How much equity to offer investor?

21 Replies

I’m in contract on a small deal for 500k. A long time friend of mine expressed interest in being a cash partner, simply looking for a better return than his savings account. This would be through monthly cash flow or the cash return upon exit or refi.

For simplicity sake, if I’m putting down 100k and he offers 50k of that we’re both 50% equity invested at this point. But the loan is in my name and I will be performing all duties, he’s 100% passive.

I know the 50% cash to cash investment shouldn’t be equal to 50% equity. The question is, what should it be equal to? Should it be 10% as it’s 10% of purchase price? It would actually be less I guess because we need about 30k in repairs. Also will need some operating capital to turnover the apartments as we reposition.

I’ve been searching syndication blogs but they don’t seem to address this, or at least I haven’t found one that could give me input on this scale.

Any ideas how to incorporate him into this deal would be greatly appreciated.

@Brian Orr - The simplest way to do this is for your friend to loan you the 50K.  This way he receives a fixed monthly income higher than his savings account and you receive the benefits of your work. You could do it in an equity structure, but that means you have to quantify the value of your contributiuons, i.e. finding the deal and managing the property. This is how larger syndications do it while the GP's also contribute equity. They get paid an acquisition fee, a management fee, a disposition fee upon exit, and receive a share of the cash flow (in addition to that proportional to their equity. Although this is possible, it seems overly complicated for a $500K property.  

@Brian Orr I would offer a simple preferred return and no equity. Investor puts up $50k for 5-8% simple interest preferred return for the length of time you two decide. Thats the easiest cleanest way to do it. You can use this structure on small deals like yours all the way up to the big deals. 

@Brian Orr , how you structure this depends on how you wish to address risk.  You have received two suggestions above and both of those could work.  I'll address those two and propose another.

@Ed Matson  suggests to not give any equity, and just borrow the money from your friend and give him a fixed return.  The upside here is that you keep all the upside.  Many beginning investors choose this option...I know I did when I was starting out.  I also learned that this option can really hurt if things don't go according to plan.  The downside is if the property under-performs, and there isn't enough cash flow to service the interest payment to your friend, you could be writing your friend checks out of your own personal account.  Or, if the cash flow is only enough to service the loan, you friend would be getting all of the excess cash flow and you'd be getting nothing.

@Greg Dickerson  suggests you offer your friend a simple preferred return.  This is similar to the "borrow" option, except that the risk profile is much more favorable to you.  A preferred return is simply an allocation of 100% of the cash flow until the hurdle is met.  This means that if the property is producing zero cash flow, you aren't writing checks to your friend out of your personal account.  But when it does start to cash flow, your friend will be getting all of the cash flow until he gets his X%, and this includes any of that X% that wasn't paid when cash flow was compromised.  This beats the "borrow" option, I think, but the downside for you is you earned nothing for your hard work, but more importantly you earned nothing on your cash investment, while your friend earned it all.  

While either of those options will work, it is up to you to decide which works better for you.  Or, you could consider this third option:

You decide how much your "work" is worth.  This includes bringing the deal, obtaining the financing, guaranteeing the loan, managing the asset, and finally selling it.  Let's say that you decide that's worth 50% of the profits (or whatever percentage you and your friend agree on).  This leaves the other 50% of the profits for the "money."  You are bringing half of the money, so you are entitled to half of the "money's" 50%.

In this scenario, you get 75% of the profits (50% for the "work" and half of the other 50% for bringing half of the money) and your friend gets 25%.  You could complicate this further in two ways.  First, you could charge fees, such as a percentage of the purchase price for finding the deal and getting the loan.  Second, you could offer a preferred return.  Let's explore that for a moment.

In this case, you offer a preferred return to the "money," which means that you and your friend equally share in the preferred return.  What this does is prioritizes the folks that contributed the money (of which you are one of them) over the person in charge of the deal.  You would do this to incentivize yourself to perform, and to show your friend that a return on his investment is more important than compensation for your sweat equity.  

