$25K Mistake w/ Hard Money Lender; Pt. 2: Resolved!
In this blog, I'm going to tell you how I got around the $25,000 mistake I made with my hard money lender.
In case you missed it, in last week's blog post, I told you about the prepayment penalties on the triplex we just bought on December 17, 2021.
Well, I'm happy to say we figured out a work-around and we're looking forward to clearing 6-figures on this wholetail deal within the next 6 months.
Before we dive into how I'm getting around the prepayment penalty, let me quickly summarize the situation.
We bought a Triplex for $410,000 using a HML to fund 85% of the purchase and renovation at 8.5% interest only for one vear.
Our renovation budget for this project was $140,000.
Our total loan amount comes out to $472,000.
Immediately after I closed on the property, I found someone to buy it for $515,000.
When I called my lender to send me a payoff, they said I owed $25,000 in prepayment penalties.
$14,500 of that was the 6 months of minimum interest owed and the another $9,500 of it was 2 points on the total loan amount for not using any of the construction reserves.
Since I'm not one to simply waste $25,000, I had to get creative.
?Lease Option To Buy
The best idea i could come up with was a lease option to buy.
If you're not familiar with the concept, a lease option is a contractual agreement in which a landlord and tenant agree that, at the end of a specified period, the renter can buy the property at a predetermined price.
In this case, I'm the landlord and my buyer is the renter.
We're making the term 12 months and setting our strike price at $515,000.
We're also requiring him to pay 6 months of rent up-front to ensure he has skin in the game and doesn't simply walk away after signing the contract.
For the rental rate, we're simply passing through our carrying costs.
Right now, we're paying $2,580 per month in interest, $1,110 per month in property taxes, $215 per month in insurance, and roughly $100 per month in miscellaneous costs like utilities. When you add that all up, our current carrying costs on this asset are roughly $4,000 per month.
This is a Win-Win-Win situation.
I win because I lock in my buyer at a strong price without incurring carrying costs. Yes, it'll take me 6 months to realize my full profit, but I can wait 6 months for an extra $25,000. That's $4,000 per month without doing anything. Also, it should go without saying that I just hate the idea of burning $25,000 over a stupid mistake.
My buyer wins because he locks in lower carrying costs than what he would have to pay if he bought the property from me outright at $515,000 today. At the end of the day, he will be paying interest on a lower loan amount AND my interest rate is 25% cheaper than what he can find himself.
He told me his lenders charge him 12% interest. So let's say he raised 85% of the purchase and rehab costs, his total loan would be 85% of 515K + 140K, which is $556K. His interest-only payment would be roughly $5,500 per month. That doesn't even include his taxes, insurance, or miscellaneous costs. By using my much less expensive carrying costs, my buyer is saving close to $3,000 per month.
Finally, my lender wins because we'll perform according to the loan we signed. They'll get their interest and they won't have to charge me a 2 point penalty on the total loan amount for not using their construction reserves. This ensures we'll both be inclined to do business again in the future.
We're expecting to sign the lease option contract by the end of next week, but like any deal, there are some risks involved here.
If our buyer happens to walk away after signing the contract and putting up 6 months of carrying costs, no sweat off my back.
However. I don't think he's going to do that.
He seems highly motivated to start work on this project as soon as possible.
He already walked the property with his architect and contractor and also started the permitting process for the work he'll be doing.
The second risk is if he starts the renovation process, but can't finish and ultimately doesn't end up exercising his option to purchase the property at the strike price of $515,000.
Although this would be annoying, it wouldn't be the end of the world.
I've seen his business plan and it's a good one. If he makes any progress whatsoever, the asset that we'd be "taking back" from him would be better than what we started with and all the work would have been done on somebody else's dime. The only thing we really lose in that situation is a little bit of time.
From the buyer's perspective, there is virtually no risk. Once we sign that contract as the landlord, we don't really have a way out. As the owner's we'd be obligated to sell to him at the $515,000 strike price as long as he can feasibly exercise that option within the 12-month term.
Ultimately, we all want to succeed.
For us, that means collecting our full margin without paying a hefty prepayment penalty.
For our buyer, that means executing the business plan quickly and taking advantage of discounted carrying costs.
For our lender, that means fulfilling the terms of the loans as they were written.
If our execution is as good as our intention, 6 months from now, all three parties will be in a much better position than we are today.