Financial Risk Reduction Strategies
by Tod Snodgrass
Most rehabbers, builders, developers, wholesalers and investors need capital from time to time in order to acquire properties. While there are many sources of capital available, finding the most cost-effective means for financing your deals can play a critical role in whether any particular deal winds up in the red or in the black. While funding comes in many shapes and sizes, generally speaking they boil down to either using your own funds or availing yourself of outside capital, i.e. SEM: Somebody else’s Money. SEM usually involves one of three options: debt, equity or co-venture. What follows are some ideas to consider to increase profits by reducing or at least mitigating the cost of funding your next project.
Private Real Estate Investors (REI) funders (the “money people”) typically are staring at two big factors that go into their decision-making process(es): Yield and risk. What most want is the highest return, with the best security achievable. So, if you are not getting the desired result in terms of securing the funding you need from REI funders, you might want to ask yourself what things you can potentially change to make your offerings more attractive to them as a group. Here are five options, methods, etc. to consider, which may or may not apply to your unique situation.
- Offer a profit percentage kicker. This is not to imply you should give away all your profits on a deal, but by giving a debt investor a very modest share of the back-side profits…say 5%, this could make the difference between them investing with you, or not. By “sweetening the pot” with after-the-fact, profit-based earnings you may be laying the ground work for a long-term business relationship by employing this “investor reward” technique.
- Equity vs. debt. Some investors shun debt deals, for their own reasons, and are just happier with equity. And as the old saying goes in marketing: Ask the customer what they want to buy, and then sell it to them.
If equity is what they want, and you can safely build that particular component into the current deal, why not do it?
Equity offers a potential advantage over debt: No monthly payments to make and less or no debt to worry about paying off later. Equity players earn their profits when the deal is done, or over time via ongoing net profit earnings (buy & hold).
Supposing an equity partner wants out of a deal, but you want to stay in it—now what? Options include:
- Bring in a replacement equity partner
- Refinance the deal to cash out the departing equity partner, etc. However, the downside to a refi is that your debt service costs will rise, so be sure to pencil out how this option works out dollars-and-cents-wise, over time.
- Co/joint venture. Instead of a pure debt play or pure equity play, consider a co-venture: the “money people” bring the cash, you bring the deal, and then you two do a profit split at the end. This does not have to be a permanent business structure, but instead can simply be a one-off just for a single investment and/or only one property. Now you might wind up doing a series of joint-ventures with that person, but each is still an individual one-off.
- Debt for equity swap. Example: you would like to turn your current buy/rehab/sell project into a buy & hold, i.e. to help reduce your tax burden via long term capital gains, over time. Some private funders (those who provide gap/bridge financing for example) may be open to the idea of turning the current loan they have with you into an ownership percentage. This works particularly well if you are saddled with a high level of debt but an even greater amount of equity due to efficiencies you were able to achieve during the rehab. Let’s face it, too much debt service can eat into meager profits very quickly. A swap allows you to reduce debt service, thereby increasing cash flow.
- Ask real estate investors what they want. If you are in the dark about what certain investors are looking for in terms of yield, deal structure and risk, consider this: Just come right out and ask the top (10?) potential investors you know this question: What kind of deal are YOU looking for? Once you “blend” the answers from all 10, you will probably find their collective answer will be pretty close to what the marketplace is currently sustaining in terms of risk, yield and deal structure.
Truth is, there are multiple ways to construct deals. What most capital investors are seeking is a strong feeling of trust, and the comfort level that stems from that trust. An uncomfortable (or unhappy) investor simply won’t invest. Your job is to find out what the potential capital investor wants…debt, equity, co-venture, shared profits, equity kicker…and then, if you can justify it, sell them what they want to buy.