I know of very few guys who have been able to leverage their money — without the aid of additional private capital — into acquisition of significant amount of real estate. Indeed, most of the successful investors become such by figuring out how to leverage other people’s money.
Most of us, having exhausted our own resources, eventually begin exploring ways to attract private capital to our deals. And while the there are countless ways, all of them fall into one of three categories:
- Limited Partnership
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When most of us think of partnerships, this is what we think of. This is when you and a friend(s) set up an LLC, fund it with some money from each one of you, and go buy an asset. These are easy to do, with limited reporting requirements and minimum paperwork. This is what most people do.
There are some issues here. For one, this type of structure is referred to as “democracy” because each of the members gains voting rights according to the proportional ownership of the LLC. Which means what? It means that in order to decide whether to go with carpet or tile flooring, you have to have a vote. That’s right — a democracy requires an agreement. And yes, things can be discussed in the operating documents, but at the end of the day, it is what it is.
Also, if the LLC takes out a loan, most of the time all of the members will be required to sign full recourse. If you are trying to attract money to your deal, the notion of recourse is no good!
So, be sure that you like the people you go in business with, and be sure you know them well. Money tends to amplify that which is there — if you are dealing with a nice person, they will be even nicer with money on the line. If you are dealing with a not-so-nice person, talk about pain…
Limited partnership is a mechanism that allows you to alleviate both of the problems of a democracy. For one thing, this structure is comprised of general partners and limited partners, whereby the limited partners are only there to provide funding, while GP retains operational control. This is huge. Additionally, limited partners are not subject to recourse from the banks, which is very attractive to them.
Seemingly, this solves all of the issues. However, since LPs have no operational control, in essence what you are doing is dealing in securities, and the only proper way to do it is via Reg D exclusion. Unfortunately, between legal and due diligence, you must have at least $50,000 to get things rolling. This is obviously quite tough for newer investors. Besides, these additional costs, as well as the split of the general partner, make Reg D totally impractical on small deals.
So, what do you do, if you need funding for down-payment on a smaller deal?
You do debt!
This is where you approach a friend for a loan. You offer an attractive proposition, collateralized by the asset. By doing this, you retain the ownership of the deal, and your private money becomes a lender with property as collateral.
Now, if there is a bank involved, then obviously the DSCR has to conform, and your debt partner is forced to sit in second position behind the bank, unless you can be more creative.
OPM is perhaps the greatest advantage of real estate. OPM can lower the price of entry tremendously. However, that doesn’t mean that it’s easy to figure out what, where, how, and why.
Hopefully this article helps a little.
Any questions about attracting private money? How did you make it work in your own business?
Let’s talk in the comments section below.