I am still pretty new at this, but I have a couple of ideas for how to get into the fast lane, despite driving a clunker at this time… I would welcome the feedback from the more experienced drivers on this board! (And I apologize in advance for the length.)
My idea is basically using OPM to build a real estate (RE) portfolio. There are a couple of different ways to spin the pitch to investors, and different ways to include the investors in the deal. I need advice on which method is best – please look at this as someone is pitching the idea to you -- which way most piques your interest? What more would it take to get you to part with your money? What questions do you have that I have not answered?
Also, if you see any holes in my planning, please chime in (but please note, there are a couple of areas where I suspect the discussion could take a turn and go down a path I think I already have covered—no offense, I just would prefer to keep the discussion focused – so those areas are noted).
I have four multi-family properties I am eyeing (SFH converted to duplex with garage apt, a pair of 4-plexes, and a 6-plex mini-apartment. Combined purchase price would be about $800k. I need investors to pony up $250k. I will borrow $600k, leaving me with $50k in reserve. I have financing lined up at 5.5% on a non-recourse loan (ten year note, 30 yr amortization). This means of financing would enable me to have my self-directed Roth IRA be the owner rather than me. (Please don’t get sidetracked by the Roth IRA issue.)
The beauty of this is that I can repeat the process with additional investors on additional properties in the future -- I just need to fine-tune my pitch.
I think there are a couple of ways to approach the investors, and this is where I am in new territory. (1) Approach as hard money lenders, offering a decent return but not excessive – maybe 7.5%. The note would be short, 5 years max. This idea does not really appeal to me, because if someone hit me up, I would ask why they didn't just go to a bank? (2) Approach investors on a property by property basis. Close each property into an LLC (a compartment of a Series LLC) and have the investors be in on that deal only. Investors contribute 20-25% of purchase price and have equivalent equity in the LLC, and take that much of the income stream. This is a bit more work for me (as opposed to #3) and I don't have as much upside because I don't own 100% of the deal. OR (3) Close all purchases into one master LLC, with investors in that master LLC so they have their risk spread out by 4 rather than concentrated into 1 property – but have the LLC Agreement state that investors can be bought out by the LLC for a return of capital plus a stated rate of annualized return (I was thinking 10%) at any point within the first 5 years. Not sure I can swing this under approach #2.
For what it is worth, my lender would prefer option #3, but is not opposed to any of the 3. I think the LLC for the portfolio (option #3) – with the clearly defined exit strategy for them, plus valuable tax deductions -- might be the easiest sell to investors. Although I could do an exit strategy with the investor per property approach, it is much more difficult (basically with option #3 I get to hold the investors’ preferred return and pay down the portfolio loan quicker, then refinance the loan to give them the 10% return). Please don’t get sidetracked by the details of the exit strategy.
Also, the tax deduction aspects of the deal are best in the master LLC angle. Under the master LLC approach, the investor-members each get 19.5% interest and I (or my Roth IRA) gets a 2.5%. interest. The investors would get 97.5% of the tax deductions under this approach (as opposed to 20-25% under option #2 and none under option #1). More on that below.
The LLC would borrow $600k at 5.5% , ten year note but 30 year amortization. Purchases four multi-family properties in Texas, in a stable market that has thus far been relatively unaffected by the burst of the housing bubble (3 of the 4 properties are near college campus with a steady stream of renters). Aggregate purchase price ~$800k.
Important numbers: Debt service = $3,400 /month. Tax, insurance & maintenance = $3,100/month. Total expense = $6,500/month. Projected income = $9,600/month. Free cash flow = $3,100/month – applied to retiring the bank loan (not the investors' preferred return--yet).
I am assuming that projected income will rise at the same rate as taxes and insurance, leaving free cash flow a constant (and making math easier). All free cash flow will be plowed into retiring the debt, and the tax & insurance component of monthly income will be put into an interest bearing account (earning about 1.5%) until those expenses are paid at year’s end. Also the $50k reserve fund (balance of the $250k capital contribution) will be in an interest bearing account.
