“I would never pay your rates!” Almost every private money lender has heard this line time after time in discussions about financing a real estate project. Sometimes, they are right; it does not pay to leverage holdings. But the answer is not as easy as getting a high rate and saying, “I don’t like debt.” While the cost of a loan may sound pricy, the cost of an equity partner can be incredibly expensive.
Paying 12 percent to 15 percent in interest automatically deters a number of developers and potential borrowers. But few people have the cash to do the necessary work required to get a project to the next stage. Buying additional land, entitlements, engineering, architecture, construction, soil studies and a host of other kinds of improvements certainly enhance the value of any project, but they also cost money. Covering the costs of those improvements can come in one of three ways; out of pocket, obtaining partners or borrowing. If the money is not sitting in the checking account, you may want to consider a few things before scoffing at paying 12 percent and taking a partner. Let’s assume:
• You bought five acres of land for $1 million
• You need another $1 million for improvements
• Once improved, you can sell that land for $3 million after 3 years.
A) Take on a 50 percent partner to raise the $1 million , or
B) Borrow $1 million of hard money for one year at 12 percent and convert to a bank loan for two years at 8 percent.
As the example clearly shows, it was far more expensive to take on a partner than it was to borrow money, even at a high rate. The rate of return was higher and more money in your pocket at the end. A number of considerations should go into this model with the most important being a comparison of the ultimate sales price with the total potential cost of interest. While it seems obvious, it is worth pointing out that if you believe your project can yield high rates of return, the more you should be willing to pay in interest, and the less you should want to take on an expensive equity partner. If your project has narrow margins, forgo costly debt and consider taking on a partner instead.
This is a simple, realistic investment model, however, there are other considerations to partnerships and leverage. Many people have experienced a partnership so disastrous they would pay any amount of interest to avoid repeating it. On the other hand, real estate investing is a risky proposition, and much can be said for sharing that risk, regardless of the ending rate of return. Control is also a consideration. When borrowing, the only areas of control you give up in your project are the ones outlined in your loan covenants. In partnerships, control can be a significant variable.
Every investment stands on its own and has a number of variables and differing criteria. But next time you receive a loan proposal quoting a high rate of interest, don’t be so quick to dismiss the option of borrowing hard money. It may be the easiest way to save hundreds of thousands of dollars.