I get asked a lot of questions, and the answer I'm often tempted to give is "how long is a piece of string?" And look, I understand. The person asking the question is learning, and they're asking the question because it will help them take the next step on their journey to become a property developer.
The problem is, so many questions don't have a simple, exact answer. Why? Because every deal is different. And although I don't say anything about string, my go-to answer of "it depends!" is basically the same thing.
The person who asked the question doesn't usually like it much, but that's the best answer I can give - at least until I have more information about a particular development deal.
So let's run through some things to consider when you're trying to answer the question "What should I pay a money partner?" with something more specific than "it depends!".
Type of Agreement
First up - what sort of agreement are you going to have with your money partner? These generally fall into two main categories:
There are also two main ways of paying a money partner:
Now, a lender providing a 1st mortgage at 80% LVR on a residential property is in a relatively low risk position. Quite a lot will have to go wrong for the property to lose more than 20% in value. So in return, they generally get the lowest interest rate out of all these options.
When you get to the bottom of the list of security types, the lender is in a much riskier position. If something goes wrong, the lenders with first and second mortgages will get paid out first, and if the market has tanked completely, there's a chance they might not get paid out all of the funds they've put into your project. Therefore they're going to expect you to pay a high rate for the funds.
As an example, a standard home loan interest rate from a regular lender such as a bank is going to be right at the bottom end of the range. A private lender with an unsecured loan is going to be at the top end - sometimes as high as 30%.
Risk Factors: Now you have a rough idea of where the loan you need is likely to fall on the spectrum, the other thing to consider is risk factors. Although it potentially won't make much difference to the interest rate if you're getting a first mortgage from one of the big banks, risk can have a huge impact on the interest rate when it comes to private lending. After all, rates of 20% or more are quite common for private lenders.
Experience: If this is your first time out of the gates as a Property Developer, expect to pay higher rates. Obviously a lender wants to know their money is going to be used safely and effectively, and if they can see you've done ten identical projects already, and they've all made the expected profit, naturally they're going to feel confident the same will happen with the project they're lending their funds for. They're more likely to lower their rate. They're definitely not going to be as comfortable with someone without that track record.
Rate of Return: There are different ways of calculating this (don't get me started!) but in essence, the bigger the rate of return, or the higher the level of profit, the less risky the development deal becomes. Essentially, there's more fat in the deal in case things go wrong. So higher profit usually means a slightly lower rate, although not always.
Amount: An investor putting $50k into a deal is going to feel less at risk than an investor putting $1m in. Although neither of them would want to lose their money, $1m is going to cause way more pain than $50k, and the interest rate will reflect that risk. You may have heard the saying "don't put all your eggs in one basket" and that applies here. Putting $1m in one deal is much riskier than putting $50k each in 20 deals.
Time: How long is the deal going to last? Markets change over time, so a short deal is generally considered less risky because there's less time for market conditions to change. Now, it's quite possible that a longer timeframe will mean the market's actually gone up, and so higher prices for the end product will increase your profits. But it also increases the risk of the market moving against you, too, so that affects the interest rate.
A loan agreement might also include an element of profit sharing, but I'll cover that as part of JV agreements. Nonetheless, that share will be influenced by the same set of risk factors.
Joint Venture Agreement
Working out how to pay a money partner in a JV scenario is a little different. Generally JV partners are each allocated a share of the profit, rather than an interest rate. So consideration needs to be given to the role each person is going to play in the joint venture.
Depending on the type of deal, there are four major elements to consider:
The profit split varies depending on the type of deal, and what you negotiate between you. For example, if you're doing a renovation as part of a deal, and the working partner is going to do a lot of the work themselves, that piece is important and a potential split might be 25% each.
If the deal is more of a paper shuffle through town planning, then you might fold the knowledge and working partner into one share, and allocate 1/3 each.
The risk factors mentioned in the loan agreements section also need to be considered. Essentially, though, for a JV you start off with a pie, and how that pie is divided is likely to be different for every deal.
Despite all the information I've just given you, the answer to the question "What should I pay a money partner?" is still "it depends". Hopefully, though, you now have a better idea about what factors are useful when determining the answer, and have a better starting point when you enter into negotiations with your potential money partners in the future.
The problem is, so many questions don't have a simple, exact answer. Why? Because every deal is different. And although I don't say anything about string, my go-to answer of "it depends!" is basically the same thing.
The person who asked the question doesn't usually like it much, but that's the best answer I can give - at least until I have more information about a particular development deal.
So let's run through some things to consider when you're trying to answer the question "What should I pay a money partner?" with something more specific than "it depends!".
