Everyone wants to jump right into their first deal. 99% of people will do this the wrong way and miss out on thousands and possibly millions of dollars (depending on how big the deal is and how many deals they do). I’m going to go through the best ways to set up your first deal (or any deal) starting from the method most commonly used to the method that everyone should be using (but is rarely, if ever used – I only know one person who uses method 3 and he’s worth ~$20mm before age 40). All of these methods are assuming that you have very low startup capital and are doing deals with other people’s money.
From worst to best, the methods are: charging an asset management fee, charging a promote over a certain IRR hurdle, charging a promote based on an equity multiple hurdle and getting a high leverage loan (hard money, seller financing, etc.).
The consistent theme? Get to the equity at all costs.
Method 1 – Charging an Asset Management Fee
This is by far the worst method and should only be used if you have no other options. Unfortunately, a lot of people end up going this route because they don’t run the numbers and can’t delay gratification (they want the immediate cash in Year 1). No matter how you slice it, this method does not make the returns palatable. In a typical asset management fee structure, you take 2% of the equity. It’s honestly not even worth doing a small deal at these terms unless your only incentive is to build a track record.
What’s wrong with this strategy? You’re not getting to the equity. If the property’s NOI increases 50%, none of that increase will go into your pocket. On a sale you’ll get zero residual value. You get none of the upside. To make matters even worse, this income is not tax advantaged (because you do not own any equity in the actual property). Avoid this method at all costs, unless you are simply using your first deal to build a track record to chase subsequent deals.
Method 2 – Charging a Promote Over a Certain IRR Hurdle
With this method, you’ll be charging a promote over a certain hurdle rate. What does this mean? This means that once the deal hits a certain IRR (8% is the typical amount), you’ll receive a certain percentage of the profits (typically 20%).
Why is this a good structure to use? 1. It gives you full participation in the equity upside of the deal, but no participation in the downside (unless you decided to put equity into the deal as well or you are guaranteed on the loan.). 2. It aligns your interests with the interests of your investors (you don’t make any money unless the deal goes well). 3. The cashflow isn’t weighed down by heavy deal costs such as an asset management fee (almost all your distributions will come at the sale with an IRR-based promote).
This is a good structure for private equity deals but it’s important to make sure that it’s a good structure for *your* deal. The IRR metric is mainly valued by institutional funds, rather than by small-scale investors. In fact, I’d be willing to be that your investors won’t even know how to define the term. Aside from the fact that confusing your potential investors with a complicated structure will make it nearly impossible to raise equity, most of your investors will actually be looking for a different metric, “cash-on-cash”. The cash-on-cash return is simply the post-debt cashflow divided by the initial equity investment (see below for more on this in method 3).
As a benchmark, you should be charging a 20% promote at minimum. That is absolutely standard for the industry – any lower and you’re actually cheating yourself. Since your first deal will most likely be a friends and family deal, you should actually be getting a sweetheart deal on your promote. For example, I’m getting a 50% promote on my first deal – this isn’t industry standard and you should not expect to receive this going forward.
Method 3 – Charging a Promote Based on an Equity Multiple Hurdle
This method is very similar to the method above (method 2), aside from one primary difference. With this method, once you are in the money, you stay in the money. In the method above, let’s say you had been cruising at a 10% IRR for the first 5 years of the deal. Now, for the last 5 years you log a 2% IRR. What happens now? To put it bluntly – you’re screwed. You’re no longer in the money and will most likely net zero dollars on the deal, which is a huge waste of time. Method 3, however, allows you to consolidate and hold your gains (once you return a equity over a certain equity multiple hurdle it’s nearly impossible to dip back under that hurdle unless you issue a capital call).
Another benefit of this method is that it focuses on the cash-on-cash metric mentioned above rather than IRR. Your investors are going to want to know how much money they will be getting back per year. With this promote structure, you’ll be able to maximize their yearly cashflow, while also shortening the time frame in which you’re “out of the money” (shortening the time it takes for you to hit your equity multiple hurdle). Say your cash-on-cash is 20% – then you know you’ll hit a 1x equity multiple in 5 years. You’re able to hit this multiple quicker because you have no heavy deal costs (an asset management fee) weighing down the deal.
