My real estate investing journey began the same way most people start. I was in a dead end situation and got sucked in by the promise of fat checks, passive income, and paying less taxes.
I became obsessed with all things real estate. I spent most of my free time reading books on buying rental property, listening to podcasts that interviewed successful real estate investors, and watching fix and flip shows on HGTV (Tarek & Christina BAE).
But no matter how much I learned, I was too scared to jump in.
I was mentally blocked. Around the time I became serious about investing in real estate, I was licking my wounds from getting my face ripped off in the restaurant industry.
I had to proceed with caution. I didn’t want to make the same mistakes twice.
- Going at it alone in a new industry
- Putting all my eggs in one basket
?BiggerPockets
In late 2016, Matt & Liz Faircloth were guests on one of my favorite podcasts: BiggerPockets. During their episode, I learned they operated their business out of Trenton, NJ.
This was the first time I felt like I could actually reach out to a real estate expert and manage to build a personal relationship with them because of their proximity to me.
I went to Matt & Liz’s website, signed up for their mailing list, replied to their welcome email and eventually scheduled an in-person meeting with Matt.
?Property Tour
A few days later, I met Matt at his office in Trenton, NJ. Before I got a chance to sit down, Matt asked me if I wanted to ride along with him on his daily property tour.
Of course I said yes.
We visited about 4-5 properties in the span of two hours. Some houses were stripped down to the studs, others were on their final punch-list, few were somewhere in between.
As we entered each new home, Matt would give me the high-level financials:
- We paid this much for this house.
- Our contractor is charging us this much for the work.
- We’re expecting to sell it for that much when it’s all said and done.
I kept a running tally in my head on his acquisition costs, rehab costs, and expected outsales.
After we left the last property, my acquisition and rehab tally exceeded half a million dollars.
I didn’t want to be rude but I had to ask, “How are you financing all of this? Did you hit the lotto?”
Matt chuckled and replied, “We don’t use any of our own money to do these projects. We have private money lenders knocking down our door ready to fund our deals.”
Private Money What-ers?
?Private Money Lenders
A Private Money Lender is basically a bank in the form of a person you know.
How does it work?
A Private Money Lender provides the bulk of the funds necessary to close on a property. The terms of their loan are typically 9 – 18 months long and they charge anywhere from 8 – 12% interest.
Why would an investor accept a loan with such a short term and such a high rate?
Despite what you see in today’s market (Q3 FY2020), banks aren’t always willing to lend on a property.
If the property is not in livable condition, a bank won’t lend on it.
- If a property has fire damage, a bank may not lend on it.
- If a property has water damage from a leaky roof, a bank may not lend on it.
- If the property has squatters, the bank may not lend on it.
These problems that prevent traditional banks from lending on a property are golden opportunities for investors. The uglier the house or bigger the problem, the more lucrative the opportunity.
This is where a Private Money Lender comes in.
?What does a Private Money Lender look like?
Literally anyone… but here are a few examples.
- Your uncle who owns and operates a small business.
- Your aunt that’s a healthcare professional.
- Your friend from College who has a high paying job and lives well below their means.
- Your buddy from the gym that is a top producer in their sales job.
If you want to know what your average millionaire looks like, I recommend you read The Millionaire Next Door by Thomas J. Stanley
?How Does a Private Money Lender Transaction Work?
The same way a bank funded transaction works, with less hoops to jump through.
Let’s say an investor comes across an opportunity to buy a run-down property for pennies on the dollar.
Here’s the problem, since the home is not in livable condition, the investor can’t find a traditional bank that’s willing to lend on it.
It’s a 3 bedroom, 2 bathroom 1,200 square foot ranch selling for $75,000. The comparable homes in the neighborhood have recently sold for an average of $225,000.
The investor knows the renovation will cost roughly $75,000, bringing the total all in cost to $150,000.
Since the bank won’t lend on this property, the investor calls his dear Uncle Charlie and asks him to be his Private Money Lender on this deal.
Uncle Charlie is a Doctor by profession, but can recognize an opportunity to make money in business when he sees one.
It also doesn’t hurt that he believes in his nephew so he’s willing to take a chance on him.
The investor and Uncle Charlie agree to terms:
- Uncle Charlie will provide 100% of acquisition ($75,000)
- As well as 100% of construction ($75,000)
- For a total loan amount of $150,000
- The money is due back in one year
- With an interest rate of 10%. ($15,000).
The investor signs the pertinent documents:
- Promissory Note
- Mortgage
- Personal Guaranty
- etc.
The Title company records all the documents at closing and this project is off to the races.
Once the investor is done renovating the home, he can do one of two things:
- Sell the home and get rid of it
- Refinance the home and keep it as a rental
If he sells the home for $225,000, he will realize a gross profit of roughly 60K (225K – 150K – 15K).
If he tries to refinance the home, the bank will likely give him a loan for 75% of the home’s After Repair Value. 225K x 75% = 169K.
The investor can use that money to pay off Uncle Charlie’s loan + interest and still have 4K left over for himself (169K – 150K – 15K = 4K).
Uncle Charlie makes a healthy return on his money passively.
The investor takes on more risk and is rewarded handsomely as well.
Everyone wins.
?Risk
Uncle Charlie provided all of the money, but he only made 15K, while his investor nephew walked away with as much as 60K if he sold the property.
What gives?
There are two reasonable rebuttals to this concern:
- Uncle Charlie is a passive investor. His time and effort is limited to writing a check and collecting interest on his money.
- Uncle Charlie is a lien holder against the property. If his nephew can’t perform or disappears, Uncle Charlie can foreclose on the property and take back control of the project.
Investing in the form of debt is less risky than investing in the form of equity.
Why?
Creditors get paid first.
Imagine the investor miscalculates the rehab budget and it costs 20% more to fix the property. Instead of 75K, it costs 90K.
Let’s combine that with a correction in the market for that sized home. In the 12 months it takes the investor to complete the project, the market pulls back 10% so now the sales price is 200K instead of 225K.
How much does that leave for the investor? 200 – 150 – 15 = 35K in gross profit. After selling costs, taxes, and other expenses, the investor may make the same amount as Uncle Charlie.
??I Wanted to Be Uncle Charlie
After Matt explained to me how Private Money Lending works, I was convinced.
Lending was the least risky way for me to get into real estate.
Lo and behold, the first deal Matt and I did together ended up being upside down.I wrote about that experience here.
Basically we overestimated the sales price and underestimated the renovation costs and Matt ended up coming to closing with a check out of his pocket to pay off my interest.
But that didn’t stop us from working together 9 more times. In fact, the very next deal we did together, Matt made all his money back and more. I wrote about that experience here.
Being a lender gave me front row seats to all the action. I didn’t have to learn on my own dime. I got to learn from experts in the field and got paid while I was at it.
⚖Shifting to the Equity Side of the Equation
Now I’m at a point where my network, knowledge, and access to capital is at a tipping point.
I can continue lending and make 8-12% on the money I raise and keep a small slice for myself.
Or I can take what I learned over the past 3 years as a private money lender and apply it towards the equity side of the equation.
So far in 2020 I’ve acquired 7 units.
- 4 family in Collingswood, NJ
- 3 family in Delanco, NJ
I used a Private Money Loan to finance both of these projects. I also offered equity to my property manager to align incentives and ensure the business plan is executed with little to no oversight.
I think I’ll continue to be a private money lender because “if it ain’t broke, don’t fix it”. But at the same time, I’m going to start betting on myself more and more.
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