So You Want to Scale Your Real Estate Business?
Try Diversifying Your Capital Stack
by Kendall Bazan
As a real estate investor, you are constantly seeking strategies that can help expedite the growth of your real estate business. One strategy you may not have considered is diversifying how you finance your deals. In fact, a diverse “capital stack” can be a game-changing way for you to increase your velocity. To meet your real estate business’s unique goals, you should understand the various sources of funding, the advantages and drawbacks of each, and when it strategically makes sense to use one over another.
Capital stack is a term used to describe the various sources of financing a real estate investor utilizes in their real estate investment projects. These most often include private money, hard money, conventional bank loans, or personal funds, like cash. Though there isn’t a formula for building the perfect capital stack, each funding source has its benefits. Understanding the differences can have a huge impact on the speed of execution—and ultimately the profitability—of your projects.
PRIVATE MONEY
Private money is based on a relationship between two parties, such as a friend or family member. Private money is often more flexible than a bank loan or a hard money lender, so it’s often an excellent choice for an investor who doesn’t necessarily fit the lending box that other lenders require. Terms and rates can be more agreeable because the lender is often an individual and therefore doesn’t require institutional lending boxes or standards. If you operate at a relatively low velocity and have time to manage relationships, private money might be a good addition to your capital stack.
The flexibility that comes with private money could be a huge selling point for some borrowers, but it is still essential to consider some of the drawbacks that come with it. As private money is often relationship-based, it can require a hefty amount of networking that may demand much time on the borrower’s part. Furthermore, private money is often much more finite than other funding sources, meaning that you may run into limitations or have to manage multiple private lenders at once. If truly scaling your business is your end goal, private money is likely not a sustainable option as a stand-alone source of funding. It also carries additional risk compared to other options. Because private lenders may not be bound by legal obligations, their personal preferences and opinions may start to have an impact on your investments.
BANK LOANS
The bank is one of the first places investors may look when in need of a sizable loan. While many real estate investors use bank financing for their acquisitions, it’s important to recognize its pros and cons. One of the biggest upsides to using a conventional bank loan is that it often has much lower interest rates than private or hard money. Moreover, it’s usually structured over a more extended period of time than a short-term loan. Investors often use a bank loan when executing the BRRRR (Buy, Rehab, Rent, Refinance, Repeat) or buy-and-hold strategy. Once the project is rehabbed in a BRRRR or buy-and-hold, often with short-term funding, an investor will pay off their bridge note with a lower-rate conventional bank loan. When it comes time to do a cash-out refinance using the BRRRR strategy, investors can take out a mortgage from the bank to turn their equity into cash and purchase a new property. These rental properties’ steady stream of income can go towards these long-term mortgage payments at a much lower interest rate. Similarly, investors who buy-and-hold might use a bank loan to pay off the bridge loan used to secure the property enabling them to pay a lower rate than the bridge loan.
While a bank loan can be an attractive option in some circumstances, there are quite a few caveats to consider before choosing a conventional bank loan. Banks are notorious for taking their time when underwriting a deal. They can also lack the flexibility that a high-velocity real estate investor needs when executing multiple projects and strategies at once. A bank will also have stricter requirements than other financing methods, such as a credit score threshold, an extensive record of historical performance, property condition requirements, and extensive administrative paperwork. While banks can be useful when financing longer-term and lower-risk projects, they may not share your urgency when financing your investment project.
HARD MONEY
The last major funding source are “hard money loans” (sometimes used synonymously with “short-term bridge loans”). This method provides a short-term lending solution for real estate investors to finance their rehab and new construction projects. These loans are provided by lenders who may specialize in real estate rather than a traditional financial institution or independent investor. Many seasoned real estate investors are fans of this financing method, as they can utilize the speed, reliability of funds, and lender’s customer service to increase the velocity of their real estate investment business. Successful real estate investors are often the most profitable when they move quickly on projects, keep capital in circulation, and use leverage. In this way, one of the most notable advantages of using hard money is the ability to grow your real estate portfolio without running into a shortage of funds.
Unlike banks, a good hard money lender will focus on the asset, the scope of the project, and the borrower’s investing experience rather than their financial position or liquidity, making the underwriting and administrative process much less stressful and demanding.
While hard money loans are an attractive option for investors looking for fast, flexible capital, they do come with some potential drawbacks. The main con of using a hard money lender is typically a higher interest rate; due to these loans’ convenient, short-term nature, the interest rates tend to be more than those of a bank or private money. As a result, it’s essential to ensure that your project can be completed and become profitable in that short time frame. In this way, a suitable lender will be transparent about whether your project looks profitable and beneficial for both parties and considerate of your long-term relationship, even if it means they pass on that particular deal. The reliability and speed of access to large amounts of capital and stress-free underwriting make it a perfect choice for many investors who specialize in residential rehab at high volume.
If you’re looking to grow your real estate business, it’s essential to consider how a diverse capital stack could benefit your current investing strategy. Using private money, traditional bank loans, or hard money—or a combination of the three—can significantly impact your bottom line and speed to scale as you grow your business. By understanding the pros, cons, and thinking strategically about when to employ each method, you can create an optimal capital stack for your business and take it to the next level of growth.
