First, why is this so important? What’s the big deal?

Well, I see way too many real estate investors who either want to give up too much of their deal and kill their own profits. Listen, if you find a deal, put it together manage it and see it through to a profitable result – YOU DESERVE TO GET PAID! You don’t have to give it all to the money person (even if it’s your first deal).

Remember that you’re in business for one reason and one reason only: to make money. No “if’s” “and’s” or “but’s”.

Now the other side of the coin is not giving up enough of the deal. Being too greedy. This can happen a lot too, and often does with inexperienced investors. You can’t keep everything for yourself, because you’re not shouldering all the risk. There has to be a balance somewhere…

This question is easily answered when it comes to private money loans: the piece of the deal you give up is just the interest paid to the lender based on the agreed upon rate.  For instance:

Private Money Loan: $150,000

Interest Rate: 10%

Term: 12 months

Amount Paid to Private Lender: $15,000

That one is pretty easy. However, if you’ve read any of my other stuff, you know that I’m not very big on private “lenders” – I’d much rather you had equity investors in your business. But that’s where part of the rub is – how much of the deal do you give up to your equity investors?

Let’s take a look-see:

Private Money Invested: $150,000

Projected Deal Profits (Best Case): $40,000

Projected Deal Profits (Worst Case): $20,000

Time Frame: 6 months

Let’s say we elect to start at a 50/50 split. This gives the investor a max $20k profit or a min 10k profit on $150k in 6 months. This brings them a pre-tax annualized return of 26.6% and 13.3%, respectively. Not too bad. This looks reasonable. The investor brings the money and you bring the deal and manage the project.

But what if the investor wants more?

Back to the math: what’s the minimum amount you’d be willing to do the deal for? Say it’s $10,000. In this instance, you’d look at your best and worst case profit scenarios, bake in your needed profit and work back to the investor’s number from there.  Going back to our example, you might want to give the investor maximum of 60% of the deal, figuring that you’ll end up somewhere between your best case and worst case profit scenario. Still protecting your profits while making the investor happy – that’s the name of the game.

I’m a huge advocate for real estate investors setting minimum profit numbers for themselves on deals. You just should not do deals unless you’re going to make money. I hear a lot of whining on this subject that usually goes like this: “but I need to prove myself to the investor first” or “I need to get a deal under my belt first.”

Ok, great. Just find a deal where the investors and YOU can both make a nice profit. Never – and I mean never – work for free.

Bad precedent to set and bad business in general. Always lock in your profits.

Great question.

If you’re thinking about this, you’ve already got half the battle won – you’ve decided to raise private money. You have picked the right financing option for building a successful and extremely profitable business. Like the old knight said at the end Indiana Jones and Last Crusade: “you have chosen wisely.”

To answer our question, consider my three elements of raising private money: You, Investor, Deal

For illustrative purposes, assume we have the “You” and the “Investor”  taken care of – meaning your business plan, offering documents, marketing and other components are in place and you have an investor that is ready, willing and able to place funds with you. Now, you have to make sure that You matches Investor matches Deal.

The Deal component is what you have to focus on – how you are structuring the deal?

Consider:

• How much funding do I need?
• What will the project/projects look like from a cash flow standpoint?
• What is my exit strategy for project or company?
• What returns am I willing to pay vs. what do my investors want?

One important thing to think about when raising private money for real estate investments is your total cost of capital – that is, what does it cost you to use the private investors money?

For instance, many real estate investors will give up their shirt to get money for a deal, even if it means them not making much profit. You don’t need to do this if you raise money the right way. You should always set up your deals so that you make a substantial profit. Otherwise what’s the point?

Now, don’t get me wrong – there’s being smart and then there’s being greedy. Be smart, not greedy. But don’t give up more of your deals than you have to. Otherwise, you may quickly find that your private investors will become like the bears at Jellystone Park: take the picnic basket away and they get awfully mad.

Once you determine your cost of capital, you can see if you have a match: deal matches investor matches you.

