Editor's Note: This is the final installment of our 2007 series of The Business Owner Toolbox written by our regular columnist, George Hedley. Each article is written to provide you with practical, immediately applicable business management tools to assist you on your path to building a successful, growing business.
The construction business is a hard way to build a fortune. Only a few construction business owners ever make enough money in their lifetime to acquire enough financial assets to become wealthy or retire in a comfortable way. But those who make it a priority to invest in real estate as a part of their business plan end up at least ten times wealthier than the average construction business owner.
Every day, most construction business owners drive by lots of opportunities to get rich. But they don’t take the time to stop and check out vacant property, inquire about an empty industrial building or look for property on which to build their own office and yard. They’re too busy working to make any real money. They spend their time scheduling workers, ordering materials, bidding jobs and building projects for customers who are enhancing their real estate properties. Most contractors work too hard (and too cheap) helping real estate developers and owners create huge portfolios and make tons of money.
Business or Real Estate Wealth?
A friend of mine attended an annual business luncheon where the wealthiest business owners in his community gathered. The after-lunch speaker asked the attendees a series of revealing questions. He asked them to write down their current net worth based on what they had earned by working in their businesses over their lifetimes. Then he asked them to write down how much money they would have today if they had never sold any of the real estate they owned over the years. In almost every instance, the results were unanimous. These wealthy business owners would have a larger net worth if they had never sold any of their real estate.
I am asked to speak at fifty or more conventions and meetings every year. After I speak, people always come up to ask questions, give me referrals and tell stories my message triggered. They tell me they own a construction company or some other type of business. Then they tell me their secret to success: They really make most of their money owning real estate. Some own their company building or yard plus the shopping center next door, a series of homes they rent out, or several warehouse buildings, or they have a partnership interest in a customer’s self storage project. They used their companies to get started, create a positive cash flow and make a profit—and then they made it a priority to spend half of their time investing in wealth-building real estate assets.
Developer Versus Contractor?
As a general contractor, I can’t tell you how many clients I have built for who have an oceanfront home plus one or two vacation houses in fantastic places. Each year, they want to have a job meeting two weeks before Christmas to review building projects. Then they fly off to Aspen or Hawaii for their three-week holiday. When they return in January, they expect us to have solved all their construction problems and stayed on schedule during the holidays. It doesn’t seem fair does it?
As I looked at our situation, I started questioning my business plan as a contractor. We did more work than our customer, had more employees, took lots of risk, received a one-time contractor’s fee for all of our expertise and hard work and didn’t make very much for our efforts. I reflected on the hundreds of buildings we had built for clients who were now living off perpetual monthly rental income these projects produced.
As an example, the first project I built as a contractor was for a woman who bought three acres for $150,000. We designed and built a 50,000 square foot industrial park for her on the property. Our construction contract was $1.5 million, and we made a contractor’s fee of $85,000 for overhead and profit. Of the $85,000 fee, $60,000 went for our overhead, leaving us a net profit of only $25,000. After tax, we ended up with a grand total of $15,000! Upon completion, she fully leased up the project, which initially generated a $5,000 per month positive cash flow. Now, thirty years later, her project generates a positive cash flow of over $40,000 per month, and she doesn’t even live in the same state!
What Business Are You In?
Think about your priorities and the purpose for your company. The real purpose is to give the business owner what the owner wants. Your business purpose isn’t to build buildings, install pipe, move dirt, hang drywall, or paint walls. You are in business to make a profit, build equity, seek wealth building opportunities and enjoy the benefits of business ownership.
It took me twenty years as a commercial general contractor to finally wake up and make a decision about my future. Year after year, we worked hard to make the industry average 1.5 to 3.5 percent pre-tax net profit. I endured lots of stress and took extreme risks building projects for customers who made millions owning and developing real estate. I started to realize that while our company did most of the work, our customers made most of the money. Why? Because I was in the contracting business. And my customers were in the wealth building business.
To get what I wanted, I had to continue doing business as a general contractor plus seek opportunities to create some wealth. Is the real purpose for your business to build for others, or is it to build wealth for yourself? Do you put building wealth first in your daily activities or does it fall onto your wish list of things you never get around to?
Building financial wealth is the outcome of consistently making a profit, retaining it, using it to acquire profitable business opportunities, create passive income and grow your net worth. Often, people ask me how I have enough time to run my construction company and write articles, author books and speak at conventions and company meetings. My answer is simple: “Duh! I’m the owner!” In the dictionary, the definition of “owner” doesn’t include words like worker, estimator, project manager, superintendent or hands-on control freak!
Change Your Business Plan!
