If you’ve been following me for any given period of time, you know one of my favorite things to discuss is this idea of the founders investment theory. The founders investment theory, or sometimes we call it the FIT, is the bedrock for what syndications and funds need to do in order to set themselves up in the right manner, to think about their investments in the right manner, and to present those investment opportunities to their investors. This video is a blast from the past, but this is probably the best work that I’ve done in describing founder investment theory. I think it covers all the bases on why it is so incredibly important to make sure that you’ve identified your own founder investment theory. I know you’ll find it useful. The founder investment theory is the most important thing that you can do and think about for your syndication or fund. So enjoy this video.

The founder investment theory is so important for what we do. It is really the heart and soul. It gives us guidance on what we need to do, guidance on what properties we should be looking at, gives us an idea on how we can talk to our investors, and it even gives us an idea on how to better serve our investors and ultimately ourselves at the same time. So that is why it is so important. It’s what we do. So let’s go through founder investment theory. And we’re going to go through it in a slightly different way today.

We’re going to go through it through the lens of what exactly we mean by these different models and strategies, and how we can really leverage those different strategies to be better served. So let’s go ahead and get started. We’re going to switch over to the whiteboard.

Before I drew this diagram, it looked like this: we had development, we had stabilized add value, we had value add, we had undervalued, and we had cash flow. These are the four main types of strategies that exist in any developer or any property real estate deal. So what I want to do is expand each of those and really dive into each and talk about what we mean by each.

Let’s start with how we earn the money that we do. What are those things? I’ve talked about these before, and these are the value add opportunities. But this really comes down to how we make money. There’s two ways that we make money in every investment: one is cash flow and the other is appreciation. They’re very linked. So it all boils down to our idea that value equals NOI over cap rate, or we could really look at it as our cash flow equals our value times our cap rate.

Appreciation is the delta, the change in value, which means that it would be the change in NOI over the new cap rate. So that would be the change of value. So all we’re trying to do is we’re playing with this algorithm here, or this algorithm. It doesn’t particularly matter for our purposes. So we’re playing with that, and that’s how we’re getting money.

Let’s start with cash flow properties at the very bottom of this diagram. Now with a cash flow property, what we’re trying to do is we’re trying to hold these properties for a very long time. We are going to put money into our investor’s pocket as regularly and as consistently as possible. These are not complex deals, they’re long holds. And so we’re trying to just put money in their pocket, and eventually we’ll sell it with appreciation.

That’s because we’ve got the value equals the NOI over cap rate. And so as NOI goes up just over time, if you own a property that’s big, you’re paying regular rents, and maybe you’re getting rent growth of 5% every single year. Maybe that is driving up the appreciating value. So when you take that same NOI and you add to it that increased NOI, then what you’re actually doing is you’re loading up this equation so that this number is really, really big. And probably your cap rate is fairly stable and it’s not changing much. That’s really what is going on underneath the hood.

So in order to make good money on these properties, what do we have to do? Well, they’re always going to be in prime locations and we’re going to be basically banking on rent escalations. We always try to increase our NOI. So we need to increase our income and lower our expenses. That’s what we’re trying to do. So our income is increasing naturally because of rent escalations. For this type of strategy, you’ll be looking for other opportunities, but really, that’s what you’re banking on. This is not a very hands-on way to increase the value. And then you’re going to lower the expenses. But again, this isn’t really built into the system for a cash flow strategy. You’re really just banking on these rent escalations that are very good. And you’re hoping that cap rate stays stable.

So the driver here is rent escalations. That’s what you’re trying to do.

Let’s go up the stairs to stabilized value add. This is also a longer play, but you’re really looking at this value add component. And so you’re ultimately looking for the increase in value to go up and you’re doing that primarily for this kind of property. You’re primarily doing it again from income and not really from changing your expenses or from changing the cap rate.

So where does that change in income come from? With this, we’ve got it really coming down to a couple of different strategies that work. So we’re looking for expiring leases and below market rents. Which tells us basically what our strategy is – we’re doing that by looking for releasing either to existing tenants or to new tenants. That’s one way to do it.

Or we could also as a major play here talk about re-measuring. What we’re talking about with re-measuring is the strategy where you take a property that’s already generating income, and you re-measure that whole space. Measurement standards tend to be in almost every lease I’ve seen in every state based around the Building Owners and Managers Association. The standards that they use change over a period of time. And because it’s the Building Owners and Managers Association, they want the space to be as big as possible. So it’s no longer just measuring the inside of the space while the wall figuring out what the square footage is. It’s now there are some exterior spaces that count because of overhangs, things like that. There are other ways to measure it that really increase the square footage and I’ve seen this increased by 10-20%. That’s a huge amount.

