Real Estate 031: Finding Private Lenders Script

As investors work towards building their portfolio, they often might run into an issue of finding capital to fund their deals. I have also run into this problem as I was taking down almost 1 deal a month in 2018, and needed to find a private lender (e.g. family, friends, coworkers, and other acquaintances that you have met/talked a couple times) that will help provide me with a short term loan while I execute the Buy, Rehab, Rent, Refinance, Repeat (BRRRR) strategy to force appreciation (build equity) in lieu of a 20-25% downpayment. I will share with you the steps that I took to raise capital and create win-win situations for myself and the lender.

My first private lender was an investor friend of mine, as such, we knew of each other's deals, experience, and goals prior to entering into a financial relationship. I knew that as I engage other potential lenders, I needed to be able to explain clearly what I do, my experience, and the potential returns on their investment.

My informational package included the following items:

• Business name/contact information

• Business mission and objective

• Description of how my business operates (e.g. Market, Team, Investments)

• Explanation of Private Money and how to fund a deal 

• Business track record, including photos and videos

• Referrals from previous investors or mentors

• Expectations for both parties in the deal

• Frequently asked questions

Remember that content, not format of the information is key. Be prepared to fully answer any and all questions that the potential lender may have as most private lenders do not do this on a daily basis and will need some education in the beginning

Once this was put together, I provided this information to the potential lender and walked them through the entire process. Remember that real estate is all about building relationships, so even though this potential investor may not pan out, there may be someone he/she knows that is interested or they may return in the future once they are comfortable with the concept. As much as they are interviewing you, you are interviewing them to make sure that they are not going to be a hindrance and obstacle in operating your business. Is this person a nervous individual who will be calling you every day for an update, or a pushy investor? Or will this investor be in it for the long haul and be with you on multiple deals? These are questions to carefully consider before entering any agreement with your lender.

Next, you want to learn about your potential private lender and their main concerns. During my experience, I learned that lenders mostly care about three things:

1. Return on Investment

   1. What if the rehab goes over budget

2. Securing their Investment

   1. What if the appraisal does not come in at ARV

3. Timing of their Investment

   1. What if the economy changes

   2. What if the borrower goes bankrupt

These are all important questions that you should proactively address during your walkthrough and calls with the lender as follows (Investor Script taken from the BiggerPockets forums):

“As you know, these are ‘investments’ that we’re talking about, so there is no guarantee of success. There is risk involved with any kind of investment, but as our successful track record testifies, the way we invest in real estate seeks to minimize the risk at every turn. We offer a first lien position on any property we lend on, which means if I end up breaking any of the terms in our agreement, you could foreclose on me and take the property."

“Also, because of this lien, you will get all your money back, plus interest, before I ever see a dime. I only make money if you make money. Additionally, we will sign a promissory note that clearly and legally spells out all the terms and conditions of our arrangement. Finally, we only invest in amazing real estate deals that will have significant equity in right off the bat, so we are protected against a drop in the economy. Because we buy only good deals, there is significant monthly cash flow following conservative estimates, and we set aside money each month for future expenses. All these factors help limit risk and ensure that your investment is as solid as possible.”

Below is a sample rehab and FAQ sheet that I also share with my potential lenders as appropriate:

By advising your potential lending partner on these concerns up front, you are able to build a stronger relationship and trust so that you are both on the same page. Show them different versions of a proforma on a sliding scale that show a best to worst case scenario. Although you do not want to scare off the lender, it shows that you have done your homework and will put them at ease when you run into roadblocks and have to make adjustments.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 030: Cash on Cash Return vs. Overall Return

In my previous blog posts I discussed cash on cash return, debt service coverage ratio, net income and how these metrics are used by real estate investors to evaluate a potential acquisition and proforma over 5, 10, and maybe 30 years down the line. Other investors may look to buy all cash and consider comparing cap rates to make sure they are getting a healthy return when including other factors such as neighborhood class and type of property (e.g. single family rental vs duplex, etc.). While these metrics are valuable, they do not paint the entire picture, especially for savvy investors who are looking for value add opportunities.

By value add opportunities, I am talking about forcing appreciation on your deal by raising rents to market, rehabbing the property, and other things such as sub-metering individual units on a 2-4 unit and reducing your overall expenses. Value add opportunities allow investors to “force” appreciation in a short period of time.

To evaluate a value add deal, one must consider not only the cash flow, but appreciation, tax benefits, and loan paydown when financing your property. This is also known as the overall return. To calculate your overall return on a deal, you must add up the benefits realized in these profit centers and divide it by the number of years you held the property and total monies invested. 

