Today I would like to address a topic that I have spent a lot of time thinking about, reading about, and talking about with other investors: investing other people's money(specifically for buy and hold properties, a.k.a rental properties).
If you have money to invest, are an investor looking for more funds for your future purchase, or just curious about what we think the best way to do this is, keep reading.
Why this topic is important to us?
Unfortunately, we do not have unlimited cash or financing to buy all the properties that we want to buy. As we get deeper into this aspect of investing, we knew we would hit a financial wall - then would have to get creative in order to get more property. At some point in time, our ability to leverage our finances would run out. That brought me to a search for wisdom, a search for the best way to make a scenario that would entice investors, and make our company money.
The biggest hurdle we ran into was the required cash-on-cash return, or ROI that investors were seeking - 7%-12% seemed to be the expectation. If we were unable to generate that kind of return, it would not be worth it to these investors. Here in Fairfield County, CT, those types of returns seemed to be absent in real estate, with few exceptions. Albany, our current target market, did have those types of returns for investors.
At first, the best option seemed to be in having an equity split according to the percentage of total cash an investor would put in - until I realized that this structure gave no preference to the investor, and therefore was unappealing. If we could tell an investor that they would get paid first, after typical expenses, and generate a return that would be consistent and unchanging, similar to a fixed mortgage interest rate, then we would have the golden ticket.
The Best Structure
After countless hours of reading, talking, and thinking, this is what we determined to be the best way to structure our buy and hold deals to allow other investors to be involved:
In a group-investment scenario, each investor would be given some preferred return on their money, say 6-10% of the total after-expenses cash flow. Expenses include taxes, insurance, maintenance, other costs, and vacancy. So, after those expenses are paid, the investor would get their share of the pot according to their agreed-upon split. Then, after all this money is delegated, there would be a net cashflow (assuming the property is financially feasible for this model). This cashflow would then be delegated to the company (Blast REI in this case), and the investors, according to some additional, agreed-upon split. For example, the company could take 50% of these profits, and then split the remaining 50% with the investors dependent upon their initial cash-input.
Any of the preferred interest that is intended for the investor is paid back at closing if the monthly cash flow is too low for a given quarter/month/year (term).
When the property is sold, the same after-cashflow-split would dictate how much money each party receives after all expenses are paid, and the investors get their initial investment back.
Something similar to this could be used the the deal was financed with a bank instead of all cash (see below).
Let's look at a scenario with this structure/model:
Expenses and Money OUT:
Purchase Price: $200,000 (cash)
Other Misc. Expenses + Reserves: $2,000
Monthly Rental Income = $3,000
'Preferred Return': 7%
Total net cash-flow: $23,400
After-Expenses Cashflow: $9,400
CAP Rate: 11.7%
So, suppose we have two investors, at $100,000 a piece. Each investor would get their 7% first, or $7,000 for the year.
That would leave $9,400 to be delegated at some agreed upon split. If the Investment company takes 50% and the remainder is split according to investor's shared, that company would take $4,700 for the year, and each investor would take and additional $2,350 for the year, yielding a total of 9.35%.
Now, since we want to be creative, not everyone will have tens of thousands of dollars lying around, which leads us to using the same scenario, only with leveraging of financing, or a mortgage. Note: Neither of these scenarios include closing costs, which would change the cash basis slightly, more-so in the financing example below.
'Preferred Return': 7% Total net cash-flow: $13.874.25 ROI: 27.75%
Now we take a different approach, since we have an investor that needs to qualify for this mortgage. The challenge we face is determining what that risk, paperwork, and cash outlay is worth in a residual payment to this person, until the property is sold. For sake of argument, let's say the return is 5% of the total NET cash after preferred shares are paid.
So, again, we have two investors, this time their cash outlay is only $25,000 a piece, yielding $1,750 per year (as their preferred return). With the same split of after expenses cash-flow, 50% would go to managing company, totaling $5,187.13 per year. As mentioned above, if we value the risk of getting a mortgage at 5% of total cash flow, the mortgagee would see $518.71 per year - for doing paperwork during the buying process; this would yield 22.5% to each investor, totaling $2,334.21 per year, upping their ROI to an astounding 16.34%.
In both of these examples, there are numbers that are arbitrary, used to make a point. In both cases, investors enter into an agreement to give cash for their yearly interest, but then that yield has the possibility to increase if the investment is doing well. This creates incentive for the company that puts the deal together to have each property function as a well-oiled machine - lower costs = higher margins for every one.
There are multiple investors, making the whole transaction slightly more complicated;
In the financing scenario, one investor must have enough cash to close the property, and then get paid back, tying up tens of thousands initially;
If you invest yourself, you don't have the added burden of a company to pay as part of managing the whole transaction - less money in your pocket.
The manager of the property/asset have an incentive to make the property successful, because they get a chunk of the return;
The investor is expecting a minimum return on their investment, and get their money first (after lien expenses) - giving them a basis with which to expect a return;
The investors get property options that require little-to-no upkeep on their parts - it is a low-maintenance yield on their money;
Everyone shares in profits when the property is sold, assuming there is appreciation;
Investors get excellent yields on their money, which will be paid back when the property sells.
With all of that said, let's not forget that there are a lot of other expenses associated with these properties, that were omitted for simplicity's sake. For example, hiring a management company for day-to-day activities, utilities, closing costs, renovation money, and other operating expenses. Our goal was to illustrate the structure without complicating matters.
Creating this type of model for an investment property creates an environment where everyone takes home profits, and makes money. The benefits outweigh the negatives drastically, in my opinion. As an investor, assuming the property you are investing in has been thoroughly vetted, you get a low-maintenance return on your money, and share in all the spoils of war.
If you are interested in talking more about this, feel free to email us. Otherwise, happy deal-making!
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