I’ve recently had a chance to speak with several real estate investors who want to raise money to purchase multi-family properties, and they’re all making the same mistake.
They’re giving their investors far too much of the deal and very little (or nothing at all) for themselves.
How is this a win-win?
This tells me that they’re either talking with very sophisticated investors or they’re copying the deal from a very experienced investor who is raising money from very sophisticated investors.
How I Bought, Rehabbed, Rented, Refinanced, and Repeated for 14 Rental Properties
This is the dream right? Going from zero to 10+ rental properties, providing stable cash flow and long-term wealth for you and your family, and building a scalable business model to boot! Learn how this investor did just that, in this exclusive story featured on BiggerPockets!
This is a Big Mistake
While sophisticated investors do give you access to big money, they do so by wanting terms that are very favorable to them and leave little on the bone for you.
I’ve been down this road several times myself and every time my gut told me not to do it. I’m glad I listened, and so should you.
I ask the investor how they’re structuring the deal, and they tell me, “I’m giving my investors an 8% preferred rate of return with 80% equity”, and I say “Wow, did it occur to you that you might never make any money on the deal – ever?” And then they give me a puzzled look like I’m crazy.
Let’s assume that you take a $100,000 investment from a single sophisticated investor wants to bankroll you, and you’re eager to take his money because it means you can do your next deal.
You’ve got your happy ears on.
You project a healthy 10% cash on cash return and maybe a little higher in subsequent years. Your deal isn’t a real value play but there is some upside.
Giving the investor an 8% preferred return means that the first $8,000 of cash flow are paid out first to the investor, and then the investor gets 80% of what’s left over and you get 20%.
Let’s translate this to real dollars. Let’s assume you’re actually making a 10% cash on cash return in the first year (as projected), which is $10,000 per year. Of that, the investor gets $8,000 off the top (8% of his invested $100,000), which leaves $2,000 of cash to distribute. Of that, the investor gets 80%, or $1,600 and you get $400. So the investor is paid $9,600 and you are paid $400.
Really? You’ve done and are still doing all the work, you looked at 80 deals before you finally got this one under contract, you completed the due diligence, raised the money, got the financing, risked your deposit and against all odds succeeded to close the deal. Then you sifted through property management companies until you selected the best one. Now they are optimizing income and adding value. And you get paid $400 per year? Really?
That was the Best Case Scenario
What happens if you’re projections don’t go quite as you predicted, and you only achieve a 5% cash on cash return. That means that ALL of the cash flow is distributed, and you get paid NOTHING. That’s right, nothing. And what’s worse, the 3% (or $3,000) you failed to pay out are now carried over to next year, so that in the next year, you owe 11%.
Do you see where this could go? You might never get paid anything at all, ever! And you might even owe money when you sell!
Well, you say, you’ll get paid at the end, when you sell. That’s because you have none of your own money in the deal. So, fair enough, you might get paid something in 5 years when you sell. But you’ll only get 20% of any profit, and that’s after your investor is paid his preferred return and his 80%, and then you get paid what’s left. Unless you knock it out of the park, you’ll hardly see anything worthwhile.
Why bother with something like this? Just so you say you’ve syndicated a deal?
Don’t be that guy (or gal) that works only for the investor. This is such a sweet deal for the investor and not at all for you. So don’t do it.
What’s the lesson here?
Don’t take money from very sophisticated investors until you have a very established track record and are doing BIG deals.
Here’s the Alternative
Raise money from friends, family and high net worth individuals (I’ll call both collectively “friends & family”).
What’s the difference between friends & family and the sophisticated investors?
While it’s true that friends & family may not be able to give you a million dollars to invest, they are capable at investing $50,000 and more. However, they’re not going to ask for a preferred return, so don’t offer one.
Also, keep it simple. Don’t talk about advanced concepts like “IRR” (internal rate of return) because no one will know what to do with this and it will only confuse them. Talk instead about annual cash flow (the “cash on cash” return) and the average annual return. These are concepts the friends and family investor will know and care about.
If you currently have a single sophisticated investor who wants to invest with you but only at terms that are very favorable to him, then it’s time to expand your horizons and start talking to other individuals.
Will this be a little more work? Probably. But is it really worth doing a deal you won’t get fairly compensated for? I would say decidedly not.
I don’t offer a preferred rate of return to my investors, and I give them 60% to 80% of the deal. How much depends on what I need to do to achieve the 11% – 15% average annual returns I want for my investors. If the deal is awesome I may be able to keep more equity, if it’s a little skinny I might have to give up more. But I want to end up with at least 20% of the deal for syndicating the whole thing. Anything less than that won’t be worth it for me.
At the end of the day, you want a win-win for you and the investors. Make sure you’re not giving up too much when you’re syndicating your next deal!
How are you structuring deals with your investors? What’s been working for you (and what hasn’t)?