really need to model out in your underwriting, the order of which people get paid.

Kathy:
Yes.

Dave:
Because if there’s a lot of money, it might look like a huge pot of money, but if someone gets a guaranteed 10{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} return before you get a dollar, maybe that big pot of money doesn’t go so far, and it’s really worthwhile to even draw this out, and just visually understand who’s getting paid what, before you get into any sort of partnership, including a syndication.

Kathy:
And syndications are regulated by the Securities Exchange Commission, the SEC, so you are supposed to have all of that explained in the operating agreement. It’s usually in an LLC, and a private placement memorandum, where all of that is spelled out. But most people don’t read them. They’re boring, they’re legal. But if you’re investing in a syndication, just spend the money to have an attorney review it for you, or just make sure you really understand it.
And Dave, what you said about understanding that waterfall is the most important thing. Who’s getting the profit when that profit hits? And who’s getting fees? Now, I’ve learned since that a syndicator should be charging fees, because you’re doing the work, and there might not be profit. It’s an investment, there’s no guarantee. There could be another pandemic. Right?
So in the case of, and I’ve talked about it before, but our Park City deal, we got shut down for two years because of COVID, but we’re still paying that 15{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} preferred return when we’re not making any money, and can’t do any work, and you can’t change the documents. Right? This is just… It didn’t say, “Oh, if there’s a pandemic, we’re not paying this.”
So, you’ve really got to understand the fees being charged, and if that’s going to take all the profit, and as a syndicator, or the investor in it, is it equal? Is it fair? So, typically, you would see a one to 2{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} just sort of asset management fee. We’re just kind of watching this. If it’s development, it’s going to be a higher fee, because there’s more to it, there’s more work, so the fees might be higher.
There’s generally going to be a fee for the person who does the financing, because they’re doing all that it takes to get the financing, and sometimes they’re taking a recourse loan. So, it’s okay, expect that, but not an exorbitant fee. So again, maybe one to 2{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}.
There might be an acquisition fee. Now, this is where the people get paid to just find the property, and go through the process of acquiring it. There’s still broker fees on top of that, and there might be a disposition fee, the time it takes to sell the property, even though a broker’s really doing that. So, these are all fees. Some syndications will have them, some won’t.
It’s got to be good for everybody, and there has to be enough cushion that those fees can get paid, and there’s still profit in the end. So with every syndication, make sure they have a very detailed pro forma showing you where all the money’s going. Because if it’s vague, and this is what I’ve learned over the years, if anything’s vague, then the syndicator, the sponsor, can say, “Well, the documents allow this, because it didn’t not allow it.” And so everything needs to be spelled out.
And then another big… I noticed this was with a single family fund that wanted us to wanted partner with us, and they were kind of Wall Street guys. And as we looked at their pro forma, and their documents, they were charging $500,000 per person in salaries.

Dave:
Whoa.

Kathy:
In salaries. And this is a fee that came on top of anybody, any of the investors getting their money. We’re like, “I mean, maybe you guys do that on Wall Street, but we don’t do that on Main Street. That’s not how it works.” So really look for that. Who’s getting paid? And what happens if they said this project’s going to be done in two years, but it goes for five years, do they still get that salary? So again, there’s a lot to look at. A lot of people just don’t pay attention, and they just believe the marketing materials, and don’t read actually the fine print. So, if you don’t want to read it, have somebody else who understands it, read it for you.

Dave:
Read your contracts.

Kathy:
Yes.

Dave:
God, yes. I mean that’s basically, maybe that’s just the theme of this episode. It’s just hidden fees. It’s like read your contracts, and you’ll eliminate probably half the fees that you encounter as an investor, or just a human, in life.

Kathy:
And then there’s another thing that people really don’t understand with syndications. We’ve noticed this all the over the years, is they don’t know their status… I don’t know how to say this. They don’t know their status, their position as the investor. So they don’t know where they fall in that waterfall.
They don’t know if they’re an equity investor, so they don’t even know what that means. They don’t know if there’s somebody ahead of them that has priority to them. Or they think maybe they’re a lender, they’re investing and they got a 6{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} preferred return, and they think that’s a loan. They think that that’s guaranteed. It’s not. It only comes out of profit, the preferred return, generally, unless you’re coming in as a lender.
If you’re a lender, you know what? We talked about it earlier. The loan gets paid first. Always. The lender is in the best position, almost always, and there’s usually a first and a second. Obviously the first lender has the first priority, and if there’s no profit, you still got to pay it. You still… The sponsor, the investor takes the loss, the lender doesn’t.
So, if you are investing as a lender, it’s definitely the highest priority. If you’re investing as an equity investor, you’re at the bottom. You get paid after everybody else gets paid. And if there’s huge profit, you can make a tremendous amount of money. If there’s no profit, you get nothing. If there’s losses, you lose your money.

Dave:
It’s very good advice. Well, thank you all for all this. It’s been super helpful. There are, actually, if you want to learn any more about the nuts and bolts of operating of these different types of businesses, there are actually great Bigger Pockets books for any of these.
Jay Scott did a really good house… He has two flipping books, one on estimating rehab costs, one and just being a flipper. Brandon wrote a great book about managing rental properties, and Brian Burke has a great book on investing in syndications. So, if you want to learn a little bit more about underwriting deals in a written format, you can check those out on biggerpockets.com/store.
With that, we have one question from the Bigger Pockets forums that I want to ask you guys. It is about the general economy, and then we’ll let Kathy make her flight. Emily Hazard went on the Bigger Pockets web forums and said there, “Morgan Stanley sees something called the 4-4-4 happening in 2023.” Have any of you heard of this?

