When Should You Pay Your Private Investors?

It wasn't long into my first private money deal that I realized my mistake.

Yikes.

I had promised to pay my private investor in monthly, interest only payment each month for up to 5 years.

Cash flow started to get a bit tight. The operating expenses for the lease-option house had spiked on me - unanticipated repairs.

Dang.  I should have saw that coming, right?

There was plenty of equity in the deal and the investor was quite happy to have their funds out of the stock market - but my profits were just about nil after I paid my investor each month. This was not good. I needed some cash flow, too. Interesting problem to say the least.

I didn't want to change things at this point and upset the applecart. No sense in trying to re-do the paperwork. Better to leave well enough alone.

In hindsight, I should have set the private investor up to accrue their interest and get paid off in a lump sum once the property sold. Instead, I had crimped my cash flows and virtually eliminated my month-to-month profits. Sure, I would make it up on the back end, but that was still 18-24 months out at that time.

Not fun.

Ever since then, I've learned a few valuable lessons about structuring private money deals.

First, how you structure the deal from the beginning is mission critical. Kind of like oxygen for a space mission. Gotta have it. I didn't set this one up the right way. In fact, the investor should have been an equity partner with me instead of a lender. We both would have been happier. Second, even leaving them as a private lender, setting it up to accrue interest versus monthly payments would have been better. It would have given me a better cash flow cushion in case of the unexpected.

-As an aside, for your first investors, it may be better to make payments right away.  Show good faith. People like getting checks (don't you?).

Secondly, I learned to better analyze deals where I was bringing in private money. Marginal cash flow deals with big equity weren't enough to cut the mustard anymore. I needed to be sure each deal could comfortably pay my investors (and myself) with plenty left over.

Don't run your deals close to the red line.

The "red line" analogy comes from race cars. There's a meter -called a tachometer - on most cars (yours probably has one, check it out) that measures how many times the engine is turning over each minute - called Revolutions per Minute (RPM) The more revolutions per minute your engine has, the harder it is working. There is a natural limit on most engines for how fast they can turn without blowing up. Each car tachometer has a territory behind where the numbers lie that is color coded. Red is bad. The closer your needle gets to red, the closer your car is to blowing up.

The same thing is true in real estate investing. The closer your deals run to the 'red line' - the income/expense ratio or equity/debt ratio - the closer your deal is to blowing up.

For private money, structure your payments to investors so that you stay as far away from the 'red line' as possible. If your project is a long term turnaround, don't set up monthly payments from the start that could pinch you. If you the ability to pay monthly quite easily but don't, I think you're making a mistake.

Each deal you do has to make sense for everybody. You should be willing to give up some, but not all of the deal to the investor. If everybody's not making money, it's no fun.