Since this is an extremely long post and honestly somewhat rambling, I’ll try to summarize in one small paragraph. The only jobs you want in real estate are in acquisitions and development (on the buyside) and investment sales, debt and equity capital markets on the sellside. You can argue endlessly about how the other roles have merit and how you know someone who crushes it and makes a ton of money in another position. And I’m sure they do. But you want to be putting yourself in the best position possible to make a ton of money and those are the only roles/careers that give you that.
Although this post will get into specifics regarding specific career paths, I want to start out broad by giving you the framework you should be using to make your decisions. There are two broad pieces that should be in the back of your mind with every real estate career decision you make:
Section 1 – The Framework
The First Part of the Framework – The Question Game
1. Am I learning how to do this by myself?
What does this mean? No one gets into real estate to become a corporate drone. The whole point of real estate is to learn how to run entire deals by yourself. That’s how you make the actual money in this field. Even those who are making a lot of money within a company are doing so because they’re running deals by themselves. No one is getting paid $1MM+ to run basic deal analysis in excel.
Although sort of a side tangent, it may help to explain why exactly it’s so important to be able to run deals by yourself. The people making the most money as an employee in this field (Vice Presidents and Managing Directors) are actually leveraging the company rather than the other way around. Essentially what happens is the Managing Director brings in a deal and then uses the company’s resources (analysts, etc. to close the deal). The company is essentially a shell that provides resources for the Managing Director to pursue deals (by himself).
2. Am I getting to an equity position?
Why is this so important? Getting to the equity means you get a piece of the liquidity event and a piece of the upside. Grabbing a piece of the upside in a liquidity event (the profits from the deal) is how you get rich (in every industry – not just real estate. In a sales deal, this is called ‘commission’ (yes, I know – you don’t technically get a piece of the upside as commission, but you still get paid for your performance and a piece of the deal), in a startup, this is called ‘equity’). In real estate, this ‘equity’ is called ‘carry’. Most Vice Presidents/Managing Directors actually make more money from their carry in deals than they do from their base and bonus. Given that their base/bonus amount can exceed $1MM at a good private equity firm, their carry is obviously a very significant amount.
Getting to the ‘equity’ also means that you’re in a position where your contribution to the firm is quantifiable and makes you more than just an expense line item on the P&L. You’re contributing to the success of a deal and getting a piece of it as compensation.
Lastly, carry in deal is taxed at capital gains rate (only ~20%), which means that it’s worth ~20-30% more than your typical salary/bonus.
I’ll go on another brief tangent here to explain how this works mechanically. I’ll walk through a standard (‘2 and 20’) deal scenario in which the firm collects a 2% management fee and a 20% promote (consider the promote to be the same thing as ‘carry’) over an 8% IRR hurdle (your firm doesn’t make any money until the investors hit an 8% return). Let’s ignore the management fee for now as it’s considered just ordinary income. Say your firm invests in a $300MM deal with $200MM debt and $100MM equity. You only receive carry off the equity. Typically, over a 5-year period, you can expect the equity in a deal to double, leaving you with $200MM. The first half is the investor’s principal ($100MM), which is always returned to the investor. That leaves you with $100MM in profit (ignore the 8% IRR hurdle as firms have a “catch-up” clause that renders this null once the hurdle is hit). Since the promote is 20%, your firm keeps $100MM * 20% or $20MM. If you have 5% carry, that would leave you with $20MM * 5% or $1MM. Now imagine you do several deals like this per year. As you can see, this becomes an extremely lucrative profession once move up the ranks. In case any of the above was confusing, just multiply the total equity amount of the deal by 20% to get the total carry payout, then multiply it by your share to get an approximation of the amount you’ll be receiving.
3. If I’m the best in the world at this job, how much will I get paid?
This question actually applies to every single career, not just real estate. Most people choose their career on an impulse and don’t think it through at all. This leads to them choosing a career that quickly caps them out at a certain income level. Say you want to be a hotel general manager. Look up what the best hotel general manager in the world gets paid (hint: it’s not a lot). Realize that you likely won’t even get close to that top number. What does that tell you? You should not pursue a career like this unless you know you’re fine with mediocrity.
The Second Part of the Framework – Every Decision You Make Has A Consequence
Realize that the decisions you make will close off some doors and open others. If you decide to work with a *successful* local developer (a smart choice in my opinion), realize that you will likely never be able to work for an institutional real estate private equity fund like Blackstone afterward. Conversely, if you work for Blackstone, it’s unlikely you’ll build equity in your own real estate portfolio at a young age (you’ll be too busy building Johnathan Gray’s dream). There are consequences and rewards to each path you choose.
Realize that some jobs will only be stepping stones and some paths will take way more stepping stones than others. For example, working in REPE right out of school requires only one stepping stone (as REPE is generally the end goal), while if you start out working in valuations, you will likely have to move from valuations –> brokerage –> REPE (three stepping stones). Accept that the more mistakes you made along the way, the longer it’ll take to get where you want. Everything compounds.
Section 2 – Job Functions
The Many Real Estate Job Functions
Now let’s get into the meat of it. What are the main jobs in real estate and where do you want to work?
The first type of job functions are within buyside, real estate investment firms. This includes real estate private equity shops, REITs, real estate development shops, etc. The firm may have different labels for some of these jobs (for example, acquisitions is sometimes called investments and combined with asset management as well), but it basically all boils down to the same few functions. Although I assume most of you know this, the standard career progression across all job functions is analyst –> associate –> vice president –> director –> managing director, with each role taking 2-3 years to get promoted.
