When a private money partner asks you how much capital you need for an investment opportunity never, and I mean never, say, “I don’t know, how much do you want to invest?”
That’s a recipe for disaster.
You don’t want your prospect to feel like they have some control of your transaction, because they really don’t.
Your private money program is yours.
You need to know your specific investment criteria.
You should also know exactly how much you can afford to pay partners for your investment deals.
You can structure your deals any way you want, but be very specific about what you’re investing in.
Instead of just saying, “I invest in apartment buildings,” be as specific as:
“I invest in 20 – 50 unit apartment buildings, Class C, in the County of Denver, Colorado, between $30,000 and $40,000 per door.”
That is what you invest in and what you are offering them a stake in.
When you tell your investor “I invest in 20 – 50 unit apartment buildings, Class C, in the County of Denver, Colorado, between $30,000 and $40,000 per door,” and they agree to fund it, but instead you get an office building – that’s not good.
Your deals have to match your specific criteria and what you are disclosing to your potential private money partner.
Because, they want to make money on the apartment building.
They are getting involved because of you.
You are what they are investing in.
Be authentic. True to your word. Transparent.
Now we can ask the question…
How Much Should You Pay Your Investors?
This is the answer to the million-dollar question, and what any investor is going to want to know before they sign the dotted line.
Here is what I advise you:
Pay them what the DEAL can afford.
What the deal can afford is based on different variables:
- How much are you raising?
- What is the cash flow of the property?
- What is the equity of the property?
- What are the property costs?
- What is the debt coverage ratio?
- What are your rental income and expenses?
You can find many of these answers by doing some simple math.
If math was not your strong suit, no problem, just ask yourself these questions…
What Will My Annual Cash Flow Be?
For starters, look at your gross annual income and subtract the annual operating expenses, the annual loan payments, and the annual income taxes.
Use the calculator, I won’t tell anyone.
Your annual cash flow is different from your net operating income, or NOI, because it takes the debt service into account. (Debt service is just a fancy way of saying mortgage payment.)
What Will My Rental Income and Expenses Be?
Get a copy of the rent roll and copies of all current leases from the seller (This is just a list of all the tenants, their unit numbers, how much rent they pay each month, and the terms of their leases).
When you look at the rent roll and the leases and how they relate to the number of units in the property, you’re going to come up with what’s known as a vacancy rate.
Vacancy rate means how many units are vacant, and is expressed in a percentage.
A 4% vacancy rate means that 4 units are vacant if you have a 100 unit property ie 4/100 = 4%.
The vacancy rate can be the actual rate, or it can be pro forma, which means what you think the rate will normally be even if right now it’s 100 percent occupied (0% vacancy).
What Will My Property Costs Be?
You’re going to need to know the cost of the property, the property type, the fair market value for that property, and the appreciation rate.
You’re like, “What?! I don’t know that…”
Ask your Realtor – It’s that easy!
The appreciation rate for commercial properties (commercial means five units or more) is solely based on an increase in cash flow because commercial properties aren’t affected that much by what’s happening in the market around them.
Their value is determined almost exclusively by their own cash flow.
Don’t forget to factor in the selling expenses!
Factor in The Interest Rate!
For financing, you’re going to need to figure out what kind of rate this deal supports.
- Can it support only 4% or could you go as high as 7%?
- Can you factor in some points or afford to pay more to the lender?
- What fees, if any, can you afford to pay from this deal?
To put this in perspective, your calculations can change depending on whether you’re going to use an existing private lender (usually a hard money lender) someone from your Friends/Family/Acquaintance bucket.
Private lenders have been around the block, so you’re going to have to pay points, fees, and likely a higher-than-normal interest rate.
Now, factor in…
To figure out how much to pay your investors you need to know the timeframe – a short-term investment or long-term investment – and the payment schedule.
You can make the rate anything – 2%, 6%, 10% – just be sure you’re not charging too much or paying too much. Basically, you need to determine how long you need the money.
- Is this project a rehab that you can flip and be out of in six months?
- Maybe you build in a buffer and call it eight months.
- Maybe you build in a big buffer and call it twelve months – If it pays off early, there’s no prepayment penalty.
For the payment schedule, determine how often you’re going to be paying your investors.
You can pay them monthly, quarterly, or annually, or you can make deferred payments until the deal flips.
Or, you can offer a dividend reinvestment opportunity; here your investors don’t get a payout at all, they elect instead to have their dividends reinvested right back into the fund. (You can structure your deal in many different ways – get creative)!
“But, Susan, how do you know the deal is going to deliver so I can actually pay my investor?”
Let me tell you.
I normally do some initial figuring that I call “screeners” to help me decide if the deal warrants a closer look.
First, I like to calculate the net operating income, the debt coverage ratio, and the cap rate.
Get ready to nerd out with me…
- The net operating income is the gross income minus vacancies and expenses.
- The debt coverage ratio is the net operating income divided by the annual debt payments or mortgage payments.
What lenders usually like to look for in terms of a debt coverage ratio is 1.2 or 1.3.
All that means is once you pay all the mortgage payments for the year, your operating income remains 20% (1.2) to 30% (1.3) above even.
The cap rate is the net operating income divided by the fair market value or, expressed another way, the NOI divided by the cap rate.
You can usually get cap rates online by market or from a Realtor. They are normally calculated for multiple-unit properties, not for single-family dwellings.
I know, I know, that was too much nerd.
Cash-on-cash return is just the cash flow of your investment divided by the amount you’ve invested. If you wanted to calculate the annual cash dividend that a property is throwing off to a potential investor.
Here’s how that would look:
Let’s say the net cash flow (or the return on debt service plus fees) is $25,000 and your private money partner is willing to invest $125,000. Divide $25,000 by $125,000 and you get 0.2. Multiply by 100 to get the percentage.
In this case, your cash-on-cash return is 20%.
That’s a quick and dirty way to see a basic return on your deal.
But, if you want to take other factors into account, such as the loan payment or property appreciation, calculate the internal rate of return (or yield).
Let’s say you have a $300,000 note for a 12-month term, with an interest rate of 10%, and your lender is charging 2 points.
Then it’s $300,000 divided by 10% to get the annual mortgage payment of $30,000. Two points equal $6,000. So $36,000 divided by $300,000 is a yield of 12% to your investor. The interest in this example is simple interest.
If you wanted to amortize your debt payments to your investors, you can get a simple amortization schedule online or pick up a mortgage calculator that will calculate it for you. The internal rate of return is a calculation I use to make the point to my short-term lenders that they need to go long term because they can make long-term rates with half the headaches.
If You’re Still Like, WHAT??
Next week we’ll look at some examples of private money program options you can build on to create your own, unique, customized program for your business.
Remember, this whole business; the deals, partners, money, all of it, is mainly about you.
You are the business, your word and your commitment to your why is what will make or break the show. The math is just a rich butter cream frosting to coat the cake of you.
If you need some help believing in the bottom line, you need more of my voice in your ear. Much more. So, check out my private and group coaching opportunities because sometimes it takes more than a great blog to nail a big hairy idea home in your heart.
Together we can…
Have fun. Create value.