It’s ugly out there.
Properties aren’t moving; sales volume has plummeted. Foreclosures are up 48 percent from a year ago. Prices are down as much as 20 percent to 30 percent in markets ranging from Miami to Los Angeles.
So, of course, it’s becoming a remarkable buyer’s market.
But you need money to buy. If not yours, someone else’s. And therein lies the rub. Properties are getting cheaper, but financing is getting harder to find.
So today, we’ll look at the different types of investors you can pursue. And we’ll look at how to structure your offers so investors understand that (1) your interests are completely aligned with theirs, and (2) you’re offering them a good deal.
Are You Looking for Debt or Equity Investors… or Both?
Let’s say you’re looking at an apartment building selling for $800,000. It needs $150,000 in repairs. You’ll have $20,000 in closing costs and you want $30,000 in a dedicated bank account as reserves. Once you’ve rehabbed and leased up, the building will generate a net operating income of $120,000 a year.
So your total capital requirement is $1 million. And you have three people to whom you can go to get that money: Louie the Lender, Ed the Equity Investor, and Hal the Hybrid Investor.
Let’s go to Lou first. Keeping in mind that he is a debt investor, not an equity investor, here’s a simplified version of the kind of proposal that might appeal to him:
“Hey, Lou. I have a property under contract that will be worth $1.33 million once I rehab it and lease up. That’s what comparable properties in the neighborhood are selling for. I’d like you to lend me $1 million (75 percent of the after-repair value). In exchange, I will…
- Pay you a 9 percent interest rate
- Give you a first mortgage against the property
- Sign a personal recourse note (giving you recourse to all my personal assets if I should default)
- Make you the beneficiary on the title insurance
- Make you the beneficiary on the property insurance.”
With a deal like this, even if the property doesn’t end up being profitable, you are making a commitment to pay Lou his interest and return his principal. And you are backing it up with your own assets.
Now my view on personal recourse contradicts what most real estate “gurus” teach. On the one hand, I agree that when dealing with institutions, if they don’t require a personal guarantee (and they often don’t for commercial deals), you should do a non-recourse loan. Hopefully, the institution is doing its homework and only lending up to the point where there is enough equity in the property to protect them. All the better for you.
However, when dealing with individuals, if you believe a deal merits their personal savings – then, at the very least, it merits your personal assets as collateral. What’s more, by willing to back up your promissory note and mortgage with your personal assets, you can get a better interest rate than if you only offer a non-recourse note.
Okay, let’s shift gears and see how you might approach Ed the Equity Investor…
“Ed! Have I got a deal for you! Pony up $360k and you get 50 percent of an undervalued, cash-flowing apartment building in an up-and-coming neighborhood.”
You explain to Ed that the $360,000 is to cover the $160,000 down payment, $150,000 in repairs, $20,000 in closing costs, and $30,000 in reserves. He puts up the money. Once you’re done with renovations and leasing up, the property’s value has increased by $330,000 over your total investment. So Ed gains 50 percent of that increase, or $165,000. That’s a 46 percent return on his $360,000 investment in short order.
But wait, there’s the proverbial “more!”
Ed also will get 50 percent of the distributed cash flow on the property. As I said, the net operating income on this building is $10,000 a month. If you borrow $640,000 at 7 percent over 25 years, your monthly payment will be approximately $4,525 a month. That leaves $5,475 in free cash flow. Let $1,000 per month accumulate as added reserves, and you have $4,475 per month to distribute.
Ed’s half of that distribution is about $2,238 a month or $26,851 a year. Against his $360,000 investment, that works out to a dividend yield of 7.5 percent. And that’s on top of the 46 percent equity gain he made in the first year. Ed is doing great, especially on – what is for him – a totally passive investment!
You’ll find that debt investors (like Lou) are generally people who want safety first and would like income now – such as retirees and people late in their career who are in wealth-preservation mode, rather than wealth-accumulation mode.
Equity investors (like Ed), on the other hand, often don’t care about current yield. They have a good income from their job, so they don’t need passive income right now. Instead, they’re more interested in the maximum leveraged returns they can get on a property – without having to do any of the work or management themselves.
But there is a third class of investor that likes to choose from both menus. They want a higher total return if the risk can be mitigated or eliminated. I call these investors “hybrids,” since they’ll be receptive to offerings that include the safety features of a bond and the leveraged, higher potential return of an equity stake.
So what kind of offer can you construct for them? One that has guaranteed yield and a piece of capital gain… and maybe even some of the net cash flow. For example, here’s the proposal you might make to Hybrid Hal…
“Hal, baby! I got the best of all investment worlds for you.”
You describe the property and explain why it will take $1 million to do the deal. But instead of offering Hal a 9 percent guaranteed yield or 50 percent equity, you offer him some of both. You might, for example, offer a 7 percent guaranteed yield plus 20 percent of the capital gain and 20 percent of the net cash flow after the payment of the note.
This is a great deal for Hal. He has the security of a bond. (You’ll collateralize it and structure it as such.) Yet he could end up making 12 percent to 15 percent a year with this kind of lower-risk investment. And it’s a great deal for you, since you end up with 80 percent of the capital gain and net cash flow.
(Of course, you wouldn’t really use language like “Hey, Lou!”… “Have I got a deal for you!”… or “Hal, baby!” in your proposals. That was strictly color.)
Structuring the Right Deal for Potential Investors
The key to making all three of these approaches work is to:
1. Recognize what most interests your potential investors: low-risk, collateralized income now… leveraged capital gains… or a combination of both.
2. Structure the offer in a way that gives your investors 100 percent confidence in it. That means you align your interests with theirs. When in doubt, you give them the benefit of that doubt. In other words, your first priority is the return of your investors’ capital. Then – and only then – do you start splitting profits.
Here’s what that means for every equity deal you put together…
- The only way you can make money as the general manager is if your investors make money. Period. No exceptions.
- You invest your personal money in all of your deals. It doesn’t matter if it amounts to only a minor stake of total equity capital. The point is, you have money to lose and you don’t get your money back until your investors get 100 percent of their money back. So you have no reason to enter the deal unless you believe it will be profitable.
- You get the bank financing. The investors are never on loan docs and never have any liability at all for the mortgage loan.
- You do NOT charge fees. This, again, is controversial. Some gurus advise you to charge fees on equity deals. But – especially when you’re starting out – it’s important to make it clear to your investors that the only way you can make money is if they make money. Later, if you go into real estate investing full-time, you can charge fees to keep the office running. But even then, make sure your fees are fully disclosed and not a “surprise” or buried in fine print.
- Provide regular reporting to your investors, at least quarterly. The report should be a brief description of the market and the property – not to exceed one page for each – followed by financial statements, including income statement, balance sheet, and general ledger.
I’ve relied on these same basic principles time and again to fund my deals and make my investors healthy returns. As a result, investors become repeat investors, and they recommend me to friends and associates. And as a result of that, I always have more money available to me than I can put to work… so whenever an excellent deal arises, I’m prepared to act.[Ed. Note: Now you know how to go after funding for your real estate investments. But if properties in your area are still over-inflated, you may need some guidance to find the investments themselves. Real estate expert Justin Ford knows how to locate the best real estate values in the country. Find out where you can make your real estate riches right here.]