So if you’re getting two bucks a month, let’s do it on a year, say you’re getting $24 a square foot on rent, and you’re increasing it by 20%. Let’s look at it. So for that same space, you’re getting $28.80. So you’re getting 20% more cash, same cap rate. So what’s the difference in the amount of money that’s there? Per square foot you’ve just added – let’s say it’s at a 6 cap – you’ve just added $80 per square foot of value just by re-measuring. Now, on a 10,000 square foot building, you’ve now got $800,000 more cash that you’ve magically created out of nothing. So that’s pretty amazing. It works great and it’s a great strategy here.

So let’s put in what the driver is here. Our driver is increased rent dollars over the term. Do you see the distinction? There’s a nuance here between the driver for stabilized add value and the driver for cash flow properties. Where the big driver for cash flow properties is just the natural rent escalations that are taking place, here in the stabilized value add, we’re talking about how do we take those existing rents – they’re gonna escalate as well – but how do we really shove them up in order to really bring them up to the highest level that they can be? So that is the nuance that takes place there.

Let’s go down here and talk about undervalued properties. With undervalued properties, what we’re really trying to do here – remember what an undervalued property is – it’s very low cost per square foot and a very high cap rate. That’s probably because of, or could very well be because of, expiring leases.

Here we’re not so much looking at the NOI as the main driver, what we’re looking at is this cap rate. Because what happens when all the leases have like one year left to term on them? And it’s an office building or retail building or industrial building, the cap rate is just super, super high, value is super, super low. And so you can buy these properties very inexpensively. Maybe they’re selling it now just because they need cash for some reason. Or maybe it’s because they’re afraid of what’s going to happen if it turns or whatever. But you’re buying it at this very, very high cap rate. And then you are counting on doing things that will decrease that cap rate, things such as renewing leases.

Now, there’s a distinction here too between renewing the lease for an undervalued property and renewing a lease for the stabilized value add. In the stabilized value add, you’ve got a very normal vacancy factor that’s going on, leases just are naturally expiring. And you’re going to be able to release it without much concern. In an undervalued property, there’s going to be some element of it where the value of that lease, the fact that it has such little term, is pulling that cap rate up and making it undervalued in the marketplace.

Maybe it was – imagine that you went in and there was a department store that’s not doing very well and they’ve got one year left on the lease. We have this massive property, and then you’ve got barely anything left on the lease. And that fact that it’s got so little term is just dragging that cap rate sky high in order to crush it. So that’s what is really going on in these undervalued properties – that low cap rate. And so what our driver is, your high cap rate actually – well, your driver of making money is moving cap rate down to where the rest of the market or a normally positioned property would be. You’re trying to move it down and that most of the time comes from renewing leases.

Our fourth major category is of course your value add. Now here, you’ve got a bunch of things going on. What separates it from the stabilized value add is it’s really not about just getting that increased rent dollars, you’re really trying to get the increased total dollars coming in. So what you’re trying to do is you can do any strategy to try to do really any strategy that raises that NOI or lowers that cap rate at the same time. And so here this is sort of the kitchen sink approach of what kind of fits in here.

We definitely have rent growth and we definitely have renewing leases to change that cap rate. You make changes. So what I’m trying to do is I’m trying to increase the income. And that can be any of these – rent, square footage, but that’s really rent isn’t it, or adding other income. Or here’s where we finally see we’re trying to lower our expenses, and lower them to such a point where suddenly we’ve got as few expenses as possible.

Now, that could even come in the form of transferring that risk from an existing lease structure on to a new lease structure that has different terms for paying operating expenses. So moving somebody from a modified gross to a triple net, moving somebody from a full service gross into a modified gross, that can all decrease those operating expenses, because really, it’s just changing how your pool of money is. It’s not actually lowering your expenses, it’s actually really increasing your income and how that comes in. But it also decreases the amount of risk that you’re taking.

Some of the other strategies that do lower expenses would be suddenly submetering, other energy sources like solar, or just lowering your property taxes, all in an effort to raise your NOI as high as possible. Now, we’re also trying to change our cap rate. So we’re also trying to lower our cap rate. And there are a lot of things that affect the cap rate as well.

