The Day I Learned About Private Money Lending
I first learned about Private Lending through the Bigger Pockets Podcast, an excellent resource for all things Real Estate related. By the time I caught on to the podcast, one particular investor couple, Matt & Liz Faircloth, had already been guests on the show twice.
I noticed they did business in my home state of New Jersey, so I decided to reach out. Getting to Matt was an uphill battle. I filled out the contact form on his company’s website. Then I had to fill out a survey via email. Then we chatted on the phone for about 20 minutes. Finally, I got the invite to come down to his office in Trenton.
A Day In The Life:
I got to Trenton around 9AM. We sat in his office for 5 minutes before he asked if I wanted to see what he did on a daily basis. Of course I said yes. We hopped in Matt’s car and visited a few different houses he was flipping. The first house we visited was a finished product already on the market. Buyer’s inspectors were complaining about some water issue in the basement. We caught his General Contractor there trying to come up with a solution. After a quick brainstorm session, Matt and the GC came up with a plan. Then the GC called the proper subcontractors, and the resolution would take a day or two. This was decisiveness at it’s finest.
In the car ride to the next property, Matt explained to me, “it costs roughly $100/day for me to hold on to this property. I’d rather spend $1,000 right now to fix the problem, rather than wait for a buyer’s inspector who doesn’t notice it. And it goes without saying, it’s the right thing to do.”
The second house we visited was more of a work-in-progress. A team of about 5 guys were doing all sorts of renovations at the same time. Siding and fence work outside, putting up drywall inside, someone was packing brand new appliances in the garage. It looked like a well-oiled machine.
Before leaving, he tapped the siding guy on the shoulder to ask a question. “Going forward, is it possible to concentrate the seams in one area of the house? Instead of having a seam in a different place on every row?” The lesson here was to pay attention to the details.
Turn Key Case Study:
After touring those two fix and flips, Matt took me to a turn-key product he was finishing up for a client. The numbers he shared with me were incredible. He acquired a duplex and renovated it for roughly 70% of what he would sell it to a turn-key investor for. A hefty profit, indeed. His all-in on the property was ~$85K and he had an investor lined up to buy it for ~$120K.
The turn-key investor would buy the property with tenants in place. The estimated rent provided a cash on cash return in the mid-teens (~15%). Matt’s conservative rent estimate for the duplex was $950 per unit. Each unit had 2 beds and 1 bath. We ran the numbers together assuming a 25% down at 5% interest over 30 years. We also included 10% management fee, 10% maintenance & capex budget, 8% vacancy, actual insurance, and actual property tax.
This is when I asked him the question everyone wonders about turn-key providers. Why don’t you refinance your money out, and keep the property for yourself? This is what Bigger Pockets refers to as the “BRRRR” method. Which stands for Buy, Renovate, Rent, Refinance, Repeat.
His answer surprised me. He told me his portfolio was big enough and he was more interested in doing capital gains transactions. Then I asked him how he could afford to run so many projects at the same time. That's when he told me he stopped using his own money years ago. Instead, he raises money for each deal from private investors. Investors with excess cash in bank. Or investors with access to capital looking to make money on interest arbitrage.
Private Money 101:
The $85K it took to buy and renovate the duplex we were standing in came from a person that trusted Matt with the money.
My next question was, who is lending you money to do these deals? Is it a family member? He said no. Is it a business partner? He said no. So then I asked, why does this person trust you? His answer opened my eyes to the world of Private Money Lending.
Matt said, “The lender trusts me because he’s protected: he holds the first lien against this property. I can’t sell this property, take the money and run away. The title company at closing will pay off the lien holder first, according to the terms in our note. If I run off, the lender can foreclose when the note expires. The property cash flows and is worth much more than the amount he lent to me. So whether he trusts me or not, he’s protected. But to be clear, he does actually trust me.”
Goodbye turn-key investments. Being a private lender immediately became my new shiny object. The more I thought about it, the more it made sense.
Private Money Lending Pros and Cons:
There are a few downsides to private lending. Here are the big 4:
No depreciation to offset cash flow
Interest income is taxed as ordinary income
No equity build up
In a worst case scenario foreclosure can take up to 2 years. In states that allow the use of a deed of trust as opposed to a mortgage agreement, most homes are foreclosed on through a process called non-judicial foreclosure. Georgia for example, can get you a property back in 90 days.
The most important benefit of Private Money Lending:
No Property Management. Period, Full Stop, End of Story.
Do You Really Want to be a Landlord?
People often romanticize the concept of being a landlord. Buy a property, put a tenant in, collect rent. It’s sounds so simple, a six year old can understand it. Too bad simple doesn't mean easy.
There are so many headaches that come with being a landlord:
Getting a bad tenant (late payments, call you for small issues, don’t upkeep property)
Unreliable personnel if you’re outsourcing the work (contractors, managers, etc.)
Expensive personnel if you’re outsourcing the work (plumbers, electricians, etc.)
I used to think a property manager would solve all my problems. It’s true you won’t have to deal with each individual headache, but you will foot the bill. Property Management fee (8-10% of collected rent) is a charge to just collect rent.
Everything else is a la carte. Finding you a new tenant will cost you one month’s rent. If your property manager has to call a plumber or electrician, they are going to call the first name that pops up on google ads. Or even worse, a “preferred vendor”. You know, the guys that charge 15% more so they can kick-back 10% to the people that called them in the first place.
These were some of the issues holding me back from getting in the game. I explored turn-key in depth for months. I still could never bring myself to pull the trigger on a property.
The fear I have of being a landlord comes from the line of work my parents are in. They own a motel and I grew up watching them put out fire after fire:
A guest doesn’t pay on time
A guest doesn’t want to check in or out per police
A guest steals a TV
A guest submits a chargeback weeks after their stay because it was too cold or too hot in the room
Water heaters crap out in the middle of the night in the heart of the winter
Roof leaks. Pipes burst. Etc
My Strategy Going Forward
I'm going to stick to Private Lending for the foreseeable future. I see it as an excellent way to generate a healthy (8-12%) passive cash flow while feeling confident in the value of the underlying investment. Also, being a Private Lender helps me build the right relationships for when I decide to take equity positions in the market through partnerships.