Acquisitions – This is what I do. Essentially, your job is to analyze and acquire new investments. You’re coordinating with brokers, equity partners, debt sources, leasing brokers, etc to both deploy capital and come to an informed decision. At the lower levels (analyst and associate), you’re basically answering the question “Should we buy this building?”. Once you start moving up the ranks, you begin sourcing deals as well – which is the real skill (this generally occurs at the Vice President level). The great part about this position is it’s all about relationships once you get to the top, so it becomes very hard to replicate your skillset and you become very valuable. Acquisitions has the best pay of any employee-based job in the real estate sector. See the end of this section for a rough estimate of compensation (not including carry) for those in Tier 1 markets (NY, SF, LA, BOS).
Question 1 – Yes, without a doubt. I’ve been in my job for a year and am very confident I could run a deal by myself. My firm happens to be slightly less ‘institutional’ as well, so I’m able to be involved with most aspects of the deal process, which is great and exactly what I wanted. If you’re at a firm where jobs are more siloed, you might not learn as much about the other aspects of the deal process, but you’ll still learn the acquisition process well enough to do it yourself. Additionally, even if you don’t learn how to do asset management or property management, you can always pay someone to do that yourself and it can be tacked on as a deal-level cost (which is “market” anyway).
Question 2 – Yes. Acquisitions professionals are allocated the largest portion of carry of any job in the real estate field. Heads of acquisition (at shops at which they aren’t a partner), can sometimes be taking in 10-20% of the carry.
Question 3 – The best in the world at this is someone like Johnathan Gray and he’s a billionaire. No more citations needed.
Development – This is in the same tier as acquisitions. The job criteria are very similar (sourcing and structuring investments), but they differ widely after that since development typically involves building a property from the ground-up, while acquisitions professionals buy buildings that already exist. Development requires more coordinating with general contractors, vendors, etc, rather than modeling (which is more prominent on the acquisitions side). The job function is also far more involved on a time-horizon basis, as a single development can take 3-5 years to complete. This differs from acquisitions in that the acquisitions role typically ends as soon as the asset is acquired, which means that you complete your work on the deals in a shorter time-frame. You end up getting less repetitions than an acquisitions professional because of this, which I view as a negative. Overall, a great job to have, but base pay is a considerable amount (20-30%) lower than acquisitions during the course of your career. Development professionals get a decent chunk of the carry due to the important role they play in the investment process.
Question 1 – Yes, even more so than acquisitions. The knowledge you learn in development is also far more valuable as it relates to things that simply cannot be looked up (you can’t look up how much ground up development costs, how long a permitting process will take, which city officials might be more likely to pass your application through, which general contractors will screw you over, etc.). Developers are often easily able to go off on their own and build properties at a low basis that they hold for life, which is a great way to get rich.
Question 2 – Yes, as I mentioned before, development professionals receive a significant percentage of carry.
Question 3 – The best in the world at this is someone like Gerald Hines, who’s a billionaire. Once again, no more citations needed.
Asset management – What you’re doing here is running the asset after it’s been acquired. Essentially the acquisitions team hands off the deal to the asset management team and then they run the deal until it’s sold. In this job function, you’ll be coordinating with tenants, vendors and making sure the property is running smoothly. You’ll be running refinancing analyses and staying ahead of the happenings of the asset, such as potential capital expenditures and lease expirations.
Question 1 – The answer is yes and no. Yes, you are learning how to effectively asset manage a property. But is this a skill you can actually do by yourself? The answer is – no, it’s not. What’re you going to do, pay someone to acquire a building for you and then run it yourself afterward? That’s just not a feasible business plan. So, yes, you are learning a skill, but it’s not one that you can use to run deals by yourself or make a lot of money.
Question 2 – Asset management professionals typically do not receive carry, and if they do it’s a very small amount after being at the same firm for a long time. It’s not an ideal situation. As you can see below, the pay is already significantly below acquisitions, so capping your equity upside hurts your earning potential even more.
Question 3 – I’m sure there are some absolute killers in asset management who receive carry and are making a few million a year. But, overall, you will probably get capped out in the mid hundred thousands. This obviously isn’t horrible (and your work-life balance will be much better than acquisitions), but it’s definitely something to keep in mind. Also, the fact that I can’t think of one prominent person to name as an example for this role speaks volumes.
Property management – You want to avoid this job at all costs. It’s typically a black hole, a dead end. Basically, you report to the actual asset manager. You’re typically a deal-level employee (you’re an employee on the asset’s P&L rather than the real estate firm’s P&L), which is never a good sign as it’s clear that you’re easily expendable and will likely be fired once the asset(s) are disposed of. Your work is heavily weighted towards being at the property, dealing with tenants’ issues and making sure the physical condition of the asset is sharp. The worst part of property management, however, is that it’s not even really a stepping-stone to anything else. Asset managers can often move over to the acquisitions side with relative ease if they’re smart and work hard. It’s really rare for property managers to even become asset managers.
Question 1 – Yes, you will learn how to do certain things by yourself. Unfortunately, these things just aren’t that important and are low level skills (ex. coordinating with a contractor to solve a problem that tenants are having with the HVAC system). Overall, you’re not learning how to run a deal by yourself and you’re often intentionally kept in the dark regarding the important parts of the deal.
Question 2 – Have never seen any property management position ever receive carry. There is virtually no chance of receiving any upside.
Question 3 – Property managers do not get paid well at all. The top property manager in the world is probably making $200-$300k.
For the purposes of this exercise, I’ll group debt funds into the REPE funds category because the functions and pay are similar enough.
Debt funds – I won’t spend much time on debt funds. I’m not a big fan of debt funds because debt is fundamentally less risky than equity. Less risky = lower returns = you get paid less. Additionally, debt is more boring than equity and you do way less diligence with each deal, so it’s easier to learn and not as valuable. That being said, you can make very good money working at an aggressive debt fund like Ares, etc. It really depends what they call it firm to firm, but you typically want to be in “originations”, which is essentially acquisitions but on the debt side. Debt funds are kind of brutal in terms of the way compensation works, since the returns are so thin. A lot of times, there is no upside and the only form of compensation is management fees, so it becomes almost like an asset management business. That being said, I know the head of a billion dollar plus debt fund and he absolutely cleans up and makes $1MM+/year (one of the golf clubs he belongs to has a $500k+ initiation fee). So, it’s definitely possible to make a very good living in the space, although he is admittedly the cream of the crop.