Cap rate really is all about positioning. And so we’ve got term as definitely a major factor as we talked about in the undervalued properties. But it’s also just how your property is situated. So it could be your tenant mix. For example, if you have a retail center that’s got 10 tenants, and nine of them are service tenants where it’s fix your cell phones, your H&R Block, things like that, that is nowhere near going to be as low of a cap rate as something that’s like all restaurants. All restaurants is always going to have a better cap rate, because they’re just better tenants, and they pay more money. It comes out as a matter of rent. But it also comes as just the cash that’s available. When you have a restaurant that’s earning good money, the rent cost isn’t as major of a factor. You know, it’s between 8 and 12%, normally, of their expenses, where it can be 20 to 30% of a service-based business’s expenses is just the office. Not the best way for them to choose that, but that tends to be oftentimes the case.

I mean, think about the cost of an H&R Block, and how expensive that rent is just in comparison to their operating expenses. The only other expenses that they have really as a franchise is the cost of labor. So it doesn’t really add value to it. So changing that tenant mix can definitely decrease the cap rate, which would be a good thing.

And then just changing perception. So this could be refacing, changing the architecture, making it the new cool hip building, even if it’s not new and cool, just making it a place that tenants want to go. Because every landlord is concerned about vacancy. And so the more sexy that a property is, the more likely they’re going to be able to release property and the better the perception is, which lowers the cap rate and then adds that value.

So with these, our driver is both raising NOI by more dollars, which can be rent or other income, lowering expenses, and also let’s call it repositioning or a lower cap rate. Okay. So you’re really repositioning it for a lower cap rate.

Now, the last strategy we talked about is develop and it is kind of a special thing, but it actually follows the same general model. I mean, what are you trying to do here? The driver is to create an NOI. You’re building a space in order to rent it out and have a cap rate, and the lower the better, right? So you want to build the best building you can so that cap rate is as good and as appealing in the marketplace as possible.

If I’m a developer and I’ve got a chance to build for, say, let’s say I’ve got two different fast food companies. Let’s say we’ve got on one hand we’ve got a Carl’s Jr., which generally does very good. And we’ve got an Arby’s which generally doesn’t do very good. The Carl’s Jr. is going to make more money, it’s going to have a lower cap rate because the marketplace appreciates the Carl’s Jr. much better. So that’s why it has that higher cap rate.

So I think this probably makes sense. So we’ve got that is what we’re doing when we look at the strategies and how those different value add strategies play out. We’re moving the same kinds of things in order to create that value added for our investors.

So, what is the next step of building out our founder investment theory? We start identifying our niche, which is property type. We start thinking about what our property type is, making sure that we understand what it is. We should know as many things about it as possible. How do the main tenants make money? What are the main ways that those tenants make money? What are the main risks for those kinds of tenants? What are the rest of the terms? What are the vacancies that occur? What are the lease types? How many tenants are you going to be working with? How hands-on is it versus off?

For example, if you’ve got an apartment building, it’s much, much more hands-on than a warehouse. You probably will only show up to the warehouse once to rent it. And that’s it, you probably don’t need to go very often. On an apartment building, your property manager is going to be there many days a month, visiting the property, visiting tenants, making sure that things get improved, or that the toilets aren’t flushing or leaking or whatever. So those are the kinds of things in the property type.

And then we’ve got our location – how far away is it from you, where is it located? Those are the things that fall into your niche.

The last category is your risk profile. We talked before about the spectrum – high risk, medium risk, low risk – and somewhere on the spectrum is where your investors like to sit. And here too is somewhere on this spectrum is where your risk is. Development tends to be high risk. Cash flow properties tend to be low risk. Stabilized value add tends to be medium risk. Value add tends to be medium risk. And the undervalued properties tend to be low risk.

So you see what happens here is that on this continuum between high risk and low risk, we’ve also got the complexity of the strategy. The more complex the strategy, the higher the risk is going to be. It’s just the natural part of what is there. And so that is also part of the risk profile. If you’ve got a bunch of low risk people and you’re doing development, it’s probably not going to work out very well. If you’ve got a bunch of high risk, high rollers who like taking big chances, doing this deal where you’re buying this four-plex in Beverly Hills at a 3.5 cap and you’re just waiting for rents to increase naturally, they’re not going to go for it. It’s boring, and it’s not going to happen. So it’s this risk profile.

I think I told the story of – I may not have told it to y’all. So when I was putting a deal together, I went and there was a prominent doctor who I thought for sure was going to invest in the project. And I wanted to – I thought, okay, there’s no way that I can’t get, say $300,000 from this guy. He’s got a ton of money. I know he’s sitting on cash right now without anything to do. And he doesn’t have anything to go in it. And he likes me, he knows me and trusts me. This was before I came up with founder investment theory and before I came up with this idea of a risk profile. So I had lunch with this doctor. And I said, “Dr. S, here’s this property I’m syndicating. I’ve got all this stuff. And it’s a great property, it’s gonna make a ton of money and it’s gonna make a ton of money because we’re buying it at a low cost. We’re going to wait for it to appreciate over five years and it looks like we’re gonna get a nice 15% IRR. The tenant is safe. They’re not going anywhere. It’s really going to be super duper, you’re gonna love it.”

