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A story of adaptation: or how to survive and succeed in a challenging real estate market

Guest post by Matthew Whitaker, Managing Member of Magnolia Partners, LLC and Golden Key, LLC

In December of 2007 we were faced with a decision.  After three years of successfully flipping properties to low and moderate income buyers, we awoke one day with no buyers and no plan to find new ones.  Our dilemma was very simple, do we dissolve the company or do we create a new viable model that will work in this new economy?  If we decided to create a new model, what would that look like?
We had just begun to hit our groove in the spring and summer of 2007.  We had successfully flipped around 100 properties in the first 2 ½ years of business and we were working at about a 4 to 5 house pace per month.  We were making money and had been in the black for quite some time.  We considered ourselves “real estate investors” and thought we were pretty darn good at it.  So when we found ourselves faced with a flight or fight decision only a few short months later, it seemed surreal.  My partner, Karen, and I spent days talking about what a viable model was for the new economy.  We had heard of other local groups “selling to out of state investors.”  We decided to attempt to replicate a similar model, but with a focus on local investors.
For three months Karen and I worked on a plan and developed systems and processes that involved Golden Key (GK) (www.gkhouses.com) selling properties to investors that wanted to invest passively in real estate.  Our vision was that everyone recognized the opportunity, but very few people had the skills to do something about it.  We thought we would approach professionals (executives, doctors, lawyers) and pitch them on the idea of owning 10 – 15 properties instead of investing all their money in the stock market.  Locally, based on our expected average sales price, this involved them investing $100K to 150K individually.  Our responsibility in this plan involved acquiring the properties, rehabilitating them, leasing them, and then finally selling them to these new found investors.  We felt this model would eliminate most of their risk and objections.  Questions like, “What would it rent for?” and “How much will the rehabilitation cost?” became commonplace in our initial pitches.  What we decided was that we really needed to mold two businesses–an acquisition business (to find the deals) and a management business (to process the houses and manage them on a go-forward).  Our office quickly became a “mission control” of spreadsheets and flow charts.
In 2008 we had only moderate success with pitching this business.  We had very little trouble getting people to agree that there was an opportunity, but a whole lot of trouble getting them to write a check.  We were able to identify some investors, but continuing changes in the lending environment made it harder and harder to close the deals and made it more difficult for one person to purchase multiple properties.  This resulted in a time intensive process of dealing with lenders during the close and constantly finding new investors.
Because we became very frustrated with how slowly the business was progressing, we decided if we could pool the investors versus dealing with them individually, this would allow us to really deal with one “client” and speed up the process.  Since we didn’t know how to put together a fund, we approached a local investment bank, Founder’s Investment Banking (FIB) (www.foundersib.com) in late 2008.  We thought FIB to be a good fit since they had a real estate practice that had previous experience putting together real estate focused funds.  At the time, they were disinterested, but we did plant the idea.  We continued to approach other similar groups, but with very little success.  So we continued to sell to both local and out of state investors, one house at a time.
In the spring of last year (2009), FIB came back to us and said they would be interested in putting together a fund.  The fund’s investment thesis was to purchase the homes, already renovated with a tenant already paying rent, and then to hold the properties in a portfolio renting them, and as the market recovered begin selling them to homeowners, preferably the tenants.  What they saw was that the current market was allowing for a unique opportunity, and they could purchase these homes at similar returns to what they could expect from an apartment community; however, apartment communities will always sell using the same criteria (cap rate, cash flow, etc.) that they used when purchasing it.  In comparison, single family homes can be sold to a homeowner who purchases for much different reasons and thus will pay a premium for that home.
FIB also saw this as an opportunity to enter the single family management business.  They asked if, that in addition to putting together the fund, they could invest as a partner in both the acquisition business and the management business.  This fund would give both businesses a tremendous amount of horsepower, so settling on a sales price was a challenge.  After a series of meetings, over about three months, we finally agreed on a sales price for a portion of our business.
January 1st of this year the deal was completed and the fund was closed.  The fund has purchased around 35 properties to date.  It takes us about 75 days from the time we acquire the property until the time we are able to sell it to the fund.  The fund has provided us exactly what we expected.  We’ve been able to produce product with speed.  Our margins are about 70% of what they were in the past, but we expect to do significantly more deals under this new model.
Our story is one of reinventing ourselves for the new economy.  Our biggest challenge these days is finding something that is sustainable long past the opportunities the current economy is presenting.  We never want to find ourselves in the same position we were in three years ago.  Our management company has grown from 20 houses in 2007 to almost 300 today.  We believe that the challenging market will be an opportunity for quite some time; maybe not as BIG of an opportunity as it is today, but we believe the U.S. will feel this pain for the next four to five years.  Additionally, single family management will benefit from the slow recovery and continue to grow over that same time period.
We’ve learned quite a few lessons over the last three years which will probably be, as we look back, the greatest return on our adventure reinventing Golden Key.
Our first lesson is that very few people really understand real estate investing.  This is very dangerous in a business where we talk about leverage being able to multiply an investor’s returns and the same holds true for his losses.  Becoming intimate with the actual data is a very healthy process.  What are the real expenses?  What are the real revenues?  How might they change?
Secondly, we’ve learned that investing for value over investing based on speculation is a whole lot less sexy, but it sure pays the bills.  In the past we purchased properties based on what we “thought” we could sell them for.  Today we purchase properties based on what we KNOW they will sell for.  Rental value is a much more accurate measure of intrinsic value than a sales price.
Lastly, it is hard to both manage and invest–so no matter how emotional the month is, you have to examine your business as both the operator AND the investor.  Make sure it makes sense for both.
We continue to grow and learn daily and I hope that our story will add some value to what you are doing.
Matthew Whitaker is Managing Member of Magnolia Partners, LLC and Golden Key, LLC (www.gkhouses.com) in Birmingham, Alabama.  He has been investing in single family houses since 2004.  He has acquired over 150 houses personally and has a team that has the collected wisdom of acquiring over 400 houses.

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