So just to recap, within the first type of job functions, the only roles you want are acquisitions and development.
The second type of job functions are what I’ll call “bank jobs”. I’m not going to break them out as they’re relatively boring and typically a breeding ground for mediocrity. You’ll get paid relatively decently and have great work-life balance. But it’s highly unlikely that you’ll break more than $500-$600k/year at the top end. These jobs are typically called something like credit officer, loan officer, portfolio manager, relationship manager etc. I would really try and avoid these job functions although having one is certainly not the end of the world. Your job in these roles is either to make debt investments in the form of senior debt (this is obviously where you want to be if you are employed at a bank, given that it is somewhat of an investment role) or to service the existing loan portfolio. Since you’re providing the senior debt for the investment, the analysis is pretty simple and can often be completed in an hour or so. The one plus here is that you get way more repetitions than the equity side since the deal process is much easier and the diligence is much easier. I don’t want to go too deep off on another tangent here but the reason the analysis is easier is that in the senior debt position, you’re only providing 50%-70% of the investment and have the ability to seize the asset as collateral. That obviously gives you a pretty significant buffer in case anything goes wrong.
The third type of job functions are “brokerage jobs”. These can be broken down into investment sales, debt capital markets, equity capital markets and leasing brokers (landlord representation and tenant representation).
Investment sales – This is the job function that everyone thinks of when they think of brokerage. Basically a building owner hires you to sell a building for them. You run the analyses, make the model and then find the buyers. This is the best place to be on the brokerage side (although all the brokerage jobs are relatively good). The reason this job function is so good? Not only is investment sales an “exit opportunity” by itself, but it leads directly to acquisitions jobs since you’re performing the same exact function, just on the other side of the table (this is the same reason why investment bankers can move to private equity) and you gain incredibly in-depth knowledge on specific markets due to all the data you have at your disposal.
Question 1 – I go back and forth here. Yes, you are learning how to sell a building all by yourself (even as an analyst), but are you really going to start your own brokerage? Most brokers have no wish to do this since the brokerage firms they’re at actually provide a significant array of services. So you really have to take another step over to the buyside before breaking off on your own, which isn’t great, but isn’t terrible either.
Question 2 – Yes. The common theme with all brokerage jobs is that you’re grabbing a piece of the “equity” in the form of commission. This is great because in this role, you’re purely getting paid for your performance. One thing I will say, is brokerage commissions have been getting squeezed lately, with a lot of commissions being paid out based on a flat dollar amount (~$500k for a $100MM property) rather than an actual percentage of the sale that was generated. Another reason I typically think of brokerage as a lesser job than acquisitions is that you take way more risk with your pay (a lot of brokers are purely paid on commission) and you don’t really get an adequate income premium above the acquisitions role (pay is roughly the same until you get to the top levels in acquisitions where carry really starts to take hold). Also, you’re getting paid in ordinary income rather than carry, which kills your take-home numbers.
Question 3 – The top investment sales brokers in the world get paid very well. Douglas Harmon and Adam Spies were rumored to receive a $100MM signing bonus when they moved from Eastdil to Cushman & Wakefield. That being said, this is certainly not standard, as they’re the top brokers in the world. Most very good investment sales brokers cap out at a few million a year.
Debt Capital Markets – This is one of the easiest jobs in the world (joking…kind of). Basically, what you’re doing here is helping the buyer of a building find someone to provide the debt. You’re connecting the buyer to the debt provider, usually a bank or a debt fund. In return for this service, you receive a fee (usually around ~50 basis points of the loan amount, or .5%). The great part about debt capital markets is the volume you can achieve. Debt includes not only loans at acquisition, but refinancings as well, which means that there are far more deals to broker in the debt space than in the equity capital markets space.
Question 1 – No, you’re not really learning how to do anything yourself in this job function. The only real thing you can exit to (without learning a different skillset) is starting your own debt capital markets firm. That being said, debt brokers often make great relationships through their business and sometimes are able to exit on to the principal side, although many chose to stay in the debt capital markets space.
Question 2 – Same as for investment sales. As stated above, commissions are generally ~50 bps.
Question 3 – Two of the best in the world right now are Dustin Stolly and Jordan Roeschalub, who head the NKF debt team out of New York. They closed over $10 billion worth of deals in 2018… you can run the numbers on how much they made. As a caveat though, there are company splits and team splits, which dilute their share of the pot. I’d estimate they cleared $5-$10MM each but that’s just an educated guess. Definitely won’t become a billionaire in this job function, however, as you never grab any deal upside.
Equity Capital Markets – This is the same thing as debt capital markets except you’re helping the buyer of a building find equity instead of debt. It’s an ideal business to be in if you have a lot of rich friends, as all you’re doing is introducing them to investors and collecting a fee. The fee is larger than in debt capital markets since it’s harder to source equity than debt (think it’s 1-3% although I’ve never actually seen an executed term sheet for it). Also, as mentioned previously, you can’t do as high volume in equity capital markets as you can in debt capital markets.
Question 1 – Same as for debt capital markets.
Question 2 – Same as for debt capital markets and investment sales. As stated above, commissions are generally ~100-300 bps.
Question 3 – The best in the world probably clear ~$10MM/year in this field. Aside from capital raising at a strict investment advisory firm, you can also work in-house doing fundraising at a place like Blackstone or Starwood, which gives you more job security and a relatively easy lifestyle.
