Ep. #16 - Where To Get The Money? Using Other Peoples Money (OPM) For Real Estate Investing Success - Part 2

This is Part 2 from last week's episode, so if you've not yet listened to Part 1, please go back and listen to Episode #15 first. So now let's continue our conversation on Where To Get The Money!

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Intro...

Welcome back to Part 2 of Where To Get The Money? Using Other Peoples Money (OPM) For Real Estate Investing Success - Ep. #16.

So let's continue the discussion, moving on to Private Lenders. This is where you really want to be as a Real Estate Investor. You'll often get the best terms, lowest rates, low to no points, and funding for 100% of your deals, including both the purchase price and rehab budget. You could literally buy and rehab a house through sale or refi and never have to come out of pocket with any of your own money - a deal done from start to finish with 100% Other Peoples Money.

But this way of doing business brings with it immense responsibility of ethics and character. You absolutely CANNOT do anything to cause the loss of your investor's money. As such there'a certain ways you must handle things to protect your investors even above projecting yourself. YOU should be the one taking any risk - NOT your Private Lenders. But then this gets into an entirely separate topic for which I can do a show of its own - "How To Protect Your Private Lenders From Risk".

So now for THIS episode, let's just stipulate that you'll be doing everything properly, and in another episode to come (maybe also some later in this episode if I have time), I'll lay out for you how exactly to go about protecting your Private Lenders. So now until then, I'll just speak to where and how to get the money - NOT how to handle the money after you get it.

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In most cases, excluding maybe close friends and family, you'll likely have to be able to show some sort of track record to get Private Lender funding. But if you're fortunate enough to have friends and family with enough money and they trust you enough to lend on one of your initial (or even first) project - Congrats! But please proceed with extreme caution. Make sure it's a slam dunk / no brainer project on which you can make several mistakes and still turn out well. I'll speak more on this later and in that coming episode on how to protect your Private Lenders.

One of the first skills you'll need as a Real Estate Investor is the ability to analyze potential deals. Not just that you need to be able to know for yourself what is and is not a good deal - that is likely to result in profit. But you also need to be able to relate the strength of your deal to your Private Lender. You'll need to be able to show them how this deal allows you to pay them back, WITH INTEREST - and still make a profit for yourself. Just be careful about that, as some greedy Private Lenders will then focus on what you stand to make, and will get caught up in counting your money.

If so, this is good indication that the person will not lend you any money, and even if they would, you still may be better of finding someone else to work with. Because you are the investor. You're the one with the knowledge and skills to find great deals on distressed property and rehab them into rentals or for sale as flips. If the potential Private Lender had these skills, then they should be doing what you are doing. So if they do not value your role enough to not begrudge your profit in the deal, then it may not be the makings of a great partnership. But there's an exception to this I'll explain in a moment.

What you want is that doctor, dentist, lawyer, executive or any typically highly paid individual - who is also typically too busy with their own profession to become a Professional Rental Property Investor / Landlord or Flipper. But they know that you've done the work to become capable (even if not yet expert) at one or more of these. They are then thus happy for you to do your job, while they continue to do theirs. And they'll be happy to earn a nice return on their otherwise idle funds. Or even if the funds are not idle, maybe you are able to bring a higher rate of return or a more secure and/or consistent return.

These are the type of Private Lenders you want, but at risk of contradicting my prior comment, they need not be debt lenders only. Greed can creep in on both sides... You might be able to create some of your best partnerships by not being greedy yourself and giving up some equity in the deal if it truly is the case that you'll be making a killing, which is why the potential Private Lender might not be able to help themselves counting your money. Imagine how willing to partner with you the right dentist or doctor might be, if she or he not only gets a great return on their money, but also builds wealth by obtaining a reasonable equity stake in your growing rental property empire.

I've not given any equity to Private Lenders who funded some of my single-family and small "plex" rental properties; however, as I move into acquiring larger properties through syndication, I will be giving both a return on the debt loaned to the project and some percentage of equity in the deal. But in such a case, the amount invested may be higher, as may be the length of the investment longer, and the security to the investor is different (but more on that later, or in a different episode on protecting your private lenders or maybe on deal structuring.).