After 4.5 years (end of 2014), the $600k loan balance will be reduced to $365k. The $50k reserve account (if untouched) would be $53.5. The tax and insurance fund would have accumulated $4k worth of interest. Assuming a 3.5% property value increase per year, the properties should be worth $922k, which would (at 80% LTV) yield $738k.
Add back in the $50k side account plus interest, and the $4k tax and insurance account, and I’d have an additional $57.5k, for a total of $795k. From that I have to pay off the existing loan (-$365k) and the investors’ $250k plus 10% return (-$365.6k). That would leave me as the sole owner of the LLC, with a reserve account of a little over $53k, and over $922k worth of income producing properties with 20% equity – compliments of my investors, renters and lender.
Yeah for me!
I assume I could get comparable terms in 3.5 years, and would have a 30 year fixed rate note at something under 6%. Assuming modest rent increases and a 5.5.% loan rate, I would be looking at debt service of $4,038 per month, tax and insurance expense of $3,145, for total expense of $7,183, against income of $9,900 per month. That would leave over $2,700 per month in free cash flow (less than earlier stated because loan balance is higher).
As before, I would plow that into retiring the debt, and in 8 years (when my oldest starts college) I would have the loan balance down to $537k. At that point, I would divert $2,000 per month of the free cash flow (still applying $700 to principal reduction) for 4 years to help pay for college, then resume payments for one year, and repeat the process when child #2 hits college. After he is out of college, I would resume applying all of the free cash flow to debt reduction, and have the whole thing paid off in under 20 years. Which also jibes with my anticipated retirement. At that point, the properties should be worth well north of $1.5M and monthly cash flows of $7,000.
So there is the plan. Now for where I need input. How is the best way to pitch this to investors? If I was approaching you, what more would you want to hear? And how exactly do I downplay the fact that I am using OPM to make a nice nest egg for myself?
Under Option #3, the LLC would have profit (to be passed through to members while I have investors still in the deal) of a bit over $36,000 per year (that is what gets plowed into accelerated debt repayment). But the LLC would have deductions that far exceed that, so the investors will see a net tax advantage (I think). The tax deductions include loan interest paid ($16k in yr 1, $30k, $28k, $25k and $22k in years 2-5). Also property tax paid ($18k in year 1, $38k and up in subsequent years). Also, the properties would depreciate at 3.6% per year, so $29k per year. All total, I estimate the deductions through end of 2014 will total over $400k (versus $165k in profits). That would work out to $80k per investor over 4.5 years, and assuming they are in the 28% tax bracket, those deductions should be worth maybe $5k per year to them in tax savings. CPAs, please jump in with exact figures. And I do have plans to consult a CPA when I am preparing what I will show to investors. PS -- I am an attorney and can cover the offering PPM in-house (and also deal with any evictions, if necessary).
I don’t want to lead with the tax advantages (a wise investor told me years ago that if you are selling a deal based upon the tax breaks, you need not bother pitching it to entrepreneurs and should be [itching to a different audience). However, I do think it is a cherry on the top of a 10% annualized return (with the RE as security) and an exit in under 5 years. I have a dozen potential investors in mind, that I have pre-existing relationships with and that I know have gotten out of the stock market because they are too jittery.
When I cash out the investors, each gets a 10% annualized return, and some not too shabby tax breaks over that time. I get zero cash flow for 4.5 years, but after that I own all of the LLC, which owns $900k+ worth of RE with 20% equity, and $2,700 per month in cash flow. As I mentioned above, I pull out $2 grand per month while my kids are in college to defray their costs, and still get the whole thing ($1.5M probable property value) paid off in under 20 years, just in time for MY retirement, at which time I would have a $7,000 per month positive cash flow. And if I do this once a year, I can retire a lot sooner! So I can see why I want to do this.
Other than paying up the 10% annualized return, security of the RE backing the deal, exit strategy to get them out in under 5 years, and tax advantages, how can I make the pitch even more attractive to investors to give me that capital jump start that I need?? What angle am I missing, or not highlighting?
Thanks for reading this far. I thank you in advance for your constructive criticism.