Leasing broker – There are two types of leasing brokers – those who represent landlords and those who represent tenants. Your job here is to either find space (tenant rep) or fill space (landlord rep). Much like the fundraising position in equity capital markets, it’s also possible to work in-house on either the landlord or the tenant side.
Question 1 – You really don’t learn much here as you are only dealing with a very siloed aspect of the entire deal cycle. I do know of one leasing broker, however, who bought a vacant building for under $1MM, leased it up and sold it for over $100MM. He’s now close to a billionaire. So he was able to transfer over to the principal side and leverage the skills he learned as a leasing broker to affect the most important part of the deal. You’ll never see a leasing broker who makes this much money unless they leap to the principal side.
Question 2 – Same as for debt capital markets and investment sales. In San Francisco, tenant rep brokers are paid $2/SF/year of lease and landlord rep brokers are paid $1/SF/year of lease (both cap out at 7 years). So say you were a tenant rep and your tenant signed a 20,000 SF lease for 5 years, you’d get paid $200k.
Question 3 – There’s a huge disparity here. The best in the world can clear a few million dollars on a single lease. This field is particularly unique in that one client can change your life. If you become a leasing broker for Apple/Facebook/etc., you’ll never have to work again.
The fourth type of job functions are “service/ancillary jobs”. This includes positions such as valuations, working for a title company, working for a due diligence firm such as Situs, etc. I won’t spend much time here either as these jobs are all horrendous unless you’re running your own firms. They should be avoided at all costs (will take years and years before you even make $100k). It will likely take several stepping-stones from a position like this to get into REPE (valuations –> brokerage –> REPE). If you’re in one of these positions, you need to get out ASAP (I’ll go through how I would do that below). There are always exceptions, however. I know the CEO of a very prominent title insurance firm and he makes several million dollars a year minimum.
Section 3 – How to Navigate Each Path
First of all, let me set some groundwork here. Real estate is a relationship-based industry. You NEED to network in order to get jobs. This isn’t an option or a suggestion. If you don’t network, you will lose out to someone who does.
Path 1 – “I’m in high school, where should I start?”
I get this question a surprising amount. The answer? Slow your roll. It’s certainly not too early to get involved in real estate and if you want to work for yourself, it’s never too early to start. But if you want to be an employee, no reputable company is going to hire you unless you have a degree, so I would focus on getting the grades to get into a good college and having fun. On the real estate side, I would ask your parents if they know anyone in real estate and ask if you can shadow them/do an informal summer internship. If they don’t know anyone, reach out to local developers in your area. Most would be more than happy to help. Additionally, I’d try and invest in a small project yourself with your parents. Ask them if they want to expand their portfolio into real estate and buy a small multifamily building or flip a house. You’ll learn a ton and it’ll make a great story when you’re applying for jobs.
Path 2 – “I’m in college, where should I start?
Let’s start out with the most obvious things. If your college has a real estate major or minor, you should do that. If not, business and economics will do fine. Don’t major in art or gender studies or something weird like that. You’re not applying to Facebook or Google, real estate actually has normal people working in it. They’ll think you’re a fruitcake and won’t even read the rest of your application.
Next, you’re going to reach out to everyone you know in the real estate field (and I mean everyone). This isn’t the time to be shy. Reach out to family members, friends, friends of friends, high school alumni, college alumni, etc. Scour Linkedin and Facebook. If you do all of this and still can’t find anyone, I don’t believe you. Reach out to these people, set up calls, coffee chats, whatever. Be knowledgeable when you’re talking to them. You can be honest and say you don’t have any real estate experience (and they won’t expect you to), but you sure as hell better know everything about the person you’re talking to and what it is they do, as well as how you’re planning on improving your real estate skillset. Directly ask him if their company has any positions open for a summer internship. If not, ask him if he can refer you to one of his friends who may have an opening.
If this doesn’t work and you end up with nothing, you should go through campus recruiting as a last resort (before anyone asks, yes, you should be running these processes concurrently). The reason you want to avoid campus recruiting is the process is way more structured, relationships matter less, there’s far more competition and you’ll be asked far more technical questions. It’s the same reason you’d rather get an off-market deal than a marketed deal. As a side note, even if you’re going through campus recruiting, you should also be networking with people at the firm you’re applying to. If you end up with nothing during campus recruiting, shoot for a finance role instead (can usually jump from finance to real estate). If you can’t get a finance role either, consider the summer a wash, take whatever role you can (or just travel or something) and try doubly hard the next year.
Lastly, this process should start freshmen year. If you try and start doing this senior year you’re going to end up with nothing and that’s all you deserve. Freshmen year, you should take any position you can get (it’s very hard to get an internship your first summer). Network hard at your internship freshmen summer and during the school year and then you should be relatively selective with where you work sophomore and junior summer. Ideally you get an offer to return full-time after your junior summer and can coast through your senior year of college.
Path 3 – “I’m 1-5 years out of college and have no experience in the real estate field”
Easy – shoot for a job at a brokerage firm or small development shop, using the same networking ideas mentioned above. Either should be doable within 6-12 months of networking, assuming your job experience isn’t terrible. If you have a stellar resume, you can try applying to a top real estate investment firm as well.
Path 4 – “I’m 5+ years out of college and have no experience in the real estate field”
In this scenario, you’re already in your late 20s, so you don’t have much time to lose. Each stepping stone will likely take 1 year minimum and 3 years on the top end. You’ve also already pretty much entirely lost out on the most prestigious firms unless you plan on getting an MBA (would not recommend as no one really cares in real estate). Knowing this, I would actually try and bypass the whole traditional process and would solely target small local developers. Offer to work in a low paid low while they teach you the business and then break off by yourself. You’ll be a self-sufficient millionaire within 10 years.