James:
No, I have not.

Dave:
Me neither. I hadn’t either. So, it’s called, “Morgan Stanley sees an environment in the future with 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} federal funds rate, which is a little bit below where it is now, 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} inflation, which is definitely below where it is now, and 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} unemployment, which is a bit higher. Do you think this is accurate? What are your thoughts?” All right. Anyone want to take a first swing at this?
So just as a recap, it’s Morgan Stanley forecasting that we might see a year in 2023 where the federal funds rate is 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}, inflation is 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}, and unemployment is 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}. That would be inflation and Feds coming… The Fed fund rate coming down a little bit, inflation coming down a pretty good amount, and for unemployment going up just a little bit. So, what do you guys think?

James:
It sounds balanced, and nice.

Kathy:
I think it’s hopeful.

Dave:
Yeah.

James:
I personally don’t see that happening. I actually think the federal fund rate will be around 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}. I think, hopefully inflation gets to 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}, maybe by the end of the year, it might, probably a long shot. But the one thing is this unemployment numbers are just not moving.

Dave:
Yeah, it’s wild.

James:
The labor market is getting no ease on that, and that’s where I’m like, “At some point, something’s going to happen there,” but it right now, it does not seem to be breaking.

Kathy:
Yeah, I mean that’s wishful thinking, and it would be wonderful. I guess the question is when? I mean, are they thinking it would be this year? Because the Fed has made it really clear going to keep raising rates, and shooting for 5{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} Fed fund rate, and yeah, they’re really shooting to kill jobs, and they haven’t done a great job at that yet, which I guess, depending on if you would like a job, or not, it’s good news for the person with a job that they haven’t killed the jobs the way that they wanted to. So, I highly doubt that. I think the Fed fund rate’s going to be higher, and inflation probably higher too, at this point, unless there’s a little tweaking with the data, which is possible.

Dave:
Really? I think inflation’s going down. I think, we’re already at 6.1{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}, if we stayed at the run rate we’re at for the last six months, we will be at like 2.5{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} by June. So as long as inflation doesn’t go up, we will be well under 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}, just from a mathematical perspective. It could go back up. I have no idea, but just based on the trajectory right now, I think it’s going down.
But I totally agree on the Fed funds rate. I think they’ve basically said there’s no way they’re cutting rates in 2023, and it’s already above 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56}. So, that seems like a long shot. Unemployment is just the big question, right? It’s weird. You would think that it would be higher, but it does seem like there’s kind of this bifurcation of the labor market, and there’s this big… All this public discussion about layoffs, but those are just happening in the tech sector.
If you look at more traditionally blue collar jobs, the labor market is incredibly strong there. And I read something today in the Wall Street Journal that said that 78{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} of job openings right now are at “small businesses.” So still, we hear about Amazon and Microsoft laying off businesses, but that’s not… Or, laying off people, but that’s what’s driving the labor market. It’s all these small businesses. And so, it’ll be interesting. Personally, I think that’s sort of the X factor for the economy this year is what happens with unemployment.

James:
And we are seeing, for like our job, because we’re the small business in Seattle, all the tech guys just steal everybody. And the last 24 months we’re really frustrating. You’d be like, “I need an accountant, and I can’t get an… This is crazy.”

Dave:
You can’t pay 750 grand for an accountant, James?

James:
Oh, yeah. It’s like, it’d be an entry level marketing person, they’d be like, “I’m going to get paid a $100,000 at Amazon.” I’m like, “Well, I can’t do that. It’s just, that doesn’t work.” But it is easing up a little bit. There is some, like construction companies are starting to lay off some people. There is, some of that blue collar is lightening up, but at least you can get applications now.

Henry:
Typically the layoffs that I’m seeing are in industries that had to staff up during the pandemic, or staff up during what happened as a result of the pandemic. So, the mortgage industry is doing some layoffs, but obviously, that’s affected by the rates being what they are, and mortgage applications not being what they were. And then in tech, and then a lot of different customer service industries, where they had to staff up to handle the load of calls coming in from people who were just sitting at home.

Dave:
Totally. Yeah. So, it’ll be interesting, but I hope they’re right. That sounds like a great place to wind up. If we wound up with 4{ecd1c82889c5dde6baa4cae2f6d3d4c330bac74c2b880dafaca78809ece33a56} unemployment, that would not represent a significant break in the labor market. It would be mean inflation still too high, but back in the stratosphere at least. And then, federal funds rate a little bit low below where they were? I mean, that would be wonderful. So let’s all hope that we’re right, but it does seem like there are some headwinds that might prevent this forecast from coming true.
All right. Well, Henry, James, Kathy, thank you so much for being here. For everyone listening, if you appreciate this show, appreciate the insights from the three panelists, please give us a five star review. We really do appreciate it. It really does help us. You can do that on Apple, or Spotify, so please go do that. Give us a five star review. We’d really appreciate it. Thank you all for listening. We’ll see you next time for On The Market.
On The Market is created by me, Dave Meyer and Kailyn Bennett, produced by Kailyn Bennett, editing by Joel Esparza, and Onyx Media, researched by Pooja Jindal, and a big thanks to the entire Bigger Pockets team. The content on the show On The Market are opinions only. All listeners should independently verify data points, opinions, and investment strategies.