If the deal under-performs, your 50% for doing the "work" can get carved out by you and your friend.  For example, let's say that you have an 8% preferred return.  On $100K that's $8,000 per year.  If the cash flow were $10,000 and there was no preferred return, you would get $7,500 ($5,000 for the "work" and $2,500 for your "money"), and your friend would get $2,500.  

But if there is a preferred return, you and your friend would split the first $8,000 (8%) and get $4,000 each, leaving $2,000 of remaining cash flow.  You get 50% of that $2,000 for your "work," and the remaining $1,000 is split between you and your friend for the "money's" 50% share.  Notice the difference in this example that your friend isn't the only one getting a preferred return, you get one too.  You and your friend got $4,500 each and you got $1,000 for the "work."  The end result is you got $5,500 total instead of $7,500.

But if the cash flow were to be $20,000, you and your friend would split the first $8,000 (the 8% preferred return), leaving $12,000 to be split 50% to you for the work, 25% to you for your half of the money, and 25% to your friend for his half of the money.  You and your friend each get $7,000 for your investment (half of the $8,000, plus you each get 25% of the remaining $12,000), and you get $6,000 for your "work" (50% of the $12,000 left over after the $8,000 preferred return has been paid).

What you doing here is just treating your two money partners equally, it just so happens that you are one of those money partners.  This all sounds complicated, but once you work out all of the formulas on a spreadsheet, it's a simple matter of inputting the cash flow each period and letting the spreadsheet do the work.  It might take hours up front, but each distribution takes only seconds to calculate.

@Brian Burke great answer and advice. 

Also Important to point out the equity component on the last couple of paragraphs. 

Depending on the asset and location you could still have significant appreciation in equity even without positive cash flow or income increases. 

With a preferred return you are not sharing in equity gained through appreciation and principle pay down. Therefore you could have much more of an upside by paying a preferred return on the cash flow if you are building equity and the value of the property if you bought it right.

That being said you can also lose value and equity if you buy the wrong thing in the wrong spot or overpay.

I would either do a simple 10% interest as a debt partner or a 50/50 split and then charge an asset management fee. You would charge that based on the rental income - maybe 5% or so and then you could charge it on the sale amount as well. Simple structure and easy to set up. 


@Brian Burke Your third option is awesome and makes really good sense. Since the investor in this scenario is completely passive; doesn't this fall into syndication territory? Is there a simple (non-ppm) way to structure this as a JV?

@Nick Cucci if the investor is completely passive the investment is a security no matter what the structure looks like. The only exception might be if the transaction is genuinely debt with commercially-reasonable terms (such as a reasonable LTV and secured by the real estate--which is unlikely to be the case if the investment is subordinate to debt that is already at max leverage). Having said that, these kind of deals are done all the time between friends and family and I'd be surprised if that was ever a problem from a practical sense. I'm sure the syndication attorneys on the forums could add more to this discussion than I can. :)

@Brian Burke

@Todd Dexheimer


Some great information in this thread and I'm familiar with both of you so would love your thoughts on something I'm working on. 
I'm in the middle of my first deal where a friend loaned me 100% of purchase and estimated rehab (of course going "over" budget and behind schedule but I had contingencies in place to cover that). The rehab should be done in the next 30 days and I anticipate about $400 cash flow after I refi.  

I'm looking to continue doing more deals and I can't get him his money back till I've held this property for 6 months and can refi out.

That leads me to my question. I was approached by a former co-worker/friend who is in the process of selling 2 homes and anticipates having a chunk of cash in the $300K range. He is looking to deploy that with anticipation of getting a 7% ROI and wants to be completely passive.

My 1st thought is I'd like to talk to him about simply loaning me that money at 7% interest. But not secured by any asset. Some of that I'd use for purchasing deals cash and some I'd use for advertising, etc. So basically I'm asking him to give me a business loan. 

Am I really pushing the limits asking him to just give me the cash at 7%? Should I offer to personally guarantee the loan to give him some piece of mind?

