Using Line of Credit vs. Equity Partnership for Financing Rentals

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Using Line of Credit vs. Equity Partnership for Financing Rentals

Jason L.
Rental Property Investor · Delray Beach, FL · Member since 2014 · 224 posts · 169 votes

I have an offer from a family friend to finance my next rental property. He is generously doing this as support for me, and thus he's letting me decide how I want to structure the deal (so long as he still makes money too, of course). I see two options available:

1) He finances solely as a line of credit. We haven't discussed exact rates, but I think it's rest-assured that it's going to be pretty reasonable (maybe 4.5 - 5%). He'd be willing to do 100% of the all-in cost, but I wonder if I should just only take 80-90% to keep a "standard" amount of equity for myself (just in case the market turns south or so that if I ever needed to convert to a commercial mortgage someday, then I'd already have the downpayment worked in). 

2) He comes in as a passive equity partner. It'd be a 50/50 equity split with him financing 100% of the deal and me running operations (also assume that he may or may not want a return on capital off the top of the net cash flow). I'd be assuming no financial risk if the deal (god forbid!) went bad, but I'd also be splitting half the appreciation instead of assuming it all. Considering we'd be paying cash (and thus there'd be no interest coming off the NOI like with option 1), my cash flow comes out the same as it does when I take out 80% on the LOC in option 1.

Which of these scenarios do you think sounds more fruitful? I guess where I'm getting hung up is trying to figure out how to value the equity I'm getting with the LOC vs. the no risk/no money down partnership? Obviously there's more upside to the LOC, but there is something awfully enticing about an unlimited return. Furthermore, if I go for the LOC, is it better to take out 100% of the all in cost or should I leave 10-20% equity for myself (which I can afford)?

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Patrice Penda
Investor · Hoboken, NJ · Member since 2016 · 464 posts · 179 votes
8y

As a general rule, equity capital is more expensive than debt equity.

With a first option to pay interest possibly at a rate of 5%, your case is probably no exception to that rule.
Because of that, i think the first option is best. 
Now how you want to split the equity ownership depends on what your relationship is with that person, how much he will be willing to give away, how fair you want to be (or how greedy you want to be).
It very much depends. 

That is my 2 cents

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  • Patrice Penda
    Investor · Hoboken, NJ · Member since 2016 · 464 posts · 179 votes
    8y

    As a general rule, equity capital is more expensive than debt equity.

    With a first option to pay interest possibly at a rate of 5%, your case is probably no exception to that rule.
    Because of that, i think the first option is best. 
    Now how you want to split the equity ownership depends on what your relationship is with that person, how much he will be willing to give away, how fair you want to be (or how greedy you want to be).
    It very much depends. 

    That is my 2 cents

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  • Garrett M.
    Rental Property Investor · Philadelphia, PA · Member since 2015 · 180 posts · 66 votes
    8y
    Jason Laso In business it is said that “you don’t partner what you can hire” Giving away ownership is much less desirable than making a reasonable interest payment. A good potential partner must bring something powerful and uncommon: a skill set, or network, an incredible work ethic... Unless your lender wants it, I cannot see the benefit to your business of partnering in this case.
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  • Jason L.
    OP
    Rental Property Investor · Delray Beach, FL · Member since 2014 · 224 posts · 169 votes
    8y

    @Garrett M.

    Thanks for the insight. What do you think about an interest-only loan though? Do you think it is beneficial for the lendee to try to pay off some of the principal as the property cash flows or is it better to just keep reinvesting that cash flow towards another property? Say a property cash flows $3000 for the year after expenses and interest. Should I allocate a percentage (or even all) of that towards principal to try to buy back equity, even if it's only a small amount?

    I guess my concern would be that while the money is cheap for now it probably won't be forever, and I'd like to have my bases covered in the event I had to refi at a higher rate/with a mortgage in 3-5 years (hypothetically).

