The subject of private money is a broad one and one that is vitally important to the success of any real estate investor. I’ve raised millions in private money from private lenders over the years and I’ve structured the deals in many different ways.
A question that I get asked a LOT from students is “how much should I offer the private lenders in my deal?” The answer to this is more complicated than it appears so let’s take some time and break it down.
First, when you are raising private money you are generally seeking private lenders. However, not all private lenders are created equal.
There are two types of private lenders that you should target when raising private money for your deals: 1) debt investors and 2) equity investors. Notice I use the word “investors.” Your private lenders are investors in your deals so this word can be used interchangeably with lender and in fact, investor is my preferred vernacular.
Debt investors are people that invest money in your deal for a fixed rate of return. They make an actual loan on the underlying property and you agree to pay them a certain interest rate and make monthly payments over a certain amount of time until the loan is paid in full. Debt investors do not get equity in the deal or “participate” in additional profits.
Debt investors are the least expensive investor but they take a long time to find. I typically pay my debt investors 6-8% interest only and most prefer to be in first lien position on the property so I usually only use debt investors if I can raise 100% of the funds needed to close the deal.
If I bring in new, institutional financing then my debt investor will be in second lien position and, if I can find one willing to do it, I’ll have to pay a higher interest rate on the loan. The going rate on second position debt is 9-12%.
Equity investors are people that invest money in your deal for a percentage of the profits. They “participate” in your deal and as a result most of these arrangements are referred to as participation deals. Typically these are the investors that get a percentage of the monthly cash flow plus a percentage of the equity.
Equity investors are the most expensive investors you can have in your deal but they take the least amount of time to find. Everybody wants a bigger piece of the pie. 🙂
Most new real estate investors think that if an equity investor puts up 25% of the deal then s/he is entitled to 25% of the profit (cash flow + equity). This isn’t necessarily the case. You can structure your equity investor’s participation any way you want BUT I will tell you something that a smart mentor told me one: “Susan, you can’t be broke and greedy.”
I personally like to have long term relationships with my private lenders. I want them to invest in my deals over and over again. So, I give up more of the profits initially to prove to them that doing business with me is a good thing.
In their eyes, the first deal is always going to be the riskiest so I want to reward them for that risk whether it’s real or just perceived. As they get more comfortable with me, they get more comfortable with spreading the wealth.
And, just to further complicate the issue it’s OK to combine debt and equity investors in the same deal!
Here are a few of my personal “rules of thumb” regarding private lenders:
1. If I’m only raising enough funds for downpayment and closing costs, seek out equity investors.
2. If I’m raising 100% of the funds needed to acquire a deal, seek out debt investors.
3. No verbal agreements! Make sure everything is documented in the operating agreement including the exit strategy and who gets what when we exit the deal.
4. Everything is negotiable BUT strive to make it a win for everyone involved.
Now, go out and get some debt and equity investors!