PS. If anyone can point me to some software that will help me calculate cap rates (or explain how to calculate it in Excel), that would be appreciated (and probably make my presentation a bit better).
My idea is basically using OPM to build a real estate (RE) portfolio. There are a couple of different ways to spin the pitch to investors, and different ways to include the investors in the deal. I need advice on which method is best – please look at this as someone is pitching the idea to you -- which way most piques your interest? What more would it take to get you to part with your money? What questions do you have that I have not answered?
Also, if you see any holes in my planning, please chime in (but please note, there are a couple of areas where I suspect the discussion could take a turn and go down a path I think I already have covered—no offense, I just would prefer to keep the discussion focused – so those areas are noted).
I have four multi-family properties I am eyeing (SFH converted to duplex with garage apt, a pair of 4-plexes, and a 6-plex mini-apartment. Combined purchase price would be about $800k. I need investors to pony up $250k. I will borrow $600k, leaving me with $50k in reserve. I have financing lined up at 5.5% on a non-recourse loan (ten year note, 30 yr amortization). This means of financing would enable me to have my self-directed Roth IRA be the owner rather than me. (Please don’t get sidetracked by the Roth IRA issue.)
The beauty of this is that I can repeat the process with additional investors on additional properties in the future -- I just need to fine-tune my pitch.
I think there are a couple of ways to approach the investors, and this is where I am in new territory. (1) Approach as hard money lenders, offering a decent return but not excessive – maybe 7.5%. The note would be short, 5 years max. This idea does not really appeal to me, because if someone hit me up, I would ask why they didn't just go to a bank? (2) Approach investors on a property by property basis. Close each property into an LLC (a compartment of a Series LLC) and have the investors be in on that deal only. Investors contribute 20-25% of purchase price and have equivalent equity in the LLC, and take that much of the income stream. This is a bit more work for me (as opposed to #3) and I don't have as much upside because I don't own 100% of the deal. OR (3) Close all purchases into one master LLC, with investors in that master LLC so they have their risk spread out by 4 rather than concentrated into 1 property – but have the LLC Agreement state that investors can be bought out by the LLC for a return of capital plus a stated rate of annualized return (I was thinking 10%) at any point within the first 5 years. Not sure I can swing this under approach #2.
For what it is worth, my lender would prefer option #3, but is not opposed to any of the 3. I think the LLC for the portfolio (option #3) – with the clearly defined exit strategy for them, plus valuable tax deductions -- might be the easiest sell to investors. Although I could do an exit strategy with the investor per property approach, it is much more difficult (basically with option #3 I get to hold the investors’ preferred return and pay down the portfolio loan quicker, then refinance the loan to give them the 10% return). Please don’t get sidetracked by the details of the exit strategy.
Also, the tax deduction aspects of the deal are best in the master LLC angle. Under the master LLC approach, the investor-members each get 19.5% interest and I (or my Roth IRA) gets a 2.5%. interest. The investors would get 97.5% of the tax deductions under this approach (as opposed to 20-25% under option #2 and none under option #1). More on that below.
The LLC would borrow $600k at 5.5% , ten year note but 30 year amortization. Purchases four multi-family properties in Texas, in a stable market that has thus far been relatively unaffected by the burst of the housing bubble (3 of the 4 properties are near college campus with a steady stream of renters). Aggregate purchase price ~$800k.
Important numbers: Debt service = $3,400 /month. Tax, insurance & maintenance = $3,100/month. Total expense = $6,500/month. Projected income = $9,600/month. Free cash flow = $3,100/month – applied to retiring the bank loan (not the investors' preferred return--yet).
I am assuming that projected income will rise at the same rate as taxes and insurance, leaving free cash flow a constant (and making math easier). All free cash flow will be plowed into retiring the debt, and the tax & insurance component of monthly income will be put into an interest bearing account (earning about 1.5%) until those expenses are paid at year’s end. Also the $50k reserve fund (balance of the $250k capital contribution) will be in an interest bearing account.
After 4.5 years (end of 2014), the $600k loan balance will be reduced to $365k. The $50k reserve account (if untouched) would be $53.5. The tax and insurance fund would have accumulated $4k worth of interest. Assuming a 3.5% property value increase per year, the properties should be worth $922k, which would (at 80% LTV) yield $738k.