Lets view an example below:

• Purchase price: $150,000

• Cash all-in (Downpayment, repairs, closing costs): $45,000

• Loan amount: $112,500 (75% LTV), 30 year fixed at 5% interest

• Annual Cash Flow: $3,000

Lets say that after 10 years, you decide to sell the property for $250,000, which reflect a gain of $85,000 after selling/closing costs of $15,000.

• Cash flow: 10 years * $3,000 = $30,000

• Appreciation: $85,000

• Tax Benefits: $1,000 * 10 years = $10,000 ($3,636 depreciation per year * 28% tax bracket = $1,000 per year savings)

• Loan Paydown: $21,500 ($112,500 - $91,000 Balance after 10 years)

Total return over 10 years = $30,000 + $85,000 + $10,000 + $21,500 = $146,500

Overall ROI: $146,500 / 10 years / $45,000 = 32.55% return

In this example, this means that your average return during the 10 year holding period was 32.55%. By using this simple formula, you will be able to better understand your overall return on the deal and compare it to others in your lead generation pipeline when having to choose one over the other.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 029: Financing Rentals with 15 vs 30 year mortgages?

There are a lot of nuances when it comes to real estate investing, and one important decision is financing. Once you have decided that you are going to use good debt to leverage other people's money and scale your portfolio, you must also decide the terms. Investors typically finance their properties through conventional loans (secondary mortgages with Fannie Mae, Freddie Mac guidelines), as such, they decide between 20% or more in downpayment, or 15 or 30 year mortgage terms.

In simplistic terms, 15 year mortgages will generally have better interest rates as they are being amortized over a shorter period of time and seen as less risk to the bank. To the borrower, it may seem beneficial because you have a smaller interest rate, and less interest paid during the 15 years vs the 30 years. However, once you step back and look at the bigger picture, you may want to take into consideration other intangible factors such as flexibility, potential for interest rates to increase, and the ability to use good debt when your returns are expected to far exceed the debt service (Note: if your property is not covering the debt and leaving you with a healthy amount of cash flow each month, you are taking on a big risk as the property may not be self-sustaining from day 1).

Lets take a look at some of the savings on a rental property with a 15 year vs 30 year mortgage:

Purchase price: $100,000

Down payment: 20%

Scenario A: 15 year mortgage with 5.5% interest

This will leave you with a monthly payment of principal and interest of $653. Over the course of 15 years, the total amount disbursed will be as follows:

Total payment: $117,725.95

Principal: $80,000.00

Interest: $37,725.95

Scenario B:  30 year mortgage with 6% interest

This will leave you with a monthly payment of principal and interest of $479. Over the course of 30 years, the total amount disbursed will be as follows:

Total payment: $173,083.40

Principal: $80,000.00

Interest: $93,083.40

This results in additional interest of $55,357.45 ($93,083.40 - $37,725.95).

Looking at $55,000 of interest savings may make you think this decision between scenario A and B is a no brainer, however if we take a closer look there are various factors to consider:

• Additional interest can be converted into tax savings across rental portfolio

• Opportunity cost of fast loan paydown vs re-investing the difference

For example, the monthly PI of scenario A is $653 - scenario B of $479 results in a monthly PI delta of $179 that could be used to reinvest for a higher return or used as additional payments as conventional loans typically do not have pre-payment penalties. Lets take a look at how interest payments would change if we used the $179 to make additional payments toward the 30 year loan:

Total payment: $123,515.78

Principal: $80,000.00

Interest: $43,518.13

Now the difference in interest is only $5,792.18 ($43,518.13 - $37,725.95) all the while maintaining flexibility to change directions if you wanted to, instead of locking yourself into a decision for 15 years. In addition, the $179 in savings in scenario B may come in handy when other rentals in your portfolio are not performing or may be negative $200. The extra cash flow from a 30 year mortgage may be used to offset these fluctuations.

Lets take another example and say that you use your monthly $179 PI difference from a 15 year vs 30 year and combine it with savings to purchase a turnkey rental property with a cash on cash return of 12% (These are actual deals I am seeing in the midwest for a C class neighborhood).

With a $179 starting balance and contributing $179 monthly at 12% returns, you will end up with $632,034 after 30 years when you will have paid off your home in scenario B. Without even calculating, the difference is clear. Although this is just an example, investors must understand these variables and opportunity costs when they decide to forego one for another.  There is not real benefit to paying off your mortgage from a numbers perspective. 

I do believe that risk needs to be managed and am not looking to maximize the debt across all of my rental properties, however, depending on what season you are at life: 20-30s "grow", 40-50s "maintain", 60s+ "enjoy", you may find yourself wanting to lower risk and have peace of mind. 

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!