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Before I started seeking Private Lenders, I created what can be referred to as a Private Lender Credibility Packet. Among other things, this contained a 25 or so page booklet about me, my company, my partners and team members and my prior projects. It also spoke a great deal on the process and benefits of being a Private Lender.

Upon a potential Private Lender showing interest in learning more, I would arrange a meeting with the person (if married trying to get BOTH husband and wife to attend this meeting) - and I'd leave the booklet with them for review on their own time if it appeared as if they might be interested in moving forward. I really would not even mention the book at the meeting - it would be just something sitting off to the side. The meeting would be all about getting to know them, learning their needs, and allowing them to meet and learn more about me.

Not every potential Private Lender will be a good fit, as they may not be seeking to lend for a long enough period of time (I require 18 months with an option to extend to 24). Or maybe they don't have enough to lend, as a 1st position lender must be able to fund the entire purchase price, which may be $100,000 (or more), but not likely less than $50,000 or so.

And a 2nd position lender must be able to at least fund the rehab, which is most often at least $10,000. It can be harder to work with smaller amounts in a secured position. And since these booklets are full-color / double sided printing (they're expensive to print and bind), so I don't leave them with a person if it's obvious they're not ready and able to proceed. Although I will still add them to my CRM with automated follow-up forever, as circumstances can change at any time.

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My Private Lender Credibility Packet and the booklet is meant to answer common questions that every person will have before lending their hard earned money. The person needs to know who you are, what you do, how you do it, how / when and where you learned to do it, and on / and on / and on. They will and should have a ton of questions and you'll need to have confidence building answers. This is why outside of close friends and family, you may be best served to fund your initial deals with Bank or Hard Money Loans, as I mentioned on Part 1 in Episode #15.

But in my case I must also confess to a certain mental block when it comes to friends and family. I know many family members and friends with the money to invest in my deals, but for some reason I never feel comfortable asking them to be a part of what I'm doing. I was listening to one of the older episodes of the BiggerPockets Podcast and the guest on that show mentioned that this was of thinking is actually doing a disservice to my friends and family by denying them the wealth building opportunity created by my efforts, that I apparently have no problem making available to strangers. And I can see that as true, but I've always just had the thought that business is business and that friends and family should NOT be mixed with business. Like I'd never rent one of my homes to a family member.

But then it occurred to me the reason that I would not want to rent to a friend or family member (Landlord / Tenant relationship) is unrelated to the dynamic that's at play between me and a Private Lender. I wouldn't want to be Landlord to one of my friends or family members as Tenant, because they're going to expect me to be lack on my lease and rules I apply to all other Tenants (like imposing a 5% late fee and posting a 10 day pay or vacate notice on the 6th when late on rent). They're not going to want me to treat them the same as I treat all other Tenants in a strictly business relationship.

But in the case of my relationship with Private Lenders, there's nothing for them to do after funding the project. There are no rules for them to follow. No expectations for them to meet. No favoritism they could want or expect from me. It's not like they would expect me to pay them EXTRA or HIGHER interest just because we are friends or family. When it comes to Private Lenders, all the expectations to follow rules is on ME. I'm the one that has to perform. And since I know for certain that I'm going to do what and all that I say - being reluctant to work with friends and family members as my Private Lenders makes no sense unless I doubt myself. And with the possible exception of my wife and son, no one has more confidence in me than I do. So far as it depends upon me or what's within my control, I know that I'm always going to do the right thing - so why wouldn't I make this opportunity available to my friends and family.

So, likewise, if you know that you're going to go about things the right way, with un-failing ethics and morals (protecting your Private Lenders over even yourself) - then let the world know what you're doing! You may be surprised who might just want to be a part of it - and earlier in your journey than you might otherwise think. But I'd still recommend extreme caution if considering starting out funding your initial or first project with a Private Lender - unless they're someone like myself, who is acting as both the Private Lender and Mentor or Coach to guide you through this project. Which then brings me to another aspect of Where to get the money - other Investors as your Private Lenders!