Add back in the $50k side account plus interest, and the $4k tax and insurance account, and I’d have an additional $57.5k, for a total of $795k. From that I have to pay off the existing loan (-$365k) and the investors’ $250k plus 10% return (-$365.6k). That would leave me as the sole owner of the LLC, with a reserve account of a little over $53k, and over $922k worth of income producing properties with 20% equity – compliments of my investors, renters and lender.
Yeah for me!I assume I could get comparable terms in 3.5 years, and would have a 30 year fixed rate note at something under 6%. Assuming modest rent increases and a 5.5.% loan rate, I would be looking at debt service of $4,038 per month, tax and insurance expense of $3,145, for total expense of $7,183, against income of $9,900 per month. That would leave over $2,700 per month in free cash flow (less than earlier stated because loan balance is higher).
As before, I would plow that into retiring the debt, and in 8 years (when my oldest starts college) I would have the loan balance down to $537k. At that point, I would divert $2,000 per month of the free cash flow (still applying $700 to principal reduction) for 4 years to help pay for college, then resume payments for one year, and repeat the process when child #2 hits college. After he is out of college, I would resume applying all of the free cash flow to debt reduction, and have the whole thing paid off in under 20 years. Which also jibes with my anticipated retirement. At that point, the properties should be worth well north of $1.5M and monthly cash flows of $7,000.
So there is the plan. Now for where I need input. How is the best way to pitch this to investors? If I was approaching you, what more would you want to hear? And how exactly do I downplay the fact that I am using OPM to make a nice nest egg for myself?
Under Option #3, the LLC would have profit (to be passed through to members while I have investors still in the deal) of a bit over $36,000 per year (that is what gets plowed into accelerated debt repayment). But the LLC would have deductions that far exceed that, so the investors will see a net tax advantage (I think). The tax deductions include loan interest paid ($16k in yr 1, $30k, $28k, $25k and $22k in years 2-5). Also property tax paid ($18k in year 1, $38k and up in subsequent years). Also, the properties would depreciate at 3.6% per year, so $29k per year. All total, I estimate the deductions through end of 2014 will total over $400k (versus $165k in profits). That would work out to $80k per investor over 4.5 years, and assuming they are in the 28% tax bracket, those deductions should be worth maybe $5k per year to them in tax savings. CPAs, please jump in with exact figures. And I do have plans to consult a CPA when I am preparing what I will show to investors. PS -- I am an attorney and can cover the offering PPM in-house (and also deal with any evictions, if necessary).
I don’t want to lead with the tax advantages (a wise investor told me years ago that if you are selling a deal based upon the tax breaks, you need not bother pitching it to entrepreneurs and should be [itching to a different audience). However, I do think it is a cherry on the top of a 10% annualized return (with the RE as security) and an exit in under 5 years. I have a dozen potential investors in mind, that I have pre-existing relationships with and that I know have gotten out of the stock market because they are too jittery.
When I cash out the investors, each gets a 10% annualized return, and some not too shabby tax breaks over that time. I get zero cash flow for 4.5 years, but after that I own all of the LLC, which owns $900k+ worth of RE with 20% equity, and $2,700 per month in cash flow. As I mentioned above, I pull out $2 grand per month while my kids are in college to defray their costs, and still get the whole thing ($1.5M probable property value) paid off in under 20 years, just in time for MY retirement, at which time I would have a $7,000 per month positive cash flow. And if I do this once a year, I can retire a lot sooner! So I can see why I want to do this.
Other than paying up the 10% annualized return, security of the RE backing the deal, exit strategy to get them out in under 5 years, and tax advantages, how can I make the pitch even more attractive to investors to give me that capital jump start that I need?? What angle am I missing, or not highlighting?
Thanks for reading this far. I thank you in advance for your constructive criticism.
PS. If anyone can point me to some software that will help me calculate cap rates (or explain how to calculate it in Excel), that would be appreciated (and probably make my presentation a bit better).
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