Money/Capital/Mulla is the life blood of being a real estate investor. Real Estate Investors need to develop two key skill sets as they enter the world of real estate investing:
- Get Good at Finding Deals and
- Get Great at Raising Money.
You can have a great deal but if you cannot raise money then you cannot take advantage of that deal. The first thing to understand are the different type of capital sources that you can access for raising money.
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Two Categories of Money
Money comes in all shapes and sizes. The two major categories of money are debt and equity.
Debt financing refers to money raised through some sort of loan, usually for a single purpose over a defined period of time, and usually secured by some sort of collateral. There are various types of debt financing options ranging from Fixed Rate Mortgages, Bridge & hard money funds, and owner carry-back loans. Since the real estate market crash of 2007, the debt markets have frozen and the equity requirements posed by lenders have risen. Hence it is important to understand the equity portion of the capital stack.
In today’s market, a real estate entrepreneur/investor should expect the equity component of a deal to comprise 15 to 40 percent of the appraised value of the property, and likely higher for development deals and other projects considered more risky. Equity capital is the cash money invested in the deal which can either be the investor’s own money or cash from third party capital investors: private equity, hedge funds, accredited and non-accredited investors. (Read more about how to legally raise money from these types equity sources). All of these sources provide funds in exchange for a portion of ownership, and therefore a share in the profits of the investment. Equity has the benefit of a long term capital source but it has costs associated with it which can include one or more of the following: giving up some control of your investment strategy, legal, accounting, and capital raising fees, which eat up at least three to five percent of the amount raised and equity investors will want a regular stream of information which can eat up your time to do more deals.
Real Estate investors need to strike the right balance between debt and equity financing by weighing the costs and benefits of each and making sure that you are structuring the best capital stack for the investment which benefits you and your equity investors over the investment horizon.
Different Types of Debt
- Conventional First Mortgage Debt: A conventional first mortgage loan is either a fixed or adjustable mortgage loan. A mortgage is typically given out by banks and pension funds (depending on the size of the loan) and a lien is placed on the asset as a security. Conventional debt is cheapest and lengthiest form of borrowing but it is also the least accessible and most time consuming source of debt capital.
- Second Mortgage or Junior Debt: Subordinated or “junior” debt (so named because it has only a secondary claim on assets in the event of a bankruptcy). These loans come at higher interest rates typically in the range of 8 to 12%, but they’re available from development agencies and private lenders.
- Asset Based Debt: An asset based debt can be a hard money loan. A hard money loan is a type of asset based loan through which a borrower receives funds secured by the value of real estate with limited income and asset underwriting by the lender. Hard money loans are typically issued by private investors or companies. Interest rates are typically higher than junior debt and can be in the range of 11 to 14%. Hard money loans are used for projects lasting from a few months to a couple of years hence they have a ballon risk associated with using them. So use them cautiously or else you may need to be creative to shield your investment against the “Evil” Hardmoney Lender.
Different Types of Equity
- Syndication of Accredited and Non-Accredited Investor Cash: I parallel this source of equity to Angel Investors especially when it comes to flip or turn around type investments. Angel Investors are typically high net worth individuals (accredited investors) who collaborate with like-minded individuals to invest into the entrepreneur investment related business plan. That is where the similarities end as, unlike Angel Investor groups that exist for sector such as technology, bio-tech etc- there is no such thing within the real estate sector. Within the real estate sector, Real Estate Entrepreneur/Investors has to locate each of these “Angels”; get them to commit to invest; pool their funds into a special-purpose investment fund or LLC and then execute on the investment. This traditional process is now changing with the advent of crowd funding acceptance by the SEC which arose through the Jobs Act wherein funding portals such as PropertyPeers and Fundrise are becoming disruptive forces to the process.
- Institutional Equity: Private Equity Groups and Hedge Funds fall into this category. Couple of things to keep in mind as you consider approaching this type of equity source:
- Less than 10% of private equity funds will consider an equity investment of $1 million or less
- Around 40% will consider an investment smaller than $5 million
- Two-thirds are control investments and one third are non-control
- Self Directed IRA: A self-directed IRA is technically no different than any other IRA (or 401k). A self directed IRA is unique because of the available investment options. Most IRA custodians, such as TD Ameritrade, Bank of America, Wells Fargo etc., only allow approved stocks, bonds, mutual funds and CDs. However, a self directed IRA custodian, such as Equity Trust, Pensco Trust, and others allows those types of investments in addition to real estate, notes, private placements, tax lien certificates and much more. If you can locate this equity source and work with the capital investors through the initial setup process then you have the potential to lock in a longer term equity source.
It is important as a real estate investor to use a balanced mix of debt and equity sources to achieve the highest net rate of return to your pocket with the least amount of acceptable risk to your equity capital investors. That is capital budgeting, my fellow real estate investors.
The list above is far from exhaustive and I would love to get your thoughts/ideas on other sources of either debt and equity that can be utilized to finance a real estate purchase or rehab. Share your thoughts in the comments below as that is how we will all get better by having a free flow of information So please leave me a comment and I promise to comment back.
Photo: Shelly S