Silent Partner Rate of Return For House Flip

[Petar Radakovic]

Hi everyone.  I'm in a bit of a tricky situation as I have a good family friend of the past 20 years looking to invest anywhere from $500k-1M.  To give a bit of background, I am a contractor in the DC area focusing on buying distressed properties, renovating them and/or building new, and selling them.  I am currently in the middle of one project and looking to line up the next house flip with this investor.  I am unsure of what kind of rate of return I should offer him, but here are my thoughts:

On the current project we are doing, we financed the acquisition through a hard money lender at terms of 5 points at closing and 14% interest only, 1 year balloon mortgage.  It is steep, but this is our first major house flip so I am not expecting the best rate starting out.

We were initially looking at doing construction financing to take over the HML and finish out the project, but ultimately made the decision to cut our budget and use our own cash to finance construction and just get the project done as quickly as possible (long story short, we were misled by a real estate "expert" with the CMAs and realized we probably couldn't sell the house for as much as we thought, so our goal here is to get out ASAP, but that is besides the point...). What I do know here is that the bank was offering between 4-5% on construction financing.

So that being said, there are also a couple of ways the investment relationship could work:

1) My investor functions strictly as a lender, using round numbers for example, let's just say he loans us $500k at some fixed interest rate over a period of time, and we make monthly payments to him over time. My thoughts are if a bank charges 5% and our HML charges 14%, then a fair rate would be somewhere in between those two numbers, closer to the bank rate, maybe 7-8%?? Either way, it could be structured as either a 1-2 year interest only balloon loan, or a conventional payment structure where each payment pays down part of the principal as well. In this scenario, the investor is not tied to the property and taking any of the specific investment risk, but is simply making money off of us as a lender. It could also just be considered a working capital loan in this case.

2) The investor partners with us in an LLC solely for a specific property and finances the acquisition and construction. In this scenario, we would need roughly 30% equity in the overall cost. Say for example it's a $1M package to buy/renovate, we would need $300k equity plus some working capital. We do all of the work through our construction company, where we are paid our salaries as well as some profit margin (roughly 10% of construction costs). Upon the sale of the property, any outstanding liabilities are paid off, the investor gets his money back, and then the profits from the capital gains are split on an agreed upon percentage. I have heard the term "70/30 split" loosely thrown around by some of my friends who are in commercial real estate. My understanding of a 70/30 split is the investor gets 30% of profits and we take 70% because we, as the construction company, put in all of the work and the time to make the renovation happen so it is fair that we get more than a silent partner because we did all of the work.

Option #1 appears to cost us much less in financing costs, but I do not have a good grasp on what a fair return would be for a private lender.  I am also thinking putting myself in their shoes, using an example of $500k interest only for 1 year at 5%, why would I tie up $500k of my money for an entire year to only get back $25k?  Maybe I am wrong in this train of thought, but any opinions are welcome here.

Option #2 has us splitting more profits with the investor and appears more appealing to the investor than just being a simple lender, but the investor is also liable for the risk along with us (if the home doesn't sell or construction costs too much or anything else that could occur).  Again, I'm not too experienced with what a fair return would be in this situation so any thoughts are appreciated.

[Brent Coombs]

@Petar Radakovic, if I was your Investor, I'd be looking for closer to the HML Rates than some imaginary "4-5% on construction financing" (because if you could GET that, why would you even be asking me?) I most CERTAINLY want a much better return than $25k if risking $500k!

And, I'm not interested in a 70/30 split either, even if the 70 was in my favor (which you're not considering anyway) - if it means I'm up for the same proportion of any losses!

The main issue I have with your proposal is: you're STILL unproven (to my satisfaction).

[These are the sort of responses from your investor you should prepare yourself for. If you can come up with successful retorts in order to get your own desired terms - kudos!] Cheers...