Path 5 – “I’m in the real estate field at a dead-end job”
In this position, you need to get out ASAP as you’re literally wasting your life. I would start networking aggressively and try to move over to either the investment side or to the brokerage side. It’s usually easier to get a brokerage job, so that’s where I’d start. From there, you can choose to stay (many people make a killing in the field as mentioned above) or try to transfer over to the principal side.
Section 4 – The Interview
Now, that you’ve gotten the interview you need to start prepping for it. You’re going to learn everything you can about real estate. Here are some things that you should be able to talk about proficiently (and no, I’m not going to explain each one in detail – Google is your friend): Cap rates, NOI, IRR, the three ways to value a building, LTV, LTC, the different asset classes of real estate and what’s going on in the real estate industry (browse the Real Deal). These are all base level things that will be embarrassing if you don’t know. If you’re interviewing at a top shop like Starwood, I’d go to Adventures in CRE (website) and just memorize pretty much everything (including the modeling) and you should be covered. I’ve also written some articles on the topics above that are miles ahead of anything you’d be expected to know (think all the articles are below this one if you scroll down).
But honestly, technical proficiency is one of the least important parts (at least for entry level roles). I always forgive interviewees for messing up a technical question. I immediately write people off who don’t 1. Know everything about my company. You need to have an answer for “why xx company?”. It should be related to the firm’s structure or creative deal-making. Ex. I saw this deal I really liked because of xyz and wanted to learn how to do deals like that 2. Get any part of their resume wrong (honestly just pathetic) 3. Don’t have a good reason “why real estate” (please don’t say you “like that it’s tangible”). Those three things are inexcusable to get wrong and you deserve to not get the job if you can’t put in the time to learn basic facts.
Next, you’re going to research (and know) every single publicly available piece of information about the company you’re interviewing at. Then you’re going to research your interviewers. Where did they go to school? How long have they been at the company? What is their role within the company? So on and so forth. You want to bring up these conversations organically during the interview. Then move on to the deals. You’re going to look up every single deal this guy has ever done. Did he do a crappy single tenant NNN lease deal in bumblef**k? Congratulations, that just became your favorite deal. Ask him about it.
Finally, you’re not going to ask basic unintelligent questions such as “what’s your day-to-day work life??” Everyone’s just going to say it varies and they will be unimpressed. Instead, you’re going to ask them: What’s your current acquisition strategy? Why? How has that changed over the past year? How are you underwriting deals given that most consider us to be at the top of the cycle? Are you focusing on a specific asset class now? How do you structure your deals? Is it on a fund basis or a deal by deal basis? Why do you structure it like that? Are there any deals you’re currently looking at? What was your favorite deal you’ve done so far? Why was that your favorite deal? You get the idea.
Everyone wants to jump right into their first deal. 99% of people will do this the wrong way and miss out on thousands and possibly millions of dollars (depending on how big the deal is and how many deals they do). I’m going to go through the best ways to set up your first deal (or any deal) starting from the method most commonly used to the method that everyone should be using (but is rarely, if ever used – I only know one person who uses method 3 and he’s worth ~$20mm before age 40). All of these methods are assuming that you have very low startup capital and are doing deals with other people’s money.
From worst to best, the methods are: charging an asset management fee, charging a promote over a certain IRR hurdle, charging a promote based on an equity multiple hurdle and getting a high leverage loan (hard money, seller financing, etc.).
The consistent theme? Get to the equity at all costs.
Method 1 – Charging an Asset Management Fee
This is by far the worst method and should only be used if you have no other options. Unfortunately, a lot of people end up going this route because they don’t run the numbers and can’t delay gratification (they want the immediate cash in Year 1). No matter how you slice it, this method does not make the returns palatable. In a typical asset management fee structure, you take 2% of the equity. It’s honestly not even worth doing a small deal at these terms unless your only incentive is to build a track record.
What’s wrong with this strategy? You’re not getting to the equity. If the property’s NOI increases 50%, none of that increase will go into your pocket. On a sale you’ll get zero residual value. You get none of the upside. To make matters even worse, this income is not tax advantaged (because you do not own any equity in the actual property). Avoid this method at all costs, unless you are simply using your first deal to build a track record to chase subsequent deals.
Method 2 – Charging a Promote Over a Certain IRR Hurdle
With this method, you’ll be charging a promote over a certain hurdle rate. What does this mean? This means that once the deal hits a certain IRR (8% is the typical amount), you’ll receive a certain percentage of the profits (typically 20%).
Why is this a good structure to use? 1. It gives you full participation in the equity upside of the deal, but no participation in the downside (unless you decided to put equity into the deal as well or you are guaranteed on the loan.). 2. It aligns your interests with the interests of your investors (you don’t make any money unless the deal goes well). 3. The cashflow isn’t weighed down by heavy deal costs such as an asset management fee (almost all your distributions will come at the sale with an IRR-based promote).
This is a good structure for private equity deals but it’s important to make sure that it’s a good structure for *your* deal. The IRR metric is mainly valued by institutional funds, rather than by small-scale investors. In fact, I’d be willing to be that your investors won’t even know how to define the term. Aside from the fact that confusing your potential investors with a complicated structure will make it nearly impossible to raise equity, most of your investors will actually be looking for a different metric, “cash-on-cash”. The cash-on-cash return is simply the post-debt cashflow divided by the initial equity investment (see below for more on this in method 3).
As a benchmark, you should be charging a 20% promote at minimum. That is absolutely standard for the industry – any lower and you’re actually cheating yourself. Since your first deal will most likely be a friends and family deal, you should actually be getting a sweetheart deal on your promote. For example, I’m getting a 50% promote on my first deal – this isn’t industry standard and you should not expect to receive this going forward.