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Have you ever heard of a Self-Directed IRA?

It's one of the best ways to work with Private Lenders in general, but its especially effective when the other party is also in the business of rehabbing distressed properties .

Self-Directed IRA's can be a show in and to itself, so I'll work to get a guest on the show who can speak to this topic as an expert (I'm not). But one of the critical limits of using a Self-Directed IRA is that you cannot fund your own projects. That's called self-dealing and it creates what is called a prohibited transaction.

So if you're a person like me in the business of rehabbing distressed properties into rentals or to flip, and you've got money in a Self-Directed IRA - I can't use that money to fund my own projects. Instead, I must find some other person (like you) and use this money to fund their project. And then hopefully in return they can use the money in their Self-Directed IRA to fund my projects.

As a result of this limitation on Self-Directed IRA's, you may find that some of your best Private Lenders are people you may have previously looked at just as your competition. They may be in your same area, marketing to the same property owners looking for deals on the same houses, bidding on the same properties at auction as you. But you want to get to know them for a variety of reasons, not the least of which is they may become your next Private Lender. But even more so, they may become your FIRST Private Lender, as they're experienced in the business, know if you've got a good deal on your hands, and can likely help you through it safely - while making some tax-free profit in their Self-Directed IRA in the process.

But even if not a fellow Rehab Investor, learning about Self-Directed IRA's is important for you as a funding option from anyone with money in an IRA or 401K from a former employer. In the current economic state, many people are expecting a downturn that could easily take half or more of what they now have that's invested in the stock market within their IRA or 401k. You can educate them on Self-Directed IRA's and connect them with a custodian who can aid them in making a tax-free transfer of those funds out of the volatile stock market and into one of your projects at a fixed interest rate that's competitive to what they had been getting in the stock market (if not better) - but that is now secured by the property that's worth far more than what they've loaned. In this way, you could literally be saving someone's life savings from a coming loss by getting it out of the stock market - maybe just in time.

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So while I will be doing a complete show soon on how to protect your Private Lenders from loss, I do want to briefly mention here a few critical things... When someone lends on one of my projects as a Private Lender in the 1st position (meaning they have a 1st position mortgage against the property). They are typically funding 100% of the purchase price for the property and potentially some amount (if not all) of the rehab budget.

But this money is not coming directly into my hands. Everything is handled by the closing attorney. Just as would be the case with a Bank or Hard Money Lender. The Private Lender wires the money directly into the closing attorney's escrow account. That attorney then uses those funds to complete the purchase of the property, giving the Private Lender a Deed of Trust (North Carolina is a Deed of Trust State) and a Promissory Note. Both documents get recorded with the Registry of Deeds Office of the County, such as Durham County.

The Promissory Note details all of the loan and payment terms, such as interest rate, due date and amount, loan / term length, and everything. This gets attached to the property via the Deed of Trust, which creates a lien against the property on behalf of the Private lender - again, no different than would be the case for a Bank providing a Home Mortgage. The Private Lender is now essentially the Bank who really owns this property, as they have the right to foreclose if any of the Promissory Note terms are violated, such as not paying on time or failing to repay the full loan amount by the end date.

This protects the Private Lender, as the home cannot be sold without paying them back in full. If it were to burn down to the ground, they are set as the loss payee on the insurance policy - so another form of protection. And if I got hit by a bus or caught scumbag disease and failed to uphold my commits as detailed in the Promissory Note for any reason - the Private Lender can foreclose on the property by just employing the services of an attorney or deed in lieu of foreclosure. First, I would NEVER let such a thing happen, but if it did - Yes, there would be a cost to the Private Lender of both time and money. But another form of protection is that they have only loaned up to (say) 70% Loan to Value (LTV). Once you're further along with many successful projects under your belt, you might feel safe to raise this to 75% or 80% - but not higher.