For example, let’s say you are going to buy an apartment building for a long term hold and raise capital to fund the initial equity and capital requirement coupled with a commercial loan – perhaps 25/75 (your investors contribute 25% of the purchase price and up front reserves and you get commercial financing for the remaining 75%, the stake you carve out for yourself must make sense in the big picture, but should be enough to make you quite happy). If you have investors that want a quick exit, say in 2 years or less, then it’s probably not a good idea to put their money on this deal. You’ll just have to move it out in less than 24 months. But, if you had some investors that wanted to park money for a period of 5 years or longer, then you’re in business. This gives you enough time to re-position the project and or do a refinancing and cash the initial investors out safely with good returns while protecting your investment.

Similarly, if you want to flip a property but your investor wants to keep their funds in play for a long time, you’ll have to find a home for their money when the property sells. This is one of the scenarios where raising equity capital makes so much sense. It allows you to keep the money in play for flipping as opposed to private mortgages. If you raise $100,000 to flip a house and sell it in two months and pay the investor 10% annualized on their money, and then it sits idle for 60 days while you find another project, the investor isn’t really getting the whole 10% per year, it’s actually much less (closer to 5% with 60 days on/60 days off example).

When it comes to flipping or buying and holding with private money – the answer is you should use private money for BOTH. You just have to structure the deal so that it matches with the investor and you. Once these three components are in place, growth and profits are unlimited.

First of all, the structure of the deal depends on a few factors, such as:

• Type of investment property (house, apartment, mini-storage, mixed use) – the reason this is important is because each deal has different financial performance characteristics
• Time frame of investment – how long will the deal take from funding to completion? is it a quick flip or a long term hold?
• Private investor objectives – what does the private investor want? are they looking for steady returns or will they defer for bigger upside?
  
• Tax impact of deal – what is the tax impact to you and your private investors? do accelerated depreciation, 1031′s or other factors come into the picture with the property?
  

Now that we know some of the drivers of real estate investment deal structure, let’s look at some of the ways you can structure the private money investment:

1. Limited Liability Company (LLC) – you could bring your private investor in as a member of the LLC or as a private lender to the LLC. Members have ownership interest and lenders are creditors (just like a mortgage company).  Investors that are LLC members share in the profits and cash flows. LLC’s work well for many real estate investment projects, from houses to apartment buildings. You can set up different classes of members in your LLC, with some getting preferential distributions of cash or proceeds from asset sales.
   
2. Limited Partnership (LP) - You could bring your private investors in as unit owners in a limited partnership. LLC’s have replaced LPs in many cases, but there are still some instances where LPs make more sense (when liability issues with the general partner come into play). Many people have heard of LPs before and there are also publicly traded limited partnerships as well, so there is a general investor awareness. Since they have been used for longer than LLC’s, LPs can have more traction with attorney’s and CPA’s who are working on the deal with you.
   
3. C-corporation – the big c-corp – you would bring your investors in as shareholders (or lenders to the company). You can have different classes of shareholders (common stock, preferred stock, class A or class B preferred stock). Private investors would receive their returns in the form of dividends from distributed profits or when they sell their shares for a bigger amount than their cost basis. Double taxation is an issue with C-corps, as earnings are taxed at the company level before distribution to shareholders, who then must pay taxes on dividends received. Dividends are generally taxed at lower rates than other forms of income.
   
4. S-corporation- set up the same as an C-corp in form, but no double taxation. You can only have one class of stock and you are limited in the number of shareholders you may have at 100.
   

When you match up the deal factors with the investment legal entity structure, you can stack the deck to getting private money more in your favor. If your deal structure is out of alignment – for instance using a C-corp to flip a property in 6 months (you’d be subject to double taxation and you’d have to buy back or facilitate the sale of the investor’s stock to return their capital) – you can expect to have a tougher time putting the capital together.

Carefully study deal structures and work with qualified professionals (attorney, CPA, securities lawyer) to set everything up the right way. Good professionals do come with some billable hours, but they are worth their weight in gold when they protect you and your investors and make the deal easier to complete.

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This website is for informational and educational purposes only The contents of this post and of this website do not constitute legal or tax advice. Before conducting any transaction, please consult proper legal and tax counsel.