Over the years, I have borrowed significant amounts of money to finance my real estate investing business. I started like many people do, by going to the bank and getting 30-year, fixed-rate loans.
Back in the day before the real estate crash in 2008, you could get several of these types of loans. But when the market turned (and for a long time after), the money that had been flowing in that way simply dried up.
It caused several real estate investors—me included—to seek out new sources of funding to grow our businesses and snatch up real estate at fire-sale prices.
As the saying goes, however, every cloud has a silver lining. The silver lining for me in 2009 was the discovery of private money. And private money has been the major funder of my real estate deals ever since.
If you are newer to investing, you might be wondering what private money is exactly. What advantages can it provide over other types of funding? How do you structure a deal using private money?
This post is intended to help explain those things.
What Is Private Money?
Private money is exactly what it sounds like. It is money held by private individuals. In other words, it is savings.
It is money that is held in bank accounts, CDs, IRAs—even under mattresses—by average, everyday people. These people become the bank, so to speak, by loaning their money to real estate investors like you and me.
Who Has Private Money?
If you take away anything from this post, take away this: never judge a book by its cover. You likely underestimate who has money. Lots of people have it and just don’t advertise it.
I have borrowed money from people I play racquetball with, from people I have met at my local REIA, and from people I’ve met on sites like BiggerPockets.
Why Would People Lend Me (or You) Their Money?
In short, they lend because they can make money doing so. We real estate investors can provide better returns on lenders’ money than they can get almost anywhere else.
Take CDs, for instance. A “safe” investment like that currently only earns around 2.7 percent interest, according to Bankrate.com.
How Can Private Money Be Used?
Private money can be used in almost any creative way that both you and the lender can agree to. I have used private money on both buy and hold and fix and flip real estate deals.
It can be used short- or long-term, in lump sums or installments, with or without interest payments, with shares of profits or not. The possibilities are only limited by you, the lender, and the creativity you both bring to the table.
The Structure of Private Money Deals
Buy and hold real estate investments are structured in much the same way as a conventional bank loan. The lender puts up the full amount to buy and rehab the property, and the buyer repays the loan at an agreed upon interest rate and amortization schedule.
These loans are usually for five years or less with balloon payments at the end. Many times, the lender agrees to refinance the loan at the end of the term because they like the stability of income.
On certain buy and hold deals, I have used private lenders as a second mortgage behind a primary bank lender to cover down payment or rehab costs. There are two things to remember when doing something like this:
- Be sure your lender understands their position as a second mortgage holder.
- Also, be sure your primary bank lender will allow it. (Some will not as they want some of your skin in the game.)
My fix and flip deals with private lenders have been profit sharing agreements. In these types of deals, the lender loans the entire amount to purchase and rehab the property. Then, once the property is sold, the profits are split as per our agreement.
There are no monthly payments, and the lender has no say in terms of how the property is rehabbed and listed. But, of course, I keep them informed throughout the process.
In both cases, there are significant amounts of paperwork drawn up to protect myself, the lender, and their money. A proper closing is held with an attorney and all monies are properly escrowed or exchanged.
A deed of trust is always recorded, and a promissory note outlining terms and conditions is always executed. I also give a personal guarantee, as I have no intention of defaulting, and it seems to make the lenders more comfortable.
Can You Pool Private Money?
Yes, you can—with many legal conditions. Laws have been changed in recent years to allow what is called crowdsourcing. Plus, syndications, or the combining of investor monies into an entity such as an LLC, have been utilized for decades.
That said, while pooling can be done, you need to be aware of state and federal rules. Advertising is a big no-no, for example. You can get into some real trouble if you do not report the right information or structure your dealings properly.
For these regulatory reasons, I have never used pooled private money. I am not saying that it is not a good idea to pool money, I just find that the requirements to do so are too burdensome.
For me, it has always been much easier and seemingly cleaner to have one private lender attached to one single property with one set of paperwork. However, this strategy is somewhat limiting, as there are many more people with $10,000 to pool than there are with $100,000 to lend. But this strategy has worked for me, nonetheless.
Advice for Finding and Using Private Money
First, develop a private money program that will work for your business—one that you can put on the table in front of a potential investor. Suggest loan amounts, interest rates, and profit sharing splits up front.
Also, explain in detail to potential lenders how your program will work and benefit them. Do not assume people with money will necessarily understand how money and investing works. Nor should you expect them to formulate a deal for you.
Many possess limited know-how, and out of fear of looking ignorant, they will say no. Avoid scaring away potential lenders by making things clear and easy for them.
Second, have a short, succinct speech prepared that explains what you do and how you can help people earn higher investment returns. As I said, you never know who has money. Plus, you never know who you will run into or who might be looking for better investment returns. You might encounter them anytime, anywhere—so be ready.
Lastly, remember that you, the investor, bring a lot of value to the table. The lender needs you just as much as you need them.
Create a structure that works for both of you. Do not think that the one with the gold makes all the rules. They do not!
And if an offer of private money does not work for you, walk away. I have! There are plenty of other lenders out there.
Have you used private money? Would you consider it? Why or why not?
Let’s talk about it in the comment section!