Raising Private Money – Debt or Equity Partners
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.
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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, 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.