The proposed idea is he gets 7% paid monthly with the understanding that the principal is locked up for 3 years. Then I would return his principal or he could opt to reinvest it. If I've done things right I'll have built enough of my own equity to continue to fund my own deals and still give him his money back. At that point hopefully we could do something more deal specific if he wanted to continue to invest with me. 

I very much realize that my plan definitely involves a lot of risk to him. He's going to have to really trust me. I've known him a long time but can't say if he'd consider this type of loan since there would be no actual asset initially for him to hold the note on. 

I feel that an injection of cash like this could definitely open up a lot of doors for me to scale up quicker. 

For some brief background I've got a secure W2 job that pays me ok but I am not an accredited investor. So I couldn't take his money and just put it into someones syndication. 

My plan involves reducing my W2 to part time so I can spend more time on building my investments. I've got no problem putting in the time, just need the time to put in, and of course need continued education and coaching. 

Just trying to figure out my best route and feel like him reaching out could be a nice step in moving forward. 

If he isn't open to this then I'd talk to him about doing deal by deal loans or helping him just find a place to put that money for a fee. 

Thanks in advance for your opinions and thoughts. 

@Derek Tellier seems to me that it would be tough for someone to loan their life savings to someone looking to do their second real estate deal, when they don't even have a deal.  Your friend wouldn't have the luxury of evaluating the deal itself to determine if it appears safe.  Instead, they would be putting 100% of their trust in you.  Switch places with your friend and ask yourself if you would hand over your life savings to someone just because you knew them in the same set of circumstances.  I'd bet that you wouldn't.  Now if you had a lengthy track record, that's a different story.  Or if you had a deal that you could show that might work too.

If I were you, I'd also be worried about racking up interest on $300K with no certain way to not only service the interest but return the principal.  What happens if you burn through $100K in advertising and don't find a deal?  Or what happens if you find a deal and instead of a huge profit, it loses money?  You could find yourself in jail, not just in court.

My advice would be to talk to your friend about doing a joint venture, then go find a great deal.  He keeps his money until the deal closes.  Even if you have to give him half of the profits (or even more), you are building a track record and momentum begets momentum.

@Brian Burke

Thanks for the quick response, you're right this would be a 100% trust in me situation, not an ideal scenario for him for sure and could absolutely be disastrous for me as you pointed out. These are all things I considered which is why I posted the question. Trying to determine if it's even worth bringing up as an option. 

It's easy to get excited about the options when presented with a potential influx of cash. 

I'm meeting with him next week to discuss more in depth about that he's really looking to do. That conversation will determine what happens next. A JV naturally seems like the best option. Once I determine what his definition of passive is and more specifics about what he's looking to do I'll be able to better determine how I can find a win-win for both of us.

The scenario that you laid out seems perfect for you, but like a bad deal for the investor. Not sure what your relationship is with this person, but you may only have one shot to impress, so think about what you would want as a passive investor. 

I would suggest doing a deal at a time with him as an equity partner or debt partner and offering him slightly better returns than what he expressed. I would want my money backed by real estate. If you fail, I want to know that I get the asset. 

Also, spend as much time possible getting educated!

Originally posted by @Brian Orr :

I’m in contract on a small deal for 500k. A long time friend of mine expressed interest in being a cash partner, simply looking for a better return than his savings account. This would be through monthly cash flow or the cash return upon exit or refi.

For simplicity sake, if I’m putting down 100k and he offers 50k of that we’re both 50% equity invested at this point. But the loan is in my name and I will be performing all duties, he’s 100% passive.

I know the 50% cash to cash investment shouldn’t be equal to 50% equity. The question is, what should it be equal to? Should it be 10% as it’s 10% of purchase price? It would actually be less I guess because we need about 30k in repairs. Also will need some operating capital to turnover the apartments as we reposition.

I’ve been searching syndication blogs but they don’t seem to address this, or at least I haven’t found one that could give me input on this scale.

Any ideas how to incorporate him into this deal would be greatly appreciated.

 Why give equity when you're doing all the work and have the liability (loan in your name)?

Negotiate that he is a lender - lend you $50K and you promise him 12% interest or give him $500/month.

For smaller deals and specially if I put some of my money...I don't give equity.