Fortunately in 1994 I made a decision to change the way we do business. We are now in the opportunity business. Our construction business creates opportunities to cover our overhead and make a profit. It also puts us in the middle of the real estate market, which presents opportunities for us to own and develop projects. Our wealth building business plan is to seek real estate projects or property where we can add our construction expertise and create value-added real estate investments. For example, if we find an old under-utilized industrial building to buy and upgrade, it gives us the opportunity to generate construction income during the remodel. Upon completion, we lease the building to tenants. This creates long-term positive cash flow while increasing our financial wealth.
Seek Value-Added Property!
We purchased a 24,000 square foot well-located warehouse building for $1.25 million. It needed lots of refurbishment and a new tenant. Between myself and some friends, we invested $250,000 of cash equity and got a $1.3 million loan from the bank to buy the property. We spent $300,000 upgrading the building and then leased it to an excellent company at a higher lease rate. Today, we enjoy great monthly net cash flow and have been offered over $2.5 million from potential buyers who want to purchase our building. It’s not for sale as it will continue to grow in value and generate increasingly higher monthly cash flow for us owners.
Joint Venture with Customers!
Another type of win-win we seek is joint venture projects with our construction customers. We offer to take both construction and financial risk. This allows us to share in the eventual profits of development projects. For example, one of our customers asked us to build a project as the general contractor. I asked him if he had all the equity needed to complete the development transaction. He said he was investing $400,000 himself but still needed another $400,000 to put the deal together. I offered to provide the additional $400,000 equity needed for 50 percent of the project ownership and profits. This arrangement provided us with a $4 million construction job plus 50 percent of the overall project development profit. I funded our $400,000 equity capital partly from our construction fee plus $100,000 of my money and the balance from a few friends who were looking for somewhere to invest their money. As a contractor, our contractor fee for overhead and profit was $220,000. But as a developer, we made another $400,000 from our investment—an easy way to triple your return on energy!
What’s Your Real Estate Goal?
Getting involved in real estate takes a decision to make wealth building your priority. Once we decided to make real estate a part of our business plan, we set a simple goal to buy, joint venture or develop at least 20,000 square feet of commercial property every year. From that, we would generate construction profits, create passive positive cash flow from the properties and build our financial net worth. If we continued to acquire or develop 20,000 square feet of properties every year for twenty years, we would own 400,000 square feet of buildings. These buildings would generate, on average, at least $.15 per square foot monthly of positive cash flow, which equals $60,000/month net income. And owning 400,000 square feet of leased commercial property should equate to at least $20 per square foot in net asset value, which equals $8 million net worth. Not bad for only adding one small project to our portfolio every year.
I often get asked for my No. 1 business tip for success. Many contractors fall in love with their equipment, tools and machines. But most never get ahead by owning lots of toys. My answer is to buy your first real estate investment before your next truck. What’s your real estate investment goal?
Start Small but Start!
I started investing in real estate in a small way by buying a residential duplex for $40,000, upgrading it and then raising the rent. This created additional property value and a positive cash flow. Another real estate investment I made while building my business was to buy my own building for my company. Getting started with small real estate projects reduces the fear of the unknown. You learn how to work with real estate brokers, find property, make an offer, go to escrow, get a loan, review documents, close escrow, lease out space, hire property managers, negotiate and do what successful real estate investors do everyday.
Every real estate investment has a team of professionals who contribute to the overall success of the project. As a contractor, I know how to hire an architect, go to the city and build the project. But I didn’t know much about real estate contracts, making an offer, finding a construction loan or putting a project budget and pro-forma together, which would calculate whether the project made financial sense. Not knowing how to do some of the parts of the project held me back from moving forward on my plan to start a real estate investment portfolio. What is holding you back from moving forward?
The real estate project team is made up of:
- Developer
- Equity investors
- Real estate broker
- Mortgage broker
- Lender
- Real estate attorney
- Architect and engineers
- General contractor
- Subcontractors
- Escrow company
- Title company
What part of the team do you need the most help with? You are probably building projects for customers who have lenders, brokers, attorneys, title companies and escrow officers on their team. Get their names and go meet them. Ask questions and learn. These resources are the best place to start building your team. Ask for referrals to professionals who specialize in the project types you want to pursue.
Where to Start?
In order to find a good real estate investment or development project, you’ve got to find the right property for you. The most important person on the project team is the developer. The developer has a business goal to find a certain type of property to purchase, in a general location, within finite financial parameters. What kind of investment property do you want to start with?
You need to know:
- Property type
- Property condition
- General location
- Upside potential
- Amount of equity available to invest
- Borrowing capacity
- Financing availability
- Minimum financial return desired
Cash Is King!