Method 3 – Charging a Promote Based on an Equity Multiple Hurdle
This method is very similar to the method above (method 2), aside from one primary difference. With this method, once you are in the money, you stay in the money. In the method above, let’s say you had been cruising at a 10% IRR for the first 5 years of the deal. Now, for the last 5 years you log a 2% IRR. What happens now? To put it bluntly – you’re screwed. You’re no longer in the money and will most likely net zero dollars on the deal, which is a huge waste of time. Method 3, however, allows you to consolidate and hold your gains (once you return a equity over a certain equity multiple hurdle it’s nearly impossible to dip back under that hurdle unless you issue a capital call).
Another benefit of this method is that it focuses on the cash-on-cash metric mentioned above rather than IRR. Your investors are going to want to know how much money they will be getting back per year. With this promote structure, you’ll be able to maximize their yearly cashflow, while also shortening the time frame in which you’re “out of the money” (shortening the time it takes for you to hit your equity multiple hurdle). Say your cash-on-cash is 20% – then you know you’ll hit a 1x equity multiple in 5 years. You’re able to hit this multiple quicker because you have no heavy deal costs (an asset management fee) weighing down the deal.
Most importantly, the way method 3 is structured, your promote simply becomes equity once the multiple is hit. What you’re doing here is leveraging your time investment (assuming you had put no money down) into 20% equity in the property. I cannot emphasize enough how important this is – leveraging your time into equity is how you become rich.
Lastly, the final reason that this method is better than method 2 is that it is far easier to calculate. Instead of having to create a returns waterfall to calculate your promote, you simply start taking 20% (or whatever percent you agreed on) of the cashflow once the equity multiple hurdle is hit.
Method 4 – Getting a High Leverage Loan
Essentially what you’re doing here is getting a loan for as high of an amount as possible so that you can own the entire deal with a small down payment. This is not a bank loan as they won’t give you high enough leverage – you’ll have to turn to private sources (you’re looking for 90%+ leverage).
Why is this the best model? Since your “investor” is actually a lender, you actually own the entire building. You end up with 100% equity.
Obviously, doing this comes with more risk. Since you levered the property up so high, you now have a huge debt load that you have to pay off. If the market turns south, you could be in deep trouble. Since you have all of the upside, you also have all of the downside as well. Risk reward profiles exist for a reason.
The most important thing to keep in mind through all of this – no matter what structure you chose, do not deliberately mislead or screw over your investors. Aside from being morally wrong, the whole idea is that you have an investor base that grows with you. It is infinitely better to have terms that are a slightly worse on your first deal and to have that investor keep investing with you than to fleece your investor and never have them invest with you ever again.
To close everything out, I want to put some hard numbers out there so you can conceptualize this difference better.
- $250,000 purchase price
- 10% initial cap rate
- 10-year hold
- Property appreciates 3% per year
- Value-add deal in which the NOI increases 50% in the first year, then 3% thereafter
- 70% leverage
- 4.5% interest rate
- 1x equity multiple hurdle on the promote structure
- 20% promote
Method 1 – Charging an Asset Management Fee
Asset management fees are usually charged on equity invested. Say the purchase price is $250,000 and the deal follows a typical 70% debt and 30% equity structure, that leaves you with $75,000*2% or $1,500 dollars a year. One hundred bucks a month. This is literally not worth your time to pursue. At the end of the 10-year hold period, you will have a whooping $15,000 dollars. Needless to say, this doesn’t cut it, which is why this is listed as the absolute worst method.
Methods 2 and 3 – Hurdle Based Promotes
For the purposes of this quick illustration, I’ll group methods 2 and 3 together. Unlike in method 1, you actually participate in the upside that is generated from adding value in Year 1. In this scenario, your profit over a 10-year hold would be ~$82k (combining the residual value won the sale and the cashflow during the hold period). Your return is over 5x higher than if you’d chosen to accept a management fee instead (and it’s tax advantaged as well).
Method 4 – Getting a High Leverage Loan
At 95% leverage and a 4.5% interest rate, you would be turning your initial investment of $12,500 into nearly $400k (total profit is ~$384k over 10 years). Needless to say, this is an incredible return and you should do every deal with this structure that you can get your hands on. Just remember that you’re taking a proportionate amount of risk to get this return.
In summary, you always want to get to the equity in any deal you do (this doesn’t only apply to real estate). Getting to the equity allows you to participate in the upside, which is where the money is made. Of all the methods presented in this article, method 4 is the best. However, it’s very rarely repeatable. Banks will not give you a very high leverage loan, so you have to turn to either seller financing (which is highly unreliable and affects the actual mechanics of deal – the deal literally can’t get done if you don’t use it. This can lead to you missing out on good deals, simply because you have a poor deal structure.) or to a hard money loan from a friend (also probably not repeatable). Method 3 is generally the best structure simply because it’s actually scalable and repeatable. Any deal you find, you can set up with an equity multiple promote (it doesn’t affect the actual mechanics of the deal).
Cap rates are the most commonly used method to value commercial real estate. Simply put, a cap rate (or capitalization rate) is the NOI divided by the property (sale) value. As mentioned in the previous article, it’s probably easiest to think of NOI as EBITDA (revenue minus expenses, before debt) as the two metrics are very similar.
Cap rates mirror every other (risk-reward) return profile in that they measure the riskiness of a particular asset. Within real estate, each asset-class has a different risk-reward profile and therefore, some assets are designated as riskier than others (the riskier the asset, the higher the cap rate). Hotels are the riskiest, followed by office and then multifamily. This is evidenced by the cap rates investors assign to each respective asset class.
As a side note, although the unlevered (pre-debt) return can change during the hold period, this is not typically referred to as a cap rate, rather it is referred to as the “yield”. Only the entry and exit yields are typically referred to as “cap rates”.
Ideally, real estate investors make their money in 3 primary ways.