And he looked at me and he was like, “Yeah, it sounds like a good deal, but it’s not for me.” And I was shocked because I was like, “Well, why? I mean if you got cash just sitting around, why would you not take a deal like this where it’s a good thing? 15% is a good return on a property with such low risk.”

And he said, “Tilden, I’ve got three pools of money that I use, okay. And this will explain why yours isn’t a good fit. So I have this category of money, and this is where a large portion of my money is pooled. It is super low risk. It’s money that you know that a great recession could come, that money is really not going anywhere. We’re talking, it’s in like long-term bonds, and it really is just going to sit there, and it’s going to sit there forever. And it’s my money that when everything goes to hell in a handbasket, I know that money’s there, and I’m going to be very, very comfortable, even if the worst thing happens. So it’s very, very low risk planning.

Now I’ve got a category of money that’s maybe a little bit smaller than my low risk category, but it’s a fairly substantial size. And this is my income money. And my income money basically pays for my standard of living so that I make sure that I’ve got money coming in for the rest of my life, and I don’t have to work or I don’t have to really do anything. I get to go on trips, I get to spend money, and my income money, it pays me one to $2 million a year. And it’s very comfortable. I’m extremely comfortable. And I’ve got a great lifestyle. And I don’t really have to worry about it. So the bulk of it is my income.”

And I said, “Okay, well, that’s two of them. But you know, I know that you put money into other projects, and you put money into some businesses, and you’ve told me about some of these investments that you’ve made in these venture capital things that you’ve been doing.”

He said, “Yeah, that is my play money. My play money, I’m not even really expecting to get that money back. You know, if I do, I expect to get like a 50% return or more. But my play money is really there so that I can have fun. I enjoy investing. I like it, it’s fun to do. And I like experimenting and seeing what happens. I like finding these people who need money, just the capital to do these crazy things. And when they pay off, they’re gonna pay off big time. But if they don’t pay off, well, ultimately, it’ll kind of even out, because five of them won’t pay off, but one will and it will do great. That’s my play money. And my play money isn’t very big.”

And I said, “Well, okay, but this is one of those projects where, you know, it’s really going to do that. It’s something where you get to be a part of it, and it’s gonna be fun.”

And he shook his head, kind of smiled and said, “No, it’s not play money. It’s got a 50% minimum return I’m looking for. You’re talking about 15%. That’s terrible. And this is like 15% in five years. I’m gonna get that money back. You know, if maybe if it was like six months, I’d do something like that, but in five years, that’s five years that I don’t have that money to put in things that are a lot more fun than your project. So it’s not play money.”

And I said, “Okay, well, you know, it’s going to be paying out dividends. And it fits that, right? So it should be income, it should be income money.”

He said, “No, you just told me that the real money is made on the appreciation of the property because you’re buying it for a low cost, and you’re gonna sell it in five years for an increased cost when the rent bumps up. You know, the amount that it’s getting right now on the income is maybe 4%. So I’m not interested in 4%. I need to get much better than that in order to live off. This is the money I live off. So it’s not income.”

“And we all know that it’s real estate. So there’s no way this thing’s low risk. It just is, it’s just a property. It’s backed by a good tenant, but you know anything could happen. You know, they’re not assigned as the US government, it’s not low risk. So although your project sounds interesting, it’s not anything that fits into one of my three categories of play money, income money, or low risk.”

So you see what I did there? I went to Dr. S, thinking that, just from the viewpoint of, I’ve got a really strong, sound investment that should make a lot of money, and was really good. And I went into the meeting thinking that investors make a decision based on “is this seem like a reasonably logical way in order to spend money?” But that’s not the way that investors actually think.

The investors think first, “Well, first, they want to know, does it make sense?” Right, they want to know that the deal makes sense, they can kind of understand it, but most of it at least. So we’ve got this idea of does it make sense. And they do need to know that. But the making sense is just a small piece of the puzzle. Because most of how they make the decision is underneath the water. This is all logic. And this is all emotion.

And if you come at it from looking at just as an investment itself, just like one thing, saying, “Does this one thing make sense?” But there are a lot of other one things out there that make sense. But when you can hit off these kinds of things, and identify where does their natural risk profile lead them? Where do they like to sit? You know, then you’re talking about all this stuff down here, all the emotion that it can make sure that it feels comfortable to them.

