When it comes to raising capital for real estate entrepreneurs, it’s important to preserve your ownership. More partners means more dilution and less profits on deals. What many people don’t know are the key ways to raise liquid capital while maintaining your share.
1. Leverage Your Illiquid Net Worth
There are two ways to leverage your net worth. The first is to take a second position loan on your property. This is easiest for wholly owned properties, as properties owned by partnerships require the partners to agree to having a second position loan.
The second way is a loan on your partnership interests. This is a much more specialized type of loan. In any case, it’s important to structure the loan properly – being mindful of covenants between senior lenders on the property as well as any partners in the deal.
What is illiquid net worth?
Illiquid net worth is equity on a real estate entrepreneur’s balance sheet that cannot readily be converted to liquid cash. Illiquid net worth prevents real estate entrepreneurs from doing more deals and growing their portfolio.
There are a few reasons that cause trapped liquidity in your net worth.
First, the equity you have in properties may be tied up with senior debt prepayment penalties. This means, if you want to sell or refinance, you need to pay extra fees to the senior lender to pay off the loan.
Other terms for prepayment penalties include defeasance (for CMBS conduit loans), and yield maintenance or breakage (for loans with rate swaps).
Second is low available loan-to-value, or LTV, from senior lenders in the marketplace. Senior lenders can only go so high in leverage, which leaves you cash-strapped in properties. By structuring a second position loan behind the senior lender up to 90% LTV, you can free up some of that illiquid net worth.
Lastly, is that many real estate entrepreneurs have their net worth tied up in partnerships across various deals in your portfolio. This can mean that any major capital events need to be approved by your partners who may have goals that are contrary to your own. These partnership interests may be comprised of limited partnerships or general partnership interests.
As a result, any equity you’ve built in those properties may not be readily accessible through a refinance or sale. Therefore, it may make sense to look into a loan on your partnership interests that doesn’t affect other partners in the deal.
Utilizing Your Liquid Net Worth
It is important to have liquid net worth in order to take on new deals without adding partners and giving away ownership. If a real estate entrepreneur has net worth tied up in illiquid equity positions, then second position loans and loans on partnership interests can be used to unlock this trapped liquidity. Having greater liquidity on your balance sheet allows you to take advantage of new opportunities as they inevitably arise.
2. Cash Out Refinance on Properties You Own
Assuming the properties you own don’t have prepayment penalties, this may be a good option. This typically involves refinancing existing debt to long term, low-cost permanent debt at the highest level of leverage possible.
The proceeds of the new loan go to pay off the old loan and any closing costs. The remainder of the proceeds are liquid funds that can be used for the purchase of additional property, or improvement of the property.
This can also be done in conjunction with a second position loan to maximize proceeds above what any senior lender is typically able to provide. It helps if you are refinancing into a loan with a lower interest rate and extended amortization beyond the existing loans.
3. Seller Financing
What is seller financing?
Seller financing is when the seller of a targeted property acquisition “carries back” or holds back part of the purchase price requirement as a loan. Oftentimes, the seller will be open to leaving their loan in second position behind a senior loan. This means that the down payment required for a real estate entrepreneur is substantially reduced, and in some cases eliminated.
Typically, lenders in the marketplace who allow for a seller loan will still like to see some cash equity from the borrower. The rule is about 10% of the total cost of the transaction. However, in some instances, you can contribute sweat equity in lieu of much of the required cash equity.
4. Sweat Equity
Build sweat equity before closing on your purchase.
In special cases, financing can be obtained for close to 100% of a property acquisition if the buyer is able to add value to the property ahead of the purchase. In many cases, we’ve seen buyers who arrange leases with new tenants in their “back pocket”. Meaning they have tenants lined up for the purchase. This creates value ahead of the purchase transaction by boosting occupancy, average lease term, or revenue.
This strategy is most relevant for properties with long term leases vs shorter term leases like multi-family property. But, there may be creative ways to add value for multi-family property.
Sweat equity can also come in the form of physical improvements to property, as well as improvements to the operating efficiency to boost net operating income (NOI).
In these cases, it’s important for the appraiser to reflect that value as being well above the purchase price of the property. This dynamic allows for the senior lender to be more flexible on any cash equity requirements.