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Raising Private Money – Debt or Equity Partners

by Spencer Cullor on May 6, 2012 · 9 comments

  
how to raise private money

When you are ready to start raising private money for your real estate deals, there are two different types of private money partners you can look for: debt partners and equity partners.  Both can help you raise all the money you need to fund your real estate deals, but they work very differently.  In this article we’re going to take a look at both debt and equity partners.  We’ll explore how they are different and why you would use each to fund your real estate deals.

Debt Partners

Let’s start with debt partners.  Debt partners will lend you money for your deals in exchange for a specific interest rate.  Their investment is secured by a promissory note or mortgage on the property and property insurance.  The interest rate they charge is usually established up front and the money is lent for a specific period of time.

If you do not perform (pay the interest rate and return their principal) during the given time period they can take the property from you. They do not participate in cash flow or the equity if the property goes up in value.  They typically just want their money returned to them in an agreed-upon period of time plus interest.  They can initially charge a higher interest rate than equity partners, but they do not participate in the upside, so overall they can be much cheaper and you get to keep more of your deal.

Most of the time you use debt partners when it’s a deal that can be financed by one investor.  They are also commonly used when you believe you can raise the value of the property over a short period of time.  In that situation, you can take on a debt partner and once you add the value to the investment, refinance it and pay back the partner.  The deal needs to have enough income to cover the interest payments to the private money partner in order to take them on.  You also have to be sure that you can cover paying off the loan in the time period it comes due.

Remember, even expensive debt partners can be much cheaper to you over the long run because they don’t require equity.  That equity would allow them to participate in the gains of the property if it goes up in value.  It would also require you to give up a percentage of the ownership.  With debt partners you typically don’t have to let them participate in the gains of the property.  That is a big plus.

Equity Partners

Equity partners, on the other hand, will invest money into your property in exchange for an ownership percentage.  The ownership in the property allows them to participate in all aspects of property ownership.  They typically receive in accordance with their ownership percentage a return on their investment that includes cash flow, appreciate, loan paydown, and any depreciation.

The return is not set up front like a debt partner.  They receive what the property generates.  If it makes a ton of money their return will be higher.  If it loses money, they might have to put more money in to keep the property afloat.  They take a slightly bigger risk, but get to participate in all aspects of ownership, which can result in a much higher return over time.  Their investment is not secured by a mortgage or promissory note.  Instead, it is protected by the cash flow the property generates as well as the property insurance.

Equity partners are commonly used on longer-term investment opportunities and on those that can’t support a higher interest rate that debt partners require up front.  They are also commonly used on projects that require several private money partners that pool their money together instead of just one.  Equity partners are also commonly used when the private money lender wants to participate in the upside of the investment.

Both equity and debt private money partners can help you grow your business.  The key is knowing how each one can be deployed most effectively in each investment situation and choosing the right type of partner for your deal.

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{ 9 comments… read them below or add one }

Brad August 30, 2012 at 7:44 pm

Thanks for the great primer on debt vs. equity partners. This is just what I was looking for and will help me guide my strategy research.

Brad

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Spencer Cullor August 31, 2012 at 6:55 am

You’re welcome Brad. Glad I could help. If I can be of any further assistance, just let me know. Best of luck!

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Geoff September 18, 2012 at 8:16 pm

I agree, very informative

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Dennis Myhre October 2, 2013 at 4:20 pm

Under an equity partnership involving a 401k investment where the investment is commercial real estate and the 401k investor is a shareholder in the net asset value of the commercial real estate property, how is the net asset value determined to know the shareholder value?

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Spencer October 3, 2013 at 9:47 am

Good question. Each investment is different and how they determine the value at any given time should be spelled out in the operating agreement for the investment. Most of the time it’s done either by taking the trailing 12 month’s financials by a given CAP rate or by getting an independent third party appraisal. This is something you should definitely discuss with the sponsor of the investment before investing so you are clear how it will be handled. If you have any other questions, just let me know. I’m happy to help. Spencer

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Dennis Myhre May 8, 2014 at 12:04 pm

Thanks for you response… I have another question regarding debt partnerships and 401k investors. This example involves an owner of 16 acres of vacant land in Henderson, Nevada who is also the sole member and manager of a private LLC (aka seller). The buyer is also a private LLC whose
manager is an insurance company that invests in commercial real estate through a 401k separate account.

In 2007, the original owner entered into a Purchase and Sale Agreement with the buyer, in which he, the owner, assigned his interest in the agreement to the seller. The basis for the agreement was for the buyer to purchase the seller, whose sole asset would be real property in Henderson. The seller would develop the property to the benefit of the buyer, and would convey 100% of it’s ownership interest to the buyer for the purchase price. A lender for the real property, the insurance company on behalf of its 401k account. and the seller (aka borrower), then entered into a Loan Purchase Agreement (aka LPA) in which the lender agreed to make an acquisition loan to the “seller” for $13.1 million to acquire the real property from the original owner. The LPA required the 401k account to guarantee the loan. The LPA was also secured by a deed of trust on the real property.

In 2008, the borrower failed to make a payment pursuant to the LPA at maturity, and the 401k account was required to purchase the loan. In 2009, the buyer, as successor by assignment to the 401k account, foreclosed on the real property, thus obtaining title to the real property.

In the 2008 Annual Report, the 401k account reported the $13.1 million acquisition as a mortgage loan acquisition, and in 2009 it’s Annual Report listed the property’s gross asset value at less than $3.5 million. The original owner apparently kept the loan proceeds, and since the commercial properties are considered “non-plan” assets (the 401k account owns shares only in the net asset value), the “buyer” owns the land. The “seller”
had no net asset value to begin with, so it has no loss. It appears that 145,000 401kinvestors were the losers.

My observation is that more 401k real estate investment accounts are building new commercial properties rather than investing in existing real estate. Is the above example the typical modality used by service providers to invest in real estate on behalf of their clients?

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GERALD ASKEW December 3, 2013 at 12:41 pm

WE ARE IN THE PROCESS OF PURCHASEING A PUBLIC-SHELL TO CREATE A R.E.I.T BY DOING A REVER-MERGER AN THEN A PRIVITE-PLACEMENT HAVE YOU EVER SEEN THIS DONE ? WITH THE PPM,WE WILL BE SEEKING (PIPE-INVESTORS )TO PURCHASE PORTFOLIOS OF DISTRESS ( MULTYFAM&ASISSTEDLIVING FACILITYS )

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Spencer December 4, 2013 at 9:02 am

Gerald, I’ve seen a ton of different ways to structure these. I would highly recommend you speak with an attorney that deals with the SEC (security exchange commission) that can guide you and give you recommendations. Each situation is very different and you’ll want someone who really understands what you are trying to accomplish and can guide you through the complex legal work. Let me know if you need recommendations. Best of luck. Spencer

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boris r December 9, 2013 at 9:54 pm

I’ve been reading about real estate for awhule. The one consant that is missed is where to find investors for a project you are working on. Where can I find these equity partners?

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