I appreciate all of your comments and questions to previous articles because it gives me fodder for articles that you’ll hopefully find helpful.
One of the questions last week was about how to structure deals with private investors.
This is a complex topic, and one that I can address a little bit over time. This week, I’d like to focus first on what investors are looking for in an investment. By this, I mean what kind of returns are they looking for. Once we understand that, we can talk about how we can structure our investments to try to satisfy our investors’ requirements (we’ll leave that for a later article!)
For this discussion, I’m going to assume you’re looking for investors for a larger buy and hold deal like an apartment building or other commercial project.
What Do Investors Look for in a Commercial Real Estate Investment?
The first thing you need to address is the risk level of the investment. Investors first and foremast care about not losing their money. Brandon talked about this in some detail in his article “The One Simple Thing Required to Raise Unlimited Money From Private Investors“.
Once they’re comfortable with the perceived level of risk of the deal itself and you as the principal, you can address some of the other aspects of the deal, which are the (1) projected returns and (2) how to structure the deal.
In this article, I’ll focus on (1) the projected returns, and next week we’ll talk about (2) different ways to structure the deal.
Here are the three questions investors will have for you about the deal:
- When will I get my money back?
- What will the overall return be?
- How much will I get paid throughout the year?
Let’s talk about each in turn.
When Will the Investor Get His Money Back?
Investors want to know how long you plan on keeping their money, or when they will receive their principal back. They will want to know what precisely your plan is for returning their principal. The answer to this question normally involves a liquidation event, either an outright sale of the asset or a cash out re-finance.
I insist on a minimum 5 year commitment before entertaining a repayment of the principal, longer is even better. Unless you’re doing a gut-rehab or re-position project where you’re adding significant value in a short period of time, 5 years is a reasonable amount of time to build good value for all involved.
If an investor insists on a shorter time frame, you need to move on. Keep in touch with the investor when you find a more suitable project.
What is the Overall Return?
Investors want to know what their return will be over the life of the investment. The overall return is a combination of cash flow distributions, paying down the loan, and appreciation of the property as realized by a sale or cash-out refinance. You add all three “profit centers” together, and you can project the overall return.
You can take the overall return over, say, 5 years, and divide by 5 to get the average annual return.
I always consider this the most useful and easily understood way to articulate overall return. You can calculate the Internal Rate or Return (IRR) which is the more “sophisticated” way to calculate the return of any investment over time, and your more “sophisticated” investors may actually use this as a criteria.
However, I’ve found that my investors (who range from completely non-sophisticated to fairly sophisticated) respond better to the average annual return – it’s just easier to understand.
What Kind of Return are Investors Looking For?
This depends on the current market environment, i.e. what are CD rates and the stock market doing. With a somewhat flat and uncertain stock market and negligible interest rates, I have found that investors are very interested in overall rates of return of 8% – 15%.
I used to think I needed to show returns of 20% plus, but those kind of deals were extremely hard to find. Not only that, my investors actually got suspicious at the very high return. “Wow, that’s a pretty big return, so, it’s a pretty risky investment, huh?”.
For both of those reasons, look for overall returns of around 12%.
How Much Will the Investors Get Paid During the Year?
While most investors care about the overall return, they also enjoy being paid during the investment, which I will refer to as “distributions”. The return from distributions is usually measured in terms of the “cash-on-cash return”, which is the percentage of distributions per year divided by the capital invested.
I have found that investors are typically happy with a 3%-8% cash on cash return.
Let’s say you take $100,000 from two investors to buy an apartment building. If you projected a 5% cash on cash return, you are saying that you plan to distribute $5,000 per year out of cash flow to your investors.
That number is after all expenses are paid out (including debt service) and must also take into consideration any distributions to you.
Preferred Rates of Return
Sometimes you can offer to investors a “preferred rate of return”, which means you agree to pay out a certain minimum before you get paid anything. Investors of course prefer this, but it is not as good for you.
For our previous example, if you agree to a 5% preferred rate of return, it would mean you pay out the first $5,000 to the investors. Anything that is left over is split according to how much equity each investor has.
Normally, the higher the preferred rate of return for the investors, the less equity I give them.
One option is no preferred rate of return, but the investors get 80% of the building. Option two is that the investors get a 5% preferred return but only get 30% equity.
I generally don’t want to give a preferred return but investors prefer it. You need to test these options with your investors to see what you need to do to get the deal done.
Be Conservative in Your Projections!
I can’t emphasize this point enough. It is far better to under-promise and over-deliver than have to explain to your investors why you missed your (originally aggressive) projections.
After you address your investor’s fear factor (i.e. making them comfortable with the risk of the investment), then you need to confidently address their “greed factor”, i.e. how much money they can make. Show your investors a solid real estate deal with reasonable returns and a conservative business plan, and you will attract capital to do as many deals you want.
Thanks for reading! Let me hear your thoughts below!