Wednesday, May 6, 2015
Safer Deal Structuring
He tested the audience Investor IQ for asking for feedback on how to structure the SAFEST possible deal for passive income. There were five loan options, and six down payment options. Every single option was chosen by someone in the audience as their correct answer to this quiz. Yet, he insisted there was a correct answer to each aspect of the deal structure.
His formula opted for the lowest loan constant of the various financing options. So although the 6% simple interest-only option had the highest interest rate of the five choices, it had the lowest loan constant. The loan constant is in actual payment price, where the lowest payment will provide the investor the greatest safety in their investment. The loan constant is the actual payment divided by the amount borrowed as the loan.
I like interest-only payments for my investments, and have used this quite successfully on both my Ballard single-family rental house and on my commercial land purchase in the Rainier Valley. Such financing helps me maintain several disposition options (potential exit strategies) on each property.
The bigger the spread between the capitalization rate (cap rate) and the loan constant, the higher the returns. Cap rate is the ratio of the net operating income derived from an income-producing asset relative to its capital cost. Antone also used Debt Coverage Ratio (how much more more you make vs. what you pay the lender), and Break Even Ratio (how close you are to breaking even) as measures of risk; with Return on Investment and Cash Flow as measures of profitability. He argues that measures of return need to be balance with risk. Sophisticated investors care more about their return OF investment than their return ON investment.
The safest option for down payment, according to George Antone, was borrowing funds from a private lender for a share of the equity rather than making monthly payments. It was safer than using your own funds, using credit card promotions, or making monthly payments to a hard money or private lender.
Safe does not necessarily mean the highest return. But over the weekend, Antone had the participants do some exercises to determine the safest options to generate the maximum amount of income. Through these exercises it was possible to compare different asset classes of real estate, and even different types of investments, using some common measures of investment.
To lower risk, Antone suggests to increase the spread between the cap rate and the loan constant; lower the leverage (borrowed funds) and increase the number of cash or equity partners; lower the loan constants on the leverage; and use money for reserves.
Participants received copies of Antone's class workbook, a jump drive with analysis software, and his newest book The Wealthy Code. It was a content-rich weekend of learning, role-playing and analysis - one of the best I have ever attended. It certainly will affect the way I structure and analyze deals in the future.
Another example of why joining your local real estate investment association is one of the smartest investments a real estate investor can make.
Thank you, REAPS!