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, you shouldn’t think in terms of either/or. You can successfully flip and hold properties with private money. How you structure the deal, though, will determine the extent of your profitability with each.When it comes to flipping, turning properties over quickly can generate healthy profits for you, but you must be careful to pay your private investors an appropriate rate. Set it up so that you pay them an ‘annualized’ return on their money. Here’s an example:

Private Money Investment: $100,000

Annual Interest Rate: 10%

Deal Profits: $25,000

Money Invested for: 45 days

Cost of Funds: $1,250

*The cost of funds should not be total points on the amount borrowed – is should be prorated annually.

In the above example, you are borrowing private money to buy and sell the property, you are making a net profit of $23,750 after you pay your investor $1,250. While this may seem disproportionate in your favor, the investor still got a great return on their money. You must protect your profits. Too many real estate investors would be willing to give up more than necessary on this type of deal – you don’t have to if you know how to set things up with the investor at the outset.

You can impair profits if you finance a long term hold with a private investor who has a 3-5 year time frame. If you plan on holding it for the rest of your life (and your kids’ lives) then it isn’t far fetched to consider buying your equity investor out with your share of the cash flows (it nets out to be the same cash on cash return for you) or setting up the note to be amortized, where you pay off part principal and interest each month.

However, private money equity partners are better than lenders for buy & hold properties. The investor comes into the project as a profit sharing partner with you and, thus, you both have the same time frame for investment going in. Many private investors would welcome a buy and hold investment, as it reduces their worry about how to turn the funds over when the investment redeems.

Private Money Re-finance

Another option to use on buy and hold with an investor that has a shorter time frame than project length is to replace their funds with those of another private investor. It can be much easier to bring a new private investor into your business on an already performing project than an altogether new investment. Keep this in mind to bring in new funds continually. You can set up the deal so that down the road, one investor can sell their interest in the project to another private investor or they can sell the note.  Take care to structure your promissory notes so that they can be sold from one investor to another or set it up so that one investor pays off the note and another investor re-loans you the money. Think of it as refinancing one private investor with another, just like a bank would do.

The best thing about working with private money is the financing flexibility you achieve with it. As long as the returns on there for you and the investor, everybody wins.