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Now keeping your Private Lenders protected in this manner, and working with them to ideally get 100% funding of both the purchase and rehab (and having it still be less than 70% LTV) requires that you get a great deal on a distressed property. You need to get a deal so great that your purchase price and worst case proposed rehab budget are less than 70% of the likely After Repair Value (ARV). Otherwise, you'll likely have to fund the rehab out of pocket.

For example, if you were seeking Private Lender funding for a purchase of $120,000 with another $20,000 needed for rehab, this property would need to have an After Repair Value (ARV) of no less than $200,000, of which 70% of this amount is the $140,000 your Private Lender would be funding for the deal.

And in this scenario, when the job is done, if you're keeping it as a rental or otherwise wish to avoid paying increased taxes for a short-term hold, you may have to own it for a full year first - because of the seasoning requirement. But then you can refinance this property at up to 75% of the ARV. So you refinance for $150,000, pay back the $140,000 you borrowed, along with interest. And let's say your borrowed at a rate of 6%, your interest owed would be $8,400 for the year. So you'd repay $148,400.

So that's a lowly profit of only $1,600 on the job (I've done much better), and technically you're not even making that much, because excluding any rental income made during the year (let's say it took you 2 months to get it rehabbed and rented, and so you have 10 months of rental income) - well, excluding that, in this example you've really not profited on the rehab to refi, because your closing and holding costs would almost certainly be 3 times the $1,600. But in my opinion, even this low profit (if you want to call it that) is a win, as now you own a cash-flow positive rental asset that will likely appreciate in value, it will benefit you greatly in taxes and has 25% equity present. I'll do a show coming up on all the ways you profit from owning Rental Real Estate, as most people only consider the cash-flow and appreciation - but there are other benefits that can be just as great, if not more so.

As I mentioned in Episode #14, even when I've been required to put in more cash out of pocket at the time of refi, it still turned out to be a great deal. But all of this was to tell you that you need to get an amazing deal if you want to both profit upfront from the deal and protect your Private Lender (the latter being by far the most critical requirement). Because if something goes wrong, such as your getting hit by that bus I mentioned - before the project is done. In a worst case scenario, your Private Lender has the property as their collateral (just as any Bank would) and they can either take over or foreclose on the property and sell it as-is with a Realtor to get their money back - since they're only in for 70% LTV ($140,000 on a house that is potentially worth $200,000). Surely in that scenario, with that spread - they can still come out whole or better.

There would be no shortage of flippers that would be willing to buy this house for $140,000 (or more) if it has an ARV of $200,000 - so your Private Lender is protected in the deal by never lending over 70% of the ARV. If it required more than that amount to complete the rehab, then you must be prepared to fund the shortage out of pocket. So a hard rule of working with Private Lenders should always be that you never allow them to over-fund the deal. Always protect your Private Lenders - but I'll go more into this on another show.

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I'm going to end it here, as I could talk a LOT more on this subject of Where to Get the Money. And just in talking about it up to this point, I've got several more ideas for additional shows on this and related topics. I could easily continue this show with a Part 3, but instead I'll just do new subjects for those additional shows.

I've only scratched the surface of Where To Get The Money. My point for these last two episodes was not to provide an exhaustive list anyway, but more to get you thinking along the lines of using Other Peoples Money in general, so that you'll not just dismiss the thought entirely of becoming a Real Estate Investor just because YOU don't have the money sitting in your bank account - Most investors don't. Real Estate Investing is a Team Sport.

For much more on this topic, please checkout the book from Brandon Turner of BiggerPockets.com called "The Book On Investing In Real Estate With No (and low) Money Down" - which you can find among other great Business and Real Estate books on the Podcast Website: andlandlord.com/books. Chapter 3 on Partnerships and Chapter 6 speak to what I've been saying here about working with Private Lenders. Chapter 5 on Hard Money Lenders and Chapter 4 on Home Equity speaks to what I said about these in Part 1 (Ep. #15). And Chapter 7 talks about Lease-Options, which I'll detail a few Lease-Options deals I've done in a coming episode on that topic. This was one of the first books I read when I started out, so I highly recommend it!

Closing...

Disclaimer...