And when you’ve got a strategy that they can kind of pick and understand, but it gives them something more than just kind of like, “Okay, that I understand it,” it gives them an idea of something that they feel like they want to be a part of. Now, sometimes people want to feel like they can be part of a value add project, because they’re taking a building that’s been dilapidated and ugly, and they’re being part of that whole thing that reimagines it and makes it awesome. And they feel like “that’s my building,” they can point to it and say, “Yeah, well, you should have seen it before.” Right? That’s an emotional thing. It may make sense in a logical portion. But not only does that in order to make sure that they feel secure about it, it’s an emotional driver.

And the same thing goes for these cash flow properties, right? So here, you’ve got investors who are afraid of all the things that could happen, they want something very secure, they want something very safe, and they want something like, “Boy, those properties have always been good, they’re always going to increase at that same level.” And it gives them that sense of comfort.

And so if you bring those same people and try and tell them how you can’t lose on this development deal, of course it’s risky and at risk, it’s all out there, you’re appealing to the wrong person, because they don’t have the emotions to drive it.

And then you’ve got the same can be said for the undervalued properties and for the stabilized add value. We’ll just use the undervalued properties as an example. You’ve got an undervalued property, you’re going to this person and you’re saying, “Look, we’ve got this building for a real steal, we’ve got a bargain here. This thing is worth much, much more than the pennies on the dollar that it’s selling for. This thing is going at such a low rate and it’s going to be a real, real great deal.” This appeals to your bargain hunters. This is a great property. And the logical part of it is really kind of small. I mean, you’ve met these people, right? You’ve met people who are so in love with finding bargains that you tell them that it’s 50% off, and they don’t even look at the price tag at that point. And that’s 50% off, it must be a great deal. And so you’re driving to this emotional spark.

This is why FIT exists. This is what it does, because every piece of it from strategy to niche – and then we’re talking about property type, to location, and the risk profile – all feeds, serves this emotional part, before it even comes close to serving the logical part. So we can serve that. And it still makes sense, because this is why we do the underwriting, right? So we do the logical part. That’s why we present good logical part, we have nice underwriting. So it all makes sense. But the whole story behind it is just to get to that emotional side, because once they’ve made the decision emotionally, they’ll do whatever it takes to make that decision logically.

And FIT is the only way to really get at it in a way that makes sense to somebody where they can feel okay doing it. You’re trying to give the logical part of them permission to say okay to the emotional part, or look at it in the converse – you’re trying to do whatever you can so that the emotional feels okay, so that the logic can just pick up the slack and pull up the rest of the way there. That is founder investment theory and why it is so powerful.

All right, so we’re gonna do a little bit shorter talk today, because we’ve talked a lot, and I think we’ve really dived in good. Here’s what I want to have happen. I want people to really spend some time thinking about this, because founder investment theory is not a light topic. It’s not something there just because I think it’s important to find the values of your company and anything like that. It is because this is how you convince investors, this is how you choose properties. And this ultimately is how you yourself are comfortable with it, too.

I mean, if you were one of these very, very low risk people and you were doing development deals, you’d have a very short life, you’re gonna be stressed out and freaked out all the time. Or if you’re just doing these cash flow deals, but you’re really like this crazy developer at heart, you are going to be bored out of your mind. So answering the question of founder investment theory is where you start.

So think it through – how do you do it for yourself? And then once you’ve decided that, now you know how to start talking to investors, and how you can start lining up to their emotional side. But you also know how to start looking for properties. Because now you know, okay, I need something that’s value add. And so I’m looking for these kinds of things. I know this is my niche, I know this is my location, this is where I want things to be. And you can start having that conversation with brokers and start building out your listings on LoopNet and Crexi and wherever else you’re looking, the MLS, and making sure that it all lines up.

I know you’ll find that useful. Again, it’s about founder investment theory. Everything boils down to that. That is what will make you successful as a syndication or as a fund, if you’re thinking about that FIT every time. It’s putting yourself into the right mind of your investor.

Now this version of the FIT, this was actually put together for people that I would coach on how to get started in real estate syndication. So it’s obviously real estate centric, but it applies across the industry. It’s across asset classes. So it’s that idea of FIT that you have to be thinking of in order to be successful in this business.

My name is Tilden Moschetti. I am a syndication attorney with the Moschetti Syndication Law Group. If we can help you with your Regulation D Rule 506(b) or 506(c) offering, please don’t hesitate to give us a call, whether it’s real estate, you’re raising money for a business, whatever it is. We can help you put that together. We can talk about your FIT, strategize about that all in the context of making your syndication or fund both investable through using the FIT as well as compliant with the rules of the SEC and the state regulators.