SPEED AND EASE DEBT Raising debt is super simple and straight-forward. The only things to negotiate are rate, points and loan-to- value ratios. Once you have a formula down with a lender it is really easy to repeat over and over again, giving you a great advantage to move fast and close more projects. EQUITY As mentioned before, there are a number of variables that can be included in equity deals. What are the profit splits? Who absorbs more of first
mentioned—Risk and Reward, Speed and Ease and Cost of Capital—when deciding how to structure each deal. RISK AND RETURN DEBT Most lenders are going to require some “skin-in-the-game”—typi- cally 15 percent to 20 percent of purchase and some amount of the rehab budget. This is the equity portion of the deal and is in a “first-loss” position. This means if the deal goes totally wrong, your contribution is going to absorb the losses first and the lender only loses principal if the loss is greater than your contribution. On the other hand, the lender earns a fixed rate of return. For short-term “bridge loans” on residential fix-and- flips, the market rates are typically between 10 percent and 18 percent. This means that you, as the sole equity owner in the project, also receive all of the profits of the project, giving you more potential upside. EQUITY For equity deals, your capital partner is also exposed to “first loss” in situations where the deal goes totally wrong. Savvy equity investors may want to structure the deal so you still absorb more of the first loss. We think this is a bad practice, and unfair to you as the operator. The reason we think it is bad practice is that the equity partner likely wants to participate in the potentially higher returns if the project is a smashing suc- cess. If an equity partner gets to partici- pate in the outsized gains of a successful project, that partner should also share the risk with you when a project goes poorly (caveat being negligence on your part as the operator). KEY TAKEAWAY For projects that are rather straight-forward with most risks known up-front, we like debt because it gives us a fixed interest expense and allows us to capture all of the potential upside. For riskier projects that have more unknowns, we’re willing to share the potential outsized upside as long as our equity partner is willing to share the risks with us.
$12,000 interest + $3,000 origination + $1,000 legal + $200 processing or $16,200. On a percentage basis, your cost of capital in this example is 16.2 percent. ($16,200 fivided by $100,000) If you hold the loan for less than one year, it may be useful to annualize the origination, legal and processing fees. To do this, simply add the fixed costs to the amount of interest you actually pay and divide by the number of months the loan is outstanding. Then multiply that
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IF AN EQUITY PARTNER GETS TO PARTICIPATE IN THE OUTSIZED GAINS OF A SUCCESSFUL PROJECT, THAT PARTNER SHOULD ALSO SHARE THE RISK WITH YOU WHEN A PROJECT GOES POORLY.
losses? Who gets to make certain big decisions around design or selling price? Sure, you can have a cookie-cut- ter equity structure in place, but if the deal is that straight-forward, why give up potential upside on a project? KEY TAKEAWAY For speed and ease, debt makes more sense for us. An established relationship allows us to move fast and close more deals. For the one or two situations that are a bit out of the box and require more creativity, we’ll work with equity partners. These are deals that have a higher risk profile but also promise greater returns if properly executed. COST OF CAPITAL DEBT Calculating your cost of capital on debt is rather straight-forward. Simply add up points, fees and total amount of interest paid and divide it by the number of months you hold the loan. Take the example of a $100,000 loan at 12 percent interest, 3 percent points origi- nation, $1,000 legal and $200 processing. Assuming you hold the loan for a full 12 months, the total annualized cost of capital would be:
by 12 to annualize it. For example, a nine-month hold peri- od would look like this: • $9,000 interest + $3,000 origina- tion + $1,000 legal + $200 processing = $13,200 • $13,200 divided by 9 months = $1,466.67 per month • $1,466.67 x 12 = $17,600 annualized cost ,or 17.6 percent Note that a shorter hold period results in less actual cost, but is higher on an annualized percentage basis. This is because the fixed costs, like the origina- tion fee, are spread over a shorter period of time. This works the other way if you hold the loan longer than 12 months. EQUITY Calculating cost of capital for equity can be a bit trickier to predict. Depending on how you structure the profit split, equity contribution, etc., your cost can range greatly. Let’s assume you have a simple 50/50 profit split with your investors. Let’s also assume that all-in expenses are $100,000 and you net a $40,000 profit after all expenses. This means that your cost of capital is $20,000 or 20 percent ($20,000 paid to
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