Most importantly, the way method 3 is structured, your promote simply becomes equity once the multiple is hit. What you’re doing here is leveraging your time investment (assuming you had put no money down) into 20% equity in the property. I cannot emphasize enough how important this is – leveraging your time into equity is how you become rich.
Lastly, the final reason that this method is better than method 2 is that it is far easier to calculate. Instead of having to create a returns waterfall to calculate your promote, you simply start taking 20% (or whatever percent you agreed on) of the cashflow once the equity multiple hurdle is hit.
Method 4 – Getting a High Leverage Loan
Essentially what you’re doing here is getting a loan for as high of an amount as possible so that you can own the entire deal with a small down payment. This is not a bank loan as they won’t give you high enough leverage – you’ll have to turn to private sources (you’re looking for 90%+ leverage).
Why is this the best model? Since your “investor” is actually a lender, you actually own the entire building. You end up with 100% equity.
Obviously, doing this comes with more risk. Since you levered the property up so high, you now have a huge debt load that you have to pay off. If the market turns south, you could be in deep trouble. Since you have all of the upside, you also have all of the downside as well. Risk reward profiles exist for a reason.
The most important thing to keep in mind through all of this – no matter what structure you chose, do not deliberately mislead or screw over your investors. Aside from being morally wrong, the whole idea is that you have an investor base that grows with you. It is infinitely better to have terms that are a slightly worse on your first deal and to have that investor keep investing with you than to fleece your investor and never have them invest with you ever again.
To close everything out, I want to put some hard numbers out there so you can conceptualize this difference better.
Assumptions:
- $250,000 purchase price
- 10% initial cap rate
- 10-year hold
- Property appreciates 3% per year
- Value-add deal in which the NOI increases 50% in the first year, then 3% thereafter
- 70% leverage
- 4.5% interest rate
- 1x
equity multiple hurdle on the promote structure
- 20% promote
Method 1 – Charging an Asset Management Fee
Asset management fees are usually charged on equity invested. Say the purchase price is $250,000 and the deal follows a typical 70% debt and 30% equity structure, that leaves you with $75,000*2% or $1,500 dollars a year. One hundred bucks a month. This is literally not worth your time to pursue. At the end of the 10-year hold period, you will have a whooping $15,000 dollars. Needless to say, this doesn’t cut it, which is why this is listed as the absolute worst method.
Methods 2 and 3 – Hurdle Based Promotes
For the purposes of this quick illustration, I’ll group methods 2 and 3 together. Unlike in method 1, you actually participate in the upside that is generated from adding value in Year 1. In this scenario, your profit over a 10-year hold would be ~$82k (combining the residual value won the sale and the cashflow during the hold period). Your return is over 5x higher than if you’d chosen to accept a management fee instead (and it’s tax advantaged as well).
Method 4 – Getting a High Leverage Loan
At 95% leverage and a 4.5% interest rate, you would be turning your initial investment of $12,500 into nearly $400k (total profit is ~$384k over 10 years). Needless to say, this is an incredible return and you should do every deal with this structure that you can get your hands on. Just remember that you’re taking a proportionate amount of risk to get this return.
In summary, you always want to get to the equity in any deal you do (this doesn’t only apply to real estate). Getting to the equity allows you to participate in the upside, which is where the money is made. Of all the methods presented in this article, method 4 is the best. However, it’s very rarely repeatable. Banks will not give you a very high leverage loan, so you have to turn to either seller financing (which is highly unreliable and affects the actual mechanics of deal – the deal literally can’t get done if you don’t use it. This can lead to you missing out on good deals, simply because you have a poor deal structure.) or to a hard money loan from a friend (also probably not repeatable). Method 3 is generally the best structure simply because it’s actually scalable and repeatable. Any deal you find, you can set up with an equity multiple promote (it doesn’t affect the actual mechanics of the deal).