The first is off the yield from the initial cap rate (ex. If the cap rate is 7%, investors get a 7% return).
The second is off juicing this initial cap rate with debt. Say you buy at a 7% cap rate (your money is getting a 7% return) and you borrow at a 4% interest rate. Now, not only are you making money off the initial return, but you’re juicing that return by leveraging the spread between the interest rate and the cap rate. The magnitude of this is obviously dependent on the amount of leverage used.
The third way is through cap rate compression. Essentially, you want cap rates to compress or decrease over your hold period. Why is this? It’s probably easiest to think about it conceptually.
Conceptually, when you sell for a lower cap rate than you bought for, it means that someone else is accepting a lower rate of return than you did. In order for them to accept a lower rate of return, something must have changed (improved) at the property to make it less risky – either you added value, market conditions improved, or something of the sort.
A different way of thinking about this is by recognizing that a cap rate is simply the inverse of an EBITDA multiple. Those of you in the regular private equity world may be familiar with the EBITDA multiple valuation method, in which a company sells for ‘x’ times EBITDA. Imagine that you bought an asset for 5x EBITDA and then sold it for 10x EBITDA. That would be a pretty incredible return, right? The effect of buying at a 5x EBITDA multiple and selling at a 10x EBITDA multiple is very similar to buying at a 10% cap rate and selling at a 5% cap rate. Just to illustrate this point, ideally, you’d want to buy at an infinity cap rate and sell at a 1% cap rate.
This is why market cycles are so important in real estate. When you buy at the top of the cycle, you’re buying at a low cap rate (let’s say 4.5%). If you buy at a 4.5%, there is essentially no room for cap rates to compress, because the lowest they can really go is 0% (unless the next buyer is willing to accept a negative rate of return). But, that’s not factoring in the cost of debt (almost everyone is going to use debt to juice their returns, so the market factors in the cost of debt into the purchase price). Banks aren’t going to just loan you money for free. So let’s say banks are willing to loan you money at a 4% interest rate. Now… you really have nowhere to go at this point but up as there is only a 50 basis point spread between the interest rate and your return. Since most buyers do not want negative leverage (although in some value-add scenarios, buyers are willing to accept negative leverage for a short amount of time), cap rates will only decrease if the fed lowers interest rates. But… what happens if the fed raises rates instead? If the fed raises rates, to 4.5%, then cap rates will very likely increase to 5% so that the spread between interest rates and cap rates persists and investors can make money. And that is where the danger begins. Just like buying at a high cap and selling at a low cap is a boon to your returns, buying at a low cap and selling at a high cap is disastrous. For arguments sake, let’s say you end up waiting to sell and selling at the bottom at a 7% cap rate. At an NOI of $100, that would mean you bought at $100/4.5% = $2,222 and sold at $100/7% = $1,429. You’ve lost over a third of your capital. Not pretty.
Now let’s imagine the reverse scenario: you buy after the market crashes. In this scenario, you’re buying at a high cap rate (say 7%) and selling at a low cap rate (say 4.5%). If you buy at a 7% cap rate, now you actually have some room to compress downwards. At an NOI of $100, that would mean you bought at $1,429 and sold at $2,222. Instead of losing 1/3 of your capital as in the previous scenario, you’ve achieved over a 50% return. That’s how powerful the effect of cap rates is.
Notice that in both scenarios, the NOI didn’t even change – all that changed was the cap rate, which made the returns drastically different.
The two scenarios above illustrate why you should never trust the ‘incredible returns’ of a sponsor who has not been through a recession. Even a blabbering moron could have made money with a fund that was started in 2010. Don’t believe me? Check the average returns of a vintage 2010 fund. Now compare that to the average returns of a vintage 2006 fund. They won’t even be comparable. Unlike in the stock market, you can’t “short” your real estate investment. There are very few ways to make your investment counter-cyclical. If you invest at the wrong time, you simply lose.
Here’s what no one wants to tell you – the biggest part of being a good real estate investor is not your actual deal-by-deal investment thesis, but rather your ability to time markets.
There are three primary methods for valuing a property. The sales comparison approach, the income capitalization approach and the discount to replacement cost approach. There are many areas of overlap within these three methods, but I’ll try to lay them out individually in the simplest way possible.
Sales Comparison Approach – The most commonly used approach, especially in residential real estate, but used extensively in commercial real estate as well. The method is very simple and involves looking at comparable buildings to see what they sold for. There are different metrics for comparison dependent on the real estate asset type. Office buildings are compared on a price per square foot basis. Multifamily buildings are compared on a price per unit basis. Hotels are compared on a price per key (room) basis (this is why hotel rooms in Manhattan are so small – more rooms typically leads to a higher property valuation). All real estate assets are valued off cap rates as well. Cap rates are simply the net operating income (very similar to EBITDA – just think of it as revenue minus expenses before debt) of a property divided by the property value. So, if a property has a NOI of $1MM and it sold for $20MM, the property sold at a 5% cap rate.
Unlike the other metrics listed above, you should be very careful when using cap rates to value a property, as they often change over the course of the hold period. For example, in a value-add deal, cap rates barely even matter. Why is this? Say you are buying a property for a 5% cap rate and plan on extensively renovating it to achieve higher rents. The higher rents will increase your NOI, which will increase your cap rate. Which means that the initial cap rate you are buying at doesn’t really matter at all. What really matters is your stabilized cap rate (yield), which should be very different if you execute your business plan correctly.
The trick with this method is accurately finding the buildings that are most similar to use as a metric for comparison. Location, vintage (age), tenant profile, recent renovations completed, etc. all factor into the decision and must be appropriately accounted for. There is no easy way to explain how to weight each of these factors to come up with accurate sales comps – you can only really learn this from experience.
