Wednesday, October 6, 2010
Private Money Questions and Answers
Whether you’re talking with buyers, sellers, or private lenders, as a real estate investor you’re going to have to answer questions, handle objections, and explain what it is that you have to offer. The better you can handle these questions and objections, the more successful you will be as an investor. The great thing is that out of all the questions that you’ll be asked, there’s a good chance that the same five or ten of them will keep coming up more than others. So, why not be prepared in advance?
Raising private money is a huge topic, well beyond what you’ll find here. The Securities and Exchange Commission (SEC) has many do’s and don’ts when it comes to raising private money.(giving proper disclosures, registrations, exemptions etc.) This is not intended at all to be legal or financial advice. You’ll want to consult with attorney to make sure you’re in compliance with the laws.
As an investor, you will want answers to questions that private lenders may ask you. Here are some to get you started:
Q) How does this work? (or) What’s your program?
My Thoughts: With private lending, it’s very important that you have a program. (ie –what do you pay, etc) Unlike hard money lending (where the lender is in the business of lending money), YOU can make the rules. Will you pay 9%, 7%, 5%? Will you make monthly payments, or will you let the payments accrue until you sell or occupy the house with a tenant?
You want to set your own program, based on your investment goals and criteria.
For my private lending program, I pay lenders 7% simple interest (no points) and secure them with a 1st and only deed of trust. I make monthly interest-only payments and I like to have a balloon payment due no sooner than three years. I chose this because I want to have many exit strategies available. I want to make money whether I buy and resell, or buy and hold. At 7%, if I’m able to buy the house at 65 cents on the dollar or less, it’s going to have a positive cash flow.
When talking about private lending, you want to make a mental shift from “asking for
money” to “offering an opportunity”. This is huge. People get tripped up with this
concept, which is what makes raising private money difficult for many investors. No one likes to ask for money. When they do, they get the feeling like they’re begging, they feel like they are asking the lender to ‘do them a favor’. Raising private money is about flapping your lips and talking with lots of people. If your attitude towards raising funds involves hoping someone will see you as a charity case and help you out, you won’t talk to enough people and you won’t raise much money.
So, don’t think that way. Instead, starting thinking about the amazing benefit you can offer others. As real estate entrepreneurs, we have the almost magical ability to create opportunities out of thin air. Stay with me here, I’m not trying to sound cheesy. A house is just a house. But, if you can negotiate a purchase that allows you to buy with a bunch of equity, now you’ve created an asset. You’ve created an asset that will allow you to offer a secured investment for someone who wants to earn good passive income, at a much higher rate than they’re probably getting now.
Think about it. A one-year CD currently is averaging around 1.2%!!!! That’s horrible. If you can offer someone the ability toreceive 7%, you’ve just changed their life!
Well, what about the stock market? Sure, you can make lots of money in the stock
market…..or lose a lot of money in the stock market. Up and down, up and down. How
can someone plan their retirement if they don’t know how much money they’re going to
earn? You have the opportunity to give someone a great return that is not only secured, but it’s predictable! Set it, and forget it.
Start changing your mindset about what you have to offer and you’ll feel more confident talking to people about private lending. The more confident you are, the more confident they will be in you, and the more successful you both will be.
My Response to “How does this work? (or) What’s your program?”:
“I buy single family and small multi-family properties at big discounts, typically 30-50% below market value. When I do, I use funds that come from private individuals like yourself. I pay a consistent, 7% return and secure the investment with a note and deed of trust on the property. Can I show you how this works?”
Q) How many of these have you done before?
My Thoughts: This is question that many new investors worry about, but honestly I
think it comes up less than most would think. If you’re new, you might wonder “How do I show a lender that I know what I’m doing, if I’ve never bought a property or borrowed private money before?"
When I got started borrowing private money, I approached family, and close friends of family. (and you should too!) The relationship was already established, and I had a good plan. I showed how the deal made sense, and that’s what you want to do. It’s less about the person, as it is about the property. Find great deals, where it’s tough for you to go wrong, and the money will be there.
That being said, if you’re asked about your experience, you don’t need to embellish, and never lie. You can instill confidence in your lender by showing them that you’ve done your homework, and you’ve surrounded yourself with a team of experienced professionals who will be working with you every step of the way to make sure everything goes well.
I recommend putting together a couple pages in your credibility kit to highlight the key team members that you have, what their experience is, and what role they will play in your investing. Some examples would be a real estate agent, attorney, title, escrow, inspector, mentor/advisor, contractor, and/or appraiser. By surrounding yourself with a good team, it will give both you and your lender more confidence.
My Response: to “How many of these have you done before?”
If you’ve done other deals: “I’ve purchased ____ homes in the last _______ years. I
have information as well as before and after photos of some of the properties I’ve
purchased lately. Can I show them to you?”
If you haven’t done other deals. “I’m part of a real estate group that purchases and sells several houses each month. I’m currently working on my first investment outside of the group, and have assembled a team of professionals to purchase some great properties. Here’s some information about the people with whom I’m working. Can I tell you a little about how we’ll be working together?”
Q) Isn’t investing in real estate really risky now?
My Thoughts: With all the negative news that people hear nowadays about the decline
of the real estate market, and all the fear that is propagated by the media, it’s easy to understand why some people would think real estate is risky right now. The most successful investors, on the other hand, take a look at all the opportunity that is out there.
Warren Buffet says “Be fearful when others are greedy and be greedy
when others are fearful”. You need to be able to explain why your business model makes sense, why you’ve chosen it and how it works in this market (even though the perception by some is that real estate is risky).
My model involves purchasing single-family homes at prices low enough that I can resell for a nice profit or rent the house and get a positive cashflow. I prefer to buy “bread and butter” homes that are around median value, so they are highly desirable for sale or rent. If the market goes up, great. If it stays flat, great.
Even if it goes down, I’ve bought cheap enough to absorb some decline and can hold the house with a positive cash flow until the market improves. My exit strategy never
depends on having to sell, and I like to work with lenders who love getting consistent monthly income and prefer not to cycle their money in and out.
My Response to “Isn’t investing in real estate really risky now?”
A) “Speculating is risky. A lot of investors got in trouble by buying homes and hoping they would go up in value. Also, often they relied on having to sell the house as their only exit strategy. Their payment was much higher than could be supported by rent. I make my investment decisions assuming zero appreciation during the lifetime of the investment, and even account for potential depreciation. By purchasing houses well below current market values, and having an investment plan that will bring in positive cashflow from rents, I’m able to maximize return while minimizing the risks. The best real estate investments properties are purchased in a market like we have now, wouldn’t you agree?”
Q) “How am I protected?”
My Thoughts: This is where you’ll go into all the ways that a lender is secured in the deal. I’ll go through briefly what’s in place to protect a lender from some of the problems that can occur.
Promissory Note – The promissory note is the agreement between the lender and the
borrower that shows how much money is loaned, the interest rate that is charged, how
and when payments and final balloon payment are made, and the penalties that occur for late payments or default. It’s the official evidence of the debt. Everything is put in writing so there is no confusion.
Deed of Trust (Mortgage)– This is the lenders security for the loan. It is recorded with the county and gives constructive notice that the lender has a financial interest in the property. (essentially a lien) If the borrower were to default, the lender can accelerate the loan (foreclose) to force the sale of the property in order to get paid.
Title Insurance – The lender will receive a title insurance policy which will protect the lender against any title issues or claims that can arise which were not found during the title search.
Hazard/Fire Insurance Policy – Should the house burn, or experience any other unexpected catastrophe or problem, the lender will be named on the hazard insurance policy and will be protected.
Personal Guarantee – In cases where the property is purchased in an entity such as a corporation, or LLC, many investors will sign a personal guarantee, which means they will personally assume the liability if the entity were to default on the agreement. This can give the lender more confidence in making the loan.
My Response to: “How am I protected?”
“That’s a great question. Let me walk you through what we put in place to make sure
you’re secure with this investment.” (discuss the items above)
Q) What happens if you don’t pay?
My Thoughts: This is a perfectly legitimate question, after all, when someone puts
money into an investment, they want to know that they’ll get paid, and what to do if
something goes wrong. If you’ve already discussed the ways that a lender is protected
(above), you will have already shown them that they have a lien against the home with a deed of trust (mortgage). This gives them the ability to go through a legal process to force the sale of the home. Now, if I ever had trouble with a property, I wouldn’t force a private lender to go through all of that. There are a lot of alternatives that can be more beneficial to both parties.
Talking about default is never fun, but if the deal goes sideways, a lender needs to know what his/her options are. If you set up the investment properly, default could even be an additional profit for the lender.
My Response to “What happens if you don’t pay?”
A) “Actually, there are several options, but first and foremost, we set up the investments to stand on their own, and default would be the absolute last thing we would ever want to happen. Let’s just assume I stopped paying, here’s what we could do. If there was just a temporary problem, we could restructure the note. Any back paymentscould be added to the balance of the loan. In this case, you would earn interest on interest. Or, I could simply deed you the house. In that case, you would own a property purchased below market value. The income from the property could create a higher return than you had before. You could choose to keep the house, or it could be sold for potentially an even greater profit.
Sound good so far? Ok, let’s just say I was a scoundrel and refused to pay. You could
call an attorney and have them start the foreclosure process. They would do all the work, and you can add all of their fees to the balance owed.
Now, we’re doing a lot of talk about default here, and I would never want anything like that to happen because I have a lot of profit to lose, but I wanted to make sure you had as much information as possible. Does that answer your question?”
Q) What if I need to get my money back early?
My Thoughts: Let’s talk a little bit about the difference between hard money, and
private money. A hard money lender is in the business of lending money. He/she will
charge a higher interest rate, but more importantly, will charge points as well. Points are a fee (1 point = 1% of the loan amount) that is charged for the loan. A hard money lender will make more money if they’re able to cycle their money in and out of investments quickly. Therefore, a hard money lender typically wants a shorter term. A private lender, who is receiving no points is going to do better by having their money working for them as long as possible, assuming they are comfortable with you and the investment.
So, you should expect for a private money lender to be happy with a mid- or long-term
investment. The question about getting their investment back early does come up though, as unexpected emergencies can arise. If you’ve set up the investment properly and the lender has a good equity cushion, you would do your best to replace their money with another lender.
My Response to: “What if I need to get my money back early?”
A) “Private mortgage loans are best suited as medium to long term investments, so if you think you might need your funds back in fewer than _____ years, this might not be the best time to invest. That being said, I understand that sometimes ‘life happens’ and you may need access to your funds early. In that case, just let me know and I will do my best to replace your investment with another lender.”
Q) Are you able to work with smaller amounts of money?
My Thoughts: Some people are just not going to have enough money to invest to allow
you to purchase a house. What if they have $50,000, but you need $100,000? An attorney can show you how more than one lender can get together and fund an LLC which can make a single loan on a piece of real estate. This type of deal is way beyond this article, so you should have it described by an attorney.
My Response to: “Are you able to work with smaller amounts of money?”
A) “I purchase homes anywhere from $80,000 - $300,000. If you have less than $80,000
to invest, I probably won’t have an investment available for you. If you know someone
else who would like to invest, there may be an opportunity. I can put you in touch with an attorney who can explain the details. Would you like me to do that?”
Q) Are you putting any of your own money into the deal?
My Thoughts: When I buy homes, I will have the lender finance the entire purchase
price, closing cost, remodel and a little more for upfront profit/contingency. That means no money out of my pocket. If you buy a good enough deal, you shouldn’t have to put any of your money in the deal either. Focus on finding great deals so you can buy better than no money down.
My Response to: “Are you putting any of your own money into the deal?”
A) “I spend my investment money on the day-to-day operations of the business,
marketing and the constant search for new investment properties. I put my money
directly into the expertise of the business so I’m able to provide more opportunities for lenders and myself.”
Q) Can I get a piece of the equity instead of just collecting simple interest?
My Thoughts: Sometimes you’ll run into lenders who want a piece of the equity. If I’m going to give away equity, I’d prefer that I don’t have to make any monthly payments at all. I’d set it up as a 50/50 split of cash flow, and equity. This could actually be a great way to structure a deal. No payments means that you don’t
have to worry about vacancies eating away at your cash flow, and if you’re holding a
property, you’ll have a better monthly income.
If you buy a house that has an $1000 payment and you can generate $1200/mo in income,
you’ve got a $200/mo positive cash flow. If you have a vacancy, you still have to pay the $1000. On the other hand, if you work with a lender using a 50/50 split of cash flow and equity, your share of the cash flow will be $600/mo (less taxes and insurance), and you won’t have to make a payment if the house is vacant.
My Response to: “Can I get a piece of the equity instead of just collecting simple
A) “I may consider an equity partnership, but they’re usually reserved for lenders who have over ______________ to invest. How much money would you have available to
Q) Why don’t you pay out a bigger percentage?
My Thoughts: Sure, everyone would LOVE a double or triple digit return on an
investment if they could guarantee there was zero risk. The only investment that can be guaranteed is from the government, and they’re not paying much! In reality, most people want the best balance of risk vs. return. A lot of investors make the mistake of offering a higher rate of return, with the assumption that paying a higher return will result in getting more private money. For the average private lender, this is backwards! Most people equate high return with high risk! So if you’re offering to pay your private lenders 12% or 15% or more, there’s a good chance that they may consider that an unrealistic return, and say no just because of the natural return vs. risk relationship.
7% interest is well above average for secured investments that are available to the general pubic. It’s a great return, but the most important thing is it sounds reasonable, it sounds less risky.
You know what? It IS less risky to pay 7% than it is to by 12%, both for you AND your
lender! You have a lower payment, so you’re more likely to make the investment cash
flow, and less likely to default. If all you did was to lower the interest rate that you pay for private money, I bet you’ll get more of it. It sounds strange at first, but it makes sense when you think about it.
My Response to: “Why don’t you pay out a bigger percentage?”
A) “Are you currently getting more than 7% consistently and securely?" (wait for answer)
I understand you may be interested in getting a higher return. I used to pay more, but here’s what I found. Paying more than 7% limits my exit strategies to just one….buy, fix and resell. I’m a very conservative investor. I don’t like risk, and I don’t want that for my lender either. Even if I plan to buy and flip a home, I want to have lots of options if a house doesn’t sell right away. I always make sure that the payment can be supported by the rental income. That way, the investment stands on it’s own. You’d want an investment to be able to pay for itself, wouldn’t you?”
If I still can’t get them to agree to 7%:
“Depending on how much money you have to invest, there may be an opportunity to become an 50/50 equity partner. How much money are you talking about having available to lend if we were to work out this type of arrangement?”
Q) I want my attorney involved in reviewing the documents before I lend you any
money. Are you willing to do that?
My Thoughts: Of course I’m willing to have a lender’s attorney review the documents.
Any other response would be wrong and should be a red flag for anyone thinking of
loaning money. I want the lender to be absolutely comfortable that they are protected and represented every step of way.
Q) “Do you have any investments right now that I can lend on?”
My Thoughts: Congrats, sounds like you’ve got a bite. Don’t jump for joy or act to
eager just yet. I like to play it cool and subtlety let the lender know that I have other lenders who are waiting to hear about my next deal. Since I’ve been able raise private money from several different lenders, this statement is absolutely true, but even if you’re doing your first deal, you can still make this statement with integrity. After all, you should have others waiting to hear about your deals. It’s a little bit of psychology.
Why do nightclubs make people stand in a big line with a bouncer in front? Believe me, it’s not because they can’t fit any more people in the club. Waiting creates anticipation, it makes the club more attractive, and people seem to want things more when there are others eagerly waiting to get in. So, creating a little bit of scarcity is a good thing, as it makes it more likely that a lender will want to get in when an opportunity is presented.
My Response to “Do you have any investments right now that I can lend on?”
A) “I’m looking at some investments right now, but currently I have some other lenders who I’ve worked with in the past and are waiting to hear about my next deal. I can’t guarantee anything, but would it be ok if I contacted you if for some reason they aren’t able to lend?”
This article courtesy of Mike Sumsky, Washington Home Solutions, http://www.wahomesolutions.com