The cheapest money in real estate wants to buy a building. Some of the most expensive investment dollars want to buy a piece of your company. Neither is the right source of capital to pay for the couch in the lobby.
That’s funny right up until you’re the operator who needs the couch. Or the walk-in freezer. And 4,000 feet of millwork, a security deposit, and enough cash to carry a new location through a ramp that might run four months or might run ten.
All of it due before you welcome a single customer.
You’ve heard us talk before about next-gen platforms needing more than just venture capital. And how OpCo and PropCo can work together.
We said there were two kinds of capital.
Venture capital funds the company. Product, brand, the team, the go-to-market. It expects your valuation to double every year, which in rough math means you need to return 100% IRR to use it! To us, that makes it the most expensive money you will take. And you sell a piece of the business to get it.
Real estate capital funds the building. It underwrites rent quality, expected exit value, and location. It generally wants low-to-mid teens IRR. Cheap, comparatively. One catch: you have to buy a building.
Leaving it at just those two sources is easy to understand. When you explain to your Grandma what you’re working on at Thanksgiving, she’ll get it. But it’s an oversimplification. There are many more types of capital. Today we’re going to talk about another one we’re looking at a lot.
Meet Betty. She’s the CEO of a company that needs more real estate in order to grow. It could be a Direct-To-Consumer shoe company that's crushing it online and is doing a brick and mortar roll out. Or a smoothie shop. Or a co-living business.
She’s opening her fourth location and buying the building doesn’t make sense. Maybe it’s a market where building valuations are high and rents are low, making it harder to underwrite as an investment property. Or maybe she only needs one floor in a five story building.
So she rents. Completely rational, every time. But it’s pretty damn expensive to open a new location.
Betty has to write checks for the security deposit, the buildout, the furniture and fixtures and equipment, and the working capital that carries the location until it stands on its own. The costs of getting open.
So how does it get funded?
Banks won’t lend against it. Betty doesn’t have enough operating history for a business loan that size.
The landlord might, if her credit looked like Amazon’s. It doesn’t. Real estate investors aren’t interested. There’s no asset for them to own at the end.
And the venture folks want their money to go to team and infrastructure, not additional physical locations.
Back to square one. Betty is in the Missing Middle Financing Chasm.
We call our solution there BuildCo. Pretty creative, huh?
Here’s how it works. An investor funds the cost of getting Betty open at another location. The capital is scoped to that location and how that unit performs.
The investor sets the repayment to be a multiple of the capital invested, paid out of revenue. Plus some warrants in the OpCo.
The underwriting barely changes from traditional real estate. The investor still diligences the location and the business the way they would if they were buying the building with Betty as a tenant. In this case with no building to buy and therefore a different downside scenario, they scope the revenue share percentage to something Betty can afford that still pays an attractive return. Say 25-30% IRR.
If the location kicks butt and revenue grows faster than anticipated, IRR goes up. If it’s slow going, IRR goes down. This structure aligns incentives in a great way. Since the investor gets paid out of revenue, there is no argument about whose interests come first. There’s one job and both parties want it done.
Then once the investment is paid back, the revenue share is done. Betty keeps every dollar the location makes for as long as she’s in the space. The project has no trailing stake and nobody with a consent right over what happens in year nine when the renewal comes up.
It’s a no-brainer for Betty. 30% capital is much cheaper than 100% capital. Pretty impressive math we are doing over here!
She can open as many locations as she wants. Or go as slow and methodical as she wants. She doesn’t have to have explosive growth in order to satisfy the VC money that she took in. Good performance makes it easier to raise the next one. And then one day she wakes up and she’s got 20 locations and JP Morgan will give her a business line of credit at a cheap rate and she’s good to go.
That’s Betty’s side.
The investor side is interesting too!
Returns are 25-30% against low-to-mid teens for what is structurally a pretty similar risk as the traditional RE investment. With similar underwriting... Is the operator any good? Does the business plan hold together? Is this the right location for it? Anyone who has underwritten a building already knows how to answer all of that.
The cash shows up early too and in a big way. You’re getting 20-40% cash-on-cash returns during the investment. That’s a pretty serious de-risking relative to a 4-7% cash-on-cash when you own the whole building. The end is defined – you know your multiple and you know roughly when you’ll have it. And since there is no residual, you aren’t worried about whether cap rates are going to be 5% or 7% and whether you make no money or some money.
Important for us to recognize that the investor is taking some early operator and early location risk so they should get compensated for that. In addition to the revenue payback, they also get some warrants in the OpCo.
Despite us being excited about it, we aren’t wizards creating things no one has ever heard of. Bars and restaurants have run this play for a long time. Somebody fronts the money to build the place out, gets paid back drink by drink, and walks away when they’re whole. The owner keeps the bar.
We think it should be applied on a much wider aperture than just bars and restaurants.
A majority of investors spend most of their time at either end of this spectrum. Venture on one side and real estate equity on the other.
The middle is where more and more of our conversations end up, because the middle is where our operators actually get stuck.
So we’re going to be doing a lot more of it.
Capital and Counsel, same as always.
Operators – ready to grow your platform with right-scoped capital?
Investors – interested in high current cash distributions with upside?
Let’s talk: [email protected]
P.S. There’s a version of this where the same investor can do OpCo, PropCo, and BuildCo. It takes some discerning capital with the right structure, but done right we think the risk/reward is hard to beat. Perhaps a post for another time!