Income Capitalization Approach – This is typically called the “Income Capitalization Approach”, but I think it’s easier to think about as the “Cash Flow Approach”. Essentially, with this method, you are valuing the property based on the cash flow it is spitting out every year. There are a ton of different ways of doing this – you can value the property based on a cash flow (EBITDA or NOI multiple) and you can value it on an IRR/NPV basis. The way in which you value it really does not matter – you will come to pretty much the same conclusion either way. My firm typically values properties on an IRR basis, so that’s what I’ll focus on.
There are a ton of flaws with the cash flow approach, the most prominent of which relate to the fact that it often assumes both the market conditions and the asset conditions will stay the same. It generally relies on an asset-specific situation, rather than market fundamentals (which is why it is inferior to the discount to replacement cost method, which truly focuses on the market fundamentals of supply and demand).
I don’t want to get into too much depth here, but a few things to be cautious of when projecting out the cash flows:
Make sure your leverage isn’t driving your returns. You should be calculating your leveraged and unleveraged returns separately and there should not be too much of a gap between the two. If the gap is large… you do not have a good investment – all you have is high leverage.
Make sure most of your profit isn’t coming from appreciation on the sale instead of income during the hold period. As a general rule, alarm bells should go off if more than 70% of your profit is coming from appreciation on the sale (obviously there are exceptions to this, especially if it is a heavy value-add deal). There are a couple ways to avoid this. One is to always make sure you are adding at least 100 basis points to your exit cap rate vs your entry cap rate. Another is to check the entry price per square foot vs the exit price per square foot. Is it reasonable? If you are going from $800 PSF to $1500 a square foot over a 3-year time frame… that is probably not reasonable.
Discount To Replacement Cost Approach – Replacement cost is simply how much it would cost to build the property, brand new, from the ground-up. It’s a criminally underrated metric – generally the least common metric that beginners think about, but likely the most important. If you are anything like me when I first started looking at real estate, you probably only care about the cashflow numbers – who cares how much it cost to build as long as it’s making money, right? Wrong. The problem with valuing an asset off cash-flow alone is that you are assuming the market conditions stay the same. This is almost never the case. At the market-level, supply often increases, which (unless followed by a similar increase in demand) gives you less bargaining power over your tenants and generally lowers rents. How does figuring out the replacement cost prevent you from making the mistake of investing in an asset that is poised to have decreasing rents?
Let’s use an example of two separate investments, both in the same market.
Scenario 1: Say you buy an asset for $1,000 per square foot (PSF) and rents are $200 PSF. To make things simple, we will assume that expenses are $100 PSF. That means your NOI is $100 PSF and your initial yield is 10% ($100/$1,000).
Scenario 2: Now let’s assume replacement cost is $1,500 PSF and you decide to build. In this scenario your yield (after years of developing) would be 6.7% ($100 PSF/$1,500), or 3.3% lower than if you had simply bought an existing building.
So, what does this mean? It means that supply will very likely not increase in your market because it makes no sense to build – why would you take on all the risks associated with development (development is the highest risk investment in real estate) for a lower yield than if you bought an asset that already exists? No one is going to do this unless 1. They get some type of government subsidy 2. They are only in it for the development fees (usually 4% of the project cost) 3. They are making a ridiculous high-risk bet that rents will continue to increase during their development period, which will increase their yield.
Markets where you can buy at a discount to replacement cost are the best types of markets to invest in because you can be relatively sure that the market conditions (supply) will not change, which allows you to take one variable out of the equation, so you only have to focus on the asset-level. It also means there is room for the market valuations to grow, because, presumably the difference between the market price PSF and the replacement cost PSF will equalize, meaning your asset will increase in value.
You should be using all of these methods for each investment you look at
It doesn’t need to be a long drawn out process for each one.
The discount to replacement cost method is very simple if you know your market. For example, San Francisco is one of the primary markets my firm invests in. Since I know off the top of my head that ground-up development costs approximately $1,200 per square foot, an alarm bell goes off in my head when I see a property that is more expensive than that. Even if you don’t know your market, all you need to do is figure out the replacement cost from someone who does (lookup market reports, talk to brokers and developers).
Sales comps should be relatively simple as well. A lot of this information is online (visit county websites, Zillow, LoopNet, etc.). If you cannot find the information directly online, see if you can pull market reports from a brokerage (Cushman and Wakefield, CBRE, Colliers etc.). If none of that works, the property is likely being marketed by a specific broker. Call him up and say you are interested in the property. Chat with him for a bit about the property and then ask him for sales comps. Be careful with this, however. Remember that brokers want to sell the building for the highest dollar amount possible and generally do not care if you get ripped off (there are exceptions if you have a good relationship with them). What does this mean? It means that you need to be scrutinizing these comps very carefully. Think of all the reasons why the comps they show you could potentially be misleading. Was the comparable building bought by a 1031 buyer? This means that they were likely rushed (there is strict deadline that 1031 buyers need to hit) and it is possibly that they overpaid out of desperation. If so, the price they paid might not be indicative of a true market price. Was the comparable building bought with foreign capital or through a pension fund? Why does this matter? Pension funds and foreign capital typical have a lower cost of capital (lower required return) and are generally willing to pay up for a property just so they can park their capital. There is a high chance you would not be willing to accept the same return they are. Obviously, the specifics will differ for each deal. If you are starting out doing your first deal, it is highly unlikely that you will be competing with pension fund capital. However, these are the types of questions you should be thinking about in any situation.
The income capitalization approach typically takes the longest as you generally have to model out the full cash flows and it requires serious thought regarding each assumption. It also takes the most amount of skill to project out accurately.
Overall, when used correctly, the methods should all mesh together (an obvious example of this is cap rates, which feature prominently in both the sales comparison approach and the income capitalization approach). The three methods should be used to create one mosaic, from which you create the framework for your decision-making process for each specific deal.