You can’t buy real estate without some cash. Have equity investors lined up and ready to write checks. Generally you’ll need between 20 to 35 percent cash equity in every property you purchase. Most lenders will finance between 65 and 80 percent of the appraised value (not the purchase price). The appraised value is based on what the property is worth after you purchase it, improve it and lease it out at market rent. If you buy a property with the intention of remodeling it, the appraised value will be based on what the upgraded property will generate in rent upon completion. In the example below, the appraised value is based on the new rents the project will generate after completion and lease-up.
Current annual gross income $50,000 before expenses
Current annual net income $40,000 after expenses before mortgage
Capitalization rate 10% based on market conditions
Current property value $400,000
Purchase price $400,000
Remodeling costs $75,000
Financing and closing costs $25,000
Total completed project costs $500,000
New gross annual rental income $66,000 before expenses
New net annual rental income $55,000 after expenses before mortgage
Capitalization rate 10%
New property value after upgrade $550,000 appraised value
Loan @ 75% of stabilized value $412,500
Equity cash investment required $137,500
Annual mortgage @ 8.5% for 25 yrs. $39,858
Net annual positive cash flow $15,142
Annual return on equity investment 11%
A good way to get started is to find equity investment partners who trust you and will co-invest cash into your projects. Split the ownership with them based on who provides what percentage of the total equity investment required. The developer should get a working or promotional interest in the project from 10 to 50 percent based on the complexity, risk and project potential. And the investors should get the balance for providing the needed capital. A typical ownership split works like this:
Equity Investment Ownership
Developer $ 0 25%
Investors $137,500 75%
In the example above, the developer gets 25 percent ownership and profit sharing for finding, creating and doing the work of managing the project. The investors get 75 percent ownership for providing all the equity capital required. The developer should always invest and provide some of the cash equity and share in the investor portion of ownership as well. As an incentive to induce investors to invest in your project, all the equity investment must be paid back before any profit sharing starts. Also, offer the investors a preferred return of 8 to 10 percent on their investment before any profit sharing is distributed.
Now Start Looking for a Good Deal!
After identifying what type of investment property you want to acquire, the next step is to find it. Seek out the best real estate broker in the market who specializes in the kind of property you want to buy. Don’t ask a residential broker to find industrial property. Hire an expert who can assist you throughout the transaction from acquisition, feasibility, escrow and financing through leasing or sales.
The best way to find a good real estate broker is to drive the areas where the property types you are looking for exist. Look at the real estate signs and the brokers who are offering property for sale or lease. Call their offices and ask for the sales manager. Explain what you are looking for and ask who would be the best broker in their office to assist in your search. Next, interview at least three brokers. All of them will tell you they specialize in every type of project, so be slow to choose the right one for your team. Select the professional who is an expert in the building type you desire and can offer the most complete services. For example, if you don’t know where to find a loan, make sure they have a relationship with several bankers. If you are weak on calculating a financial feasibility for your investment, select an experienced broker who can do that for you. If you don’t know the comparable rents in the area, make sure your broker can provide that for you as well. Find a Lending Lender!
Having a great banking relationship will make you lots of money. Make it a priority to find a banker who will work with you on your real estate projects. Banks are in the business of making real estate loans. They have specialists who are experts in most types of properties and projects. Your challenge is to go out and find the one who understands your financial goals and will help you reach your dream. Make those phone calls and go see several bankers until you find the right one who you can trust to provide the financing you need.
Reach Your Financial Goals!
The development process is challenging but financially rewarding. It takes determination and a commitment to reach the finish line and meet your financial goals. The actual process requires steady forward momentum toward a finished project or leased-up investment property. The good news is that is doesn’t take lots of people or time to make your goals become real. You can hire most of the team members required to do the tasks required. Review the development process below and determine what things you can do yourself and where you need a professional to work for you.
The Development Process
- Site selection
- Feasibility, budget and proforma
- Offer and purchase agreement, escrow and due diligence
- Site planning and preliminary design
- City approvals
- Design development
- Planning department
- Building department
- Public works and engineering
- Utility companies
- Permits
- Architecture and engineering
- Architect
- Structural engineer
- Landscape architect
- Sign program and design
- Soils and environmental engineer
- Civil engineer
- Mechanical and electrical engineer
- Investors and equity partners
- Construction lender and financing
- Construction bidding and award
- Construction
- Leasing or sales
- Permanent loan
- Property management
Finding, purchasing, developing, creating, managing and owning real estate investment property is the most fun you can have at the office. You can do it part time while managing your regular construction business. The more real estate you own, the more you want to own as you see your cash flow and financial statement grow every year. Take a look at your time management. How can you get a better return on your time? Try getting in the real estate business and you will see what a real return on your time can be!
Construction Business Owner, December 2007