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  • Garrett M.
    Rental Property Investor · Philadelphia, PA · Member since 2015 · 180 posts · 66 votes
    8y
    Jason Laso I have copied your questions and replied. 1. What do you think about an interest-only loan though? Do you think it is beneficial for the lendee to try to pay off some of the principal as the property cash flows or is it better to just keep reinvesting that cash flow towards another property? The answer to this depends on your goals. If you want to acquire properties quickly and you don’t have the money under your mattress, then you use leverage. You have to decide how much leverage you are comfortable holding. If your goal is having increased equity in your properties or even paying them down completely, then your path will be a longer one but you may feel safer about the journey. So it really depends upon what you are trying to achieve through real estate investing. I do think that having at least 20% equity in the property is a good practice. Ultimately you want to be comfortable that you can withstand a prolonged vacancy, a large capital expense or even a recessionary drop in your property’s value. Can you keep making the payments if things get weird? There are smarter people than me who are more strategic about evaluating total interest cost of an investment. Because I am still in the early phase, I am less concerned with optimization and more concerned with getting the cash flow snowball rolling. I will get technical later once I have more options and momentum. 2. I guess my concern would be that while the money is cheap for now it probably won't be forever, and I'd like to have my bases covered in the event I had to refi at a higher rate/with a mortgage in 3-5 years (hypothetically). I wanted to mention here that I wouldn’t worry too much about interest rates in the future. If you can use a conventional refinance and lock in 5% for 30 years then you are sitting pretty. Even if rates climb a bit the rest of the market factors shift in accord with rates. Higher interest may lead to less competition for properties, and so you can buy things cheaper. I wouldn’t overthink it personally. But most importantly... in having a willing private lender you are sitting on a golden goose. I like what Chad Carson has to say about private lending. I’m paraphrasing: My first duty to my investors is to make sure that they get rich and I know if I can help them get what they want then I can get what I want. If you can give your private lender a higher rate of return, treat them well, communicate often and clearly and execute on everything you say you are going to do, you will probably find that you have no shortage of money to secure your deals. A happy private lender is a treasure. Lastly, are you rehabbing these properties at all? If so and you are pursuing the BRRRR strategy, that changes the time frame in which you are borrowing from your lender. 6 months to 1 year. If you are just buying in service properties, what term do you anticipate borrowing from your lender?
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  • Jason L.
    OP
    Rental Property Investor · Delray Beach, FL · Member since 2014 · 224 posts · 169 votes
    8y

    @Garrett M. I do plan to do renovations, but inventory has risen at a much faster rate than rents have in this region, which makes getting cash flow extremely difficult.  The BRRR method would certainly be a long-term goal, although I don't think it'd be feasible any time in the near future using this approach.

    Buy house for $110k + $10k rehab = $120k AIC. 

    The house rents for $1250/mo. Using a 45% expense projection, that's $8250 annual NOI.

    Use 80% from the private line of credit ($96k) and fund the other $24k myself. At 5% interest, that is $4800 in interest every year (meaning I'd be making 14% COC).

    With some small "renter-ready" renovations, maybe the home is worth closer to $130k by the time it rents. A 75% cashout refi gets me $97.5k from the bank. That's enough to cover the private loan, but only takes out $1500 of my investment so I'm still pretty much in the same spot. Furthermore, a $97k mortgage's payment goes up to $750 per month, which is not only nearly double the private loan but also makes the house cash flow negative.

    So realistically a refi is not in the cards any time soon, unless the market appreciates at some major rate over the next year or two. The house would need to be worth closer to $160k and fetch higher rents to make that feasible (which is just very hard to find in Central Florida right now). More realistically, my goal is to lever off private money for as many years as I can to keep it cash flowing. Am I missing something here?

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  • Jay Helms
    Rental Property Investor · Gulf Breeze, FL · Member since 2014 · 1k+ posts · 733 votes
    8y

    @Jason L. - you’re in a great situation, don’t think you can lose. In a first deal with a new investor, structure it so that he will want to partner with you again, again, & again. 

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