I can't @ everyone here, but thank you all kindly for the in depth and informative responses. I swayed a bit from biggerpockets as my personal life has taken me elsewhere over the last year. But I will resubscribe and hopefully befriend and stay in touch with all of you. Tremendous responses on all fronts and I truly appreciate you all taking the time to offer advice on this new venture.

Depends how bad you need the money.  The only times I take on investors is offering them the following....

I find the deal.  I bring an agent in on it to show comps or property manager to show rental projections.  That way my investor knows that I am using a 3rd party and he/she can ask them the hard questions.  They can also find agents and PM on their own to ask questions on. If the investor is interested, they bring 100% of the money. 

If the goal of the property is a rental for cash-flow, they get 100% of the proceeds until 35% of their investment is paid back and then we go 50-50 there after.

If the goal is a flip, then they get their initial deposit back and we split the proceeds 50-50.

I want my investors to be silent, but know everything that is going on.  I also want to limit my risk b/c I am doing all the work.  You can tweek the numbers to make it fit your needs.  I prefer not to have investors, but if NEEDED, then I know my value.

@Brian Orr Good question. Have you read The Best Ever Apartment Syndication Book by Joe Fairless. This book alone will help you out tremendously on how to structure the deal. 

@Travis Watts I'm halfway through. It's about the 5th MF book i've read an a million hours of web content. Still haven't quite resolved and answer to this believe it or not. 

@Brian Orr There are also consulting and coaching programs out there that might be helpful. I remember researching a tax and legal question one time for weeks on end. I read every post, clicked on every website and read everything I could and asked everyone I knew and couldn't find the answer. I eventually called a CPA/attorney and paid $125 for their time and got my answer in 10 minutes lol 

Originally posted by @Travis Watts :

@Brian Orr There are also consulting and coaching programs out there that might be helpful. I remember researching a tax and legal question one time for weeks on end. I read every post, clicked on every website and read everything I could and asked everyone I knew and couldn't find the answer. I eventually called a CPA/attorney and paid $125 for their time and got my answer in 10 minutes lol 

Unfortunately in this case, the attorney fees are sitting at $8,000 and up. Well that is if I choose to bring on investors. I've sort of found all the answers, i've met with 3 attorneys already. The actual solution just resides in what I decide is ultimately best for this and future projects. That's the web I'm currently caught in, and probably overthinking way too much. 

 

Based on several books I have read, this seems to be a mini syndication type deal. If he is completely passive, i would offer him 30-40% vs 50%. You’ll be the asset manager and be quite a bit more involved and I think it is fair to have a larger percentage 

@Brian Orr I would use the suggestion from Brian Burke. Treating both of your cash equal would be the best way to align with your investor plus receiving upside in the deal for all of your work. By using a pref your able to receive cashflow throughout and place the money in the deal as first priority before you get to delight in the upside as the one who operates it. As far as charging fees to your friend that is up to you. If you've got a good model "spreadsheet" you can quickly play with adding some fees on the front and/or backend to see if the deal would still work for your potential investor. 

@Brian Orr I agree with what @Michael Ealy stated about not giving up the equity. If your friend is looking for a better rate of return than his savings account I would simply say. “I can give you a better rate than your savings account. How much of an interest rate would seem reasonable to you and I’ll see if I can do that.” This makes him come up with a number and then you can accept it or see if he’ll take a little lower if it’s too high. 

I do these type of scenarios all the time. I’ve worked with 40-50 private money lenders where they LEND me money for my deals rather than PARTNER with me on my deals because if they are partners then they have ownership in the deal and I need to make sure all of my accounting is done exactly perfectly in order to make sure all of the percentages are done correctly. Also, I can’t accept money from anyone else into the same account and commingle investor funds (that’s a no no!). When I accept the money as a loan then the private money lender knows exactly what to expect each month and it’s up to me to make sure that I do the numbers correctly at the beginning to make sure to the best of my ability that I will cash flow even after I have paid the private money lender.

I find this to be the easiest way to do it on small to medium deals where there is only one investor.