Type of Agreement
First up - what sort of agreement are you going to have with your money partner? These generally fall into two main categories:
- Loan Agreement
- JV Agreement
There are also two main ways of paying a money partner:
- Interest Rate
- Profit Share
So already you can see there's quite a few potential combinations available.
Loan Agreement
Loan agreements are used in situations where there's an equity shortfall. When you're buying a house, then that's essentially what a lender does, they give you the cash you don't have yourself so you can pay the full amount for the property at settlement. For residential loans that's usually 80% LVR (loan to value ratio), but depending on your circumstances it may be lower.
As a Property Developer, there will be times when you need extra equity. Sometimes it's the deposit to fill in the gap between the property price and the loan from a lender. It could also be the costs of running the deal, such as getting the development approval, renovation funds, build costs and more.
The lender gets paid an interest percentage on the funds they're providing, and in return you offer them some type of security. These are the five main types of security:
- 1st mortgage
- 2nd mortgage
- Caveat
- Unsecured Loan
- Personal Guarantee
Now, a lender providing a 1st mortgage at 80% LVR on a residential property is in a relatively low risk position. Quite a lot will have to go wrong for the property to lose more than 20% in value. So in return, they generally get the lowest interest rate out of all these options.
When you get to the bottom of the list of security types, the lender is in a much riskier position. If something goes wrong, the lenders with first and second mortgages will get paid out first, and if the market has tanked completely, there's a chance they might not get paid out all of the funds they've put into your project. Therefore they're going to expect you to pay a high rate for the funds.As an example, a standard home loan interest rate from a regular lender such as a bank is going to be right at the bottom end of the range. A private lender with an unsecured loan is going to be at the top end - sometimes as high as 30%.
Risk Factors: Now you have a rough idea of where the loan you need is likely to fall on the spectrum, the other thing to consider is risk factors. Although it potentially won't make much difference to the interest rate if you're getting a first mortgage from one of the big banks, risk can have a huge impact on the interest rate when it comes to private lending. After all, rates of 20% or more are quite common for private lenders.
Experience: If this is your first time out of the gates as a Property Developer, expect to pay higher rates. Obviously a lender wants to know their money is going to be used safely and effectively, and if they can see you've done ten identical projects already, and they've all made the expected profit, naturally they're going to feel confident the same will happen with the project they're lending their funds for. They're more likely to lower their rate. They're definitely not going to be as comfortable with someone without that track record.
Rate of Return: There are different ways of calculating this (don't get me started!) but in essence, the bigger the rate of return, or the higher the level of profit, the less risky the development deal becomes. Essentially, there's more fat in the deal in case things go wrong. So higher profit usually means a slightly lower rate, although not always.
Amount: An investor putting $50k into a deal is going to feel less at risk than an investor putting $1m in. Although neither of them would want to lose their money, $1m is going to cause way more pain than $50k, and the interest rate will reflect that risk. You may have heard the saying "don't put all your eggs in one basket" and that applies here. Putting $1m in one deal is much riskier than putting $50k each in 20 deals.
Time: How long is the deal going to last? Markets change over time, so a short deal is generally considered less risky because there's less time for market conditions to change. Now, it's quite possible that a longer timeframe will mean the market's actually gone up, and so higher prices for the end product will increase your profits. But it also increases the risk of the market moving against you, too, so that affects the interest rate.
A loan agreement might also include an element of profit sharing, but I'll cover that as part of JV agreements. Nonetheless, that share will be influenced by the same set of risk factors.
Joint Venture Agreement
Working out how to pay a money partner in a JV scenario is a little different. Generally JV partners are each allocated a share of the profit, rather than an interest rate. So consideration needs to be given to the role each person is going to play in the joint venture.
Depending on the type of deal, there are four major elements to consider:
- Equity Partner - cash for the deposit and costs of running the deal
- Serviceability Partner - gets the loan from a lender
- Knowledge Partner - finds the deal, does the feasibility and runs it from start to finish
- Working Partner - on site person, either doing physical work themselves or supervising others doing it
The profit split varies depending on the type of deal, and what you negotiate between you. For example, if you're doing a renovation as part of a deal, and the working partner is going to do a lot of the work themselves, that piece is important and a potential split might be 25% each.
If the deal is more of a paper shuffle through town planning, then you might fold the knowledge and working partner into one share, and allocate 1/3 each.
The risk factors mentioned in the loan agreements section also need to be considered. Essentially, though, for a JV you start off with a pie, and how that pie is divided is likely to be different for every deal.
Despite all the information I've just given you, the answer to the question "What should I pay a money partner?" is still "it depends". Hopefully, though, you now have a better idea about what factors are useful when determining the answer, and have a better starting point when you enter into negotiations with your potential money partners in the future.
