What Do Private Lenders Gain?

20 Replies

I just started reading the BRRRR book by @David Greene . MIND BLOWN! Up to this point I had only considered the traditional way of borrowing money through a mortgage company.

I am a newbie and am looking to not only purchase a property but to buy my 1st home as well. Thing is, and I'm sure I'm not alone due to my credit situation (meaning since I've previously paid cash for everything for almost 30 years and don't have a BAD credit score, just NO credit score) it isn't likely that I'm going to be getting any kind of loan via mortgage lender anytime soon.

I get the idea of paying cash so a private lender seems to be the best option for me. But what kind of criteria are we talking about here? And in exchange for their lending me the money what do private lenders get in return? @David Greene- you can just tell me to keep reading if this is covered later in the book and that will be end of it. Otherwise, any feedback on this? I am working with a realtor but it looks like I need to get the funding 1st before I can really tell him what to look for. Thanks for any help anyone can give. 

I am also a noob, so somebody please stop me if I’m wrong, but to my understanding the answer is interest.  Something I’m sure an attorney would lay out for you. You’re still paying the lender back, just like you would a bank, so they’re gaining interest on their payment. You’re also unlocking the possibility of future deals with the same lender. And if you’re creating a killer deal for them why wouldn’t they come back to you!

Again, to my understanding, a private lender is usually someone you already know, or that you have an existing relationship with. Most likely someone with “bigger pockets” than you. (Sorry, it was right there, I had to!) In one of the episodes of the podcast (sorry I can’t think of which one right at this moment) their guest talks about the “3 foot rule”. To paraphrase, if someone is close enough for you to touch and you have been speaking for any length of time, mention what you’re up to, i.e. real estate investing. People are usually very interested in this field, so you never know if a deal might come up!

@Gordon Olson they gain money via the borrower paying them interest. If a lender gives you $100K at 10% for 12 months, you pay him $833/mo in interest for a total of $10K over the 12 months. Plus, you’ll probably have to pay a point or two at closing, which is a few thousand more.

@Gordon Olson just like @Cole Raiford and @Travis Ward-Osborne mentioned, private investors are looking for a way to put their capital to work.  Many of them, myself included, are investors who over time end up with more capital than deals, or time to work the deals.   You not having any credit because you've paid Cash up to this point in your career hurts you at the Bank but not as much with a private investor or hard money lender.  The property, which will be your collateral, along with your business plan are the most important factors in determining if an investor will make the loan.  They will look at your credit history and background but that is secondary to the real estate.  Find a good enough deal, put together a sound business plan, and you will find an investor willing to put his capital to work in your property.

@Gordon Olson  the terms will depend on the property business plan.  If it's a Fix & Flip, you will have different terms than if it's a long-term hold.  Starting out, I think it might be easiest for you to establish a track record by doing Fix & Flip.  This could help you build some Credit and it could help you establish a solid relationship with a Lender or two.  

Fix & Flip is a lot of work, it isn't passive at all. The Flippers you see on HGTV have a lot of experience and well-developed teams so they make it look easy but they learned a lot of hard, and possibly expensive lessons to get where they are.  So if you don't have the time, skills, or connections to Flip properties, you might need to start with a different plan.

A Fix & Flip term is usually 12 months or less.  You want it to be less; it costs you interest every month, but you don't want to take a 6 month loan just in case it takes longer to rehab and sell the property than you planned.  Plan for at least a 12 month hold but work like crazy to rehab and sell the house in 4 months.

All Lenders, no matter if they're private or institutional, will want you to have some skin in the game.  You will need to have enough capital to pay down payment and closing costs.  You will probably need to pay the 1st construction draw to your contractor as most lenders, if they pay for rehab costs, will hold back the funds and reimburse you after you complete the work on a percentage basis. Not all Lenders will finance rehab costs but most of the good Fix & Flip Lenders will since they understand the business model.  A typical SFR house Flip in my area is usually 2-3 draws.

The following is strictly an example for this discussion and should not be considered an offer.

For a new investor that has some relevant experience (owns their own home, completed a Flip or two, or maybe owns one or two rentals) but not a long history of doing deals.-  A private investor might pay up to 75%-80% of the purchase price plus 100% of the rehab costs; up to 70% of the ARV.  Term would likely be 12 months with a starting rate at or above 10.99% with up to 4 points.  All of this would depend on the real estate collateral and the business plan.

After you have a track record of completed deals with the Lender, you will probably get better terms regarding points and rate.  Just like everything, this is a relationship business and the better your relationship, the lower the perceived risk to the Lender.

@Gordon Olson it’s slightly different from what you’re asking, but I would do everything you can to start building credit. Get 2 credit cards and use them for EVERYTHING you buy. Pay them off every month, on time and in full. In 6-12 months, you’ll end up with a decent credit score that a bank will help you without a problem.

In general, you want to stick with conventional (bank) mortgages. They are subsidized (or at least backed) by the government, which means you will get better interest rates (4.5%). There are also programs (FHA) which allow first time homebuyers some extra perks (5% down payment, etc).

Private lenders are looking to make money (obviously) and won’t be able to give to the same rates and perks a government backed mortgage will. They of course have their place too - and for things like flipping, commercial properties, etc - definitely worth pursuing... but I’d say not for a home purchase or first rental purchase.

@Gordon Olson - On a construction or rehab project, the Contractor will submit a payment application at specific milestones of completion.  The payment given to the contractor is a Draw against the entire construction/rehab budget.  

Some experienced Rehabbers or Flippers like to pay for the project costs out of their pocket and only uses a private lender for the purchase price. This saves them interest costs on the project.  But uses up their capital which could be used for down payments on their next Deal.  

If you have a Lender who will also loan the cost of construction the Rehabber can submit a Draw application to the Lender as reimbursement for each of the Draw's paid to the Contractor.  This saves the Rehabbers capital for future Deals and can also improve their cash on cash return.  But it increases the project costs which can turn an otherwise profitable project into a loser if it takes too long to flip.

The milestones for Draw payments to the Contractor are part of the contract negotiations so it can establish them at any point that works for both parties.  Typically, the Rehab/Flipper wants to make sure they have received all materials and labor required for each phase of the project before paying the Contractor.  On a simple Fix & Flip this might look like:

  • Draw 1 - 20% paid at Demo/Haul Off
  • Draw 2 - 20% paid at Frame/Rough In (plumbing, electrical, mechanical)
  • Draw 3 - 20% paid at Drywall - tape, texture, and paint (to include ceilings)
  • Draw 4 - 20% paid at Cabinet/Countertop install, Fixture install (lights, sinks, faucets)
  • Draw 5 - 20% paid at Flooring and Close Out/Punch acceptance
You might only do (3) Draw’s to reduce the paperwork on a short timeline project.  Each project can be a little different depending on timing and capital availabilty.  
The reimbursment application doesn’t need to follow the Draw payment schedule but the Lender will want to see the work has been completