Accidental Hard Money Lending

 

Steve: Hey Joel, can I borrow $50,000?

Joel: Ah… that’s a lot of money… What are you gonna do with it?

Steve: Well, I have an opportunity to buy a rundown house. My plan is to fix it up, put a renter inside, and then sell it to another investor as a “turnkey” rental property. It will cost me about 50k all-in, and I’ll be able to sell it for ~75k by the time I’m done.

Joel: Why don’t you just borrow the money from a bank?

Steve: I could, but there are a couple of problems with bank loans:

  • first, they’re trying to sell me a 30 year mortgage. I don’t need a loan for 30 years, my whole project will be wrapped up in 3 to 6 months!
  • next, the bank takes ~45 days to close on a loan, which is way too long… If I don’t buy this house in the next 7 days I’ll lose it to another flipper.
  • lastly, the paperwork, red tape and underwriting process is so painful, not to mention costly. I’d rather pay those fees to a friend like you and save all the headaches.

Joel: I don’t know, man. It sounds pretty risky… How sure are you that this project will work out?

Steve: Very sure. This house is a great deal, and I know what I’m doing. I’ve completed 6 similar projects in the same neighborhood this year, and they’ve all been successful. I will email you my past case studies and also some phone numbers of people I’ve borrowed money from before. If you call these references you’ll hear that I’ve never failed to pay back an investor. I’m good at what I do.

Joel: Wow, I had no idea. Are you putting in any of your own money too?

Steve: Yes, a little. I’ve already paid the $4000 deposit on the house, and about $800 for some inspections. You would be putting in the bulk of the money for this project, but I do have some skin in the game.

Joel: Ok, so if I did loan you $50,000, how much money will I make back in return?

Steve: Now we’re talking! I’ll pay you a 15% annualized return for however long the project takes. If the project takes 6 months, your return will be $3750. The absolute maximum this will take is one year, in which case your profit will be $7500.

Joel: Dang, that’s pretty good! More than the average returns I’m getting with my index funds. And, I like the fact that this is a rather “liquid“ investment. I’ll have all my cash back in under a year.

Steve: Exactly. It’s a shorter term investment that gives some diversification to your overall portfolio.

Joel: OK… Let’s take a step back and talk more about the project risks. I have some questions…

Steve: Sure, what do you wanna know?

Joel: What is the absolute biggest risk in this investment?

Steve: The single biggest risk is me and my team not executing against our business plan. This is where 90% of house flippers and new investors go wrong. You see, any person can buy a cheap house and have good ideas to fix it up. But if they don’t stay focused, follow through, and execute at a fast pace, then the project will fail.

I take great pride in the well-oiled rehab business I’ve built. My partners and I have a combined 80 flips under our belt with a perfect track record. We only take on projects that are within our wheelhouse and ruthlessly execute our business plans. I’m confident we can smash this project and all make some money!

Joel: Great answer. But I thought the biggest risk would be the economy crashing… Like what happened in 2008.

Steve: A crumbling economy is certainly a risk. But the collapse of the housing market wouldn’t be an overnight event. There are telltale signs for many months leading up to a downturn. Since my team are monitoring and tracking the area religiously, if there are any signs of a slowdown, we can wrap up our projects and exit the area before we get stuck holding real estate we don’t want. We’ve done this before in other areas.

Joel: OK well what if the house burns down? Or what if someone hurts themself or a contractor sues us or something?

Steve: Don’t be silly. We have insurance in place for all that stuff. Protecting the investment, and your money, is my #1 concern. Me and my team don’t cut any corners.

Joel: Wow. This is starting to sound much safer than I first thought. You really do know what you are doing.

Steve: Yep, I do! I wouldn’t ask you for money if I didn’t have a thorough plan.

Joel: So, if I was to invest, how do I send you the money? Do we sign some contracts or something?

Steve: The only contract you and I sign is a basic Promissory Note. Here’s the one I’ve used with many other investors… It states all the payment terms, collateral, dates and clauses for both our protection. Feel free to have it reviewed by a lawyer, it’s pretty standard stuff.

Joel: Thanks. May I also take a look at the house inspection results? Do you have area comps to prove that the house is worth what you’re paying for it, etc.?

Steve: Of course. My books are always open and you can have a copy of any doc you want. Here’s the quotes I got from 3 different rehab contractors, and if you look at this financial projection sheet, you’ll find it’s quite conservative.

Joel: Thanks. I don’t mean to be a micro-manager. I just always like to do my own due diligence as an investor.

Steve: No worries at all. I like working with experienced investors and I’m glad you take this seriously. If you notice any errors in my calculations or have questions about my business plan, please let me know. It’s always helpful to have another pair of eyes on the deal.

Joel: Sweet. Let me review everything and I’ll get an answer to you before the end of the day.

Steve: Cheers! I look forward to doing more business with you!

 

Reviewing Hard Money Contract

I always treat myself to a beer while reviewing boring RE contracts!

What is Hard Money Lending?

The above was a real conversation I had with a buddy last year. I never really knew what hard money lending was until this opportunity fell into my lap.

A Hard Money Loan is just a simple, private agreement between 2 people. A loan from one to the other, backed by real estate. It’s not as complex as most people think.

That being said, “easy in theory” investments should not be mistaken as “easy profit” investments. There’s a high amount of risk involved with lending money, especially for inexperienced investors.

 

So What’s Next For Me?

Although this investment worked out well for me (it ended up taking 9 months, I earned a $5,625 profit), I will not be doing any hard money lending again.

Here are a few realizations and things I learned this past year:

  1. In the exact 9 month timeframe I was in this investment (Dec ‘18 through Sep ‘19) the S&P 500 Index returned an annualized 22%. I only earned 15%, and in a much riskier way.
  2. Trustworthy flipping partners and well-vetted deals are hard to find. It could be many months before I find another good deal. Sitting on $50k in cash in the hopes that I stumble across another hard money lending deal isn’t smart.
  3. Being completely honest – I was kind of shitting my pants in months 6-9 of this deal. Although Steve said it could take “up to 1 year”, my expectations were higher. That’s my own fault. I don’t really enjoy investments that make me worry or get nervous about.

 

All in all, I’m gonna stick to syndications and buy & hold fourplexes as my primary strategies going forward.

 

Do you do hard money lending? What’s been your experience?

 

7 thoughts on “Accidental Hard Money Lending

  • My first question in reading this was if he did 6 projects in that same year, where are all his profits going? If he’s making $20K+ on each project, even after repaying the first couple investors, it seems like $50K would easily be lying around at this point. I realize this isn’t the point of your post but the curiosity is killing me….

    • Great question, love the curiosity!

      The short answer is Steve’s money was tied up in other deals. Most successful flippers work on simultaneous projects, some using their own money and some using OPM. He had no available cash at the time he found this deal, so he offered it to me. He prob had 5-6 other projects ongoing at the time with his partners.

      Longer answer: Steve wouldn’t want to tie up all his money in one project. If you think about it, it’s more profitable for him to use other peoples money. $50k of his own can only fund 1 deal. But borrowing other investors money, he can scale. His ROI is much higher using less of his own money. Make sense?

  • 4. Your interest is charged at ordinary income tax rates, whereas the gains on the S&P 500 may someday be taxed at much more favorable capital gains rates or not at all, depending on when, how, and by whom the gains are realized.

    Hard money lending makes more sense in a tax-advantaged account with checkbook control, like a self-directed IRA / 401(k).

    Cheers!
    -PoF

    • Hey PoF, thanks for stopping by!

      Yep, I definitely need to shuffle my investments around because right now my tax-advantaged accounts have low risk/low return holdings, and I’m in risky/high return investments with my taxable accounts. It should be the opposite!

      On another note, since I’m still on a loooong work sabbatical I have no regular income to claim in 2019. I should be paying much less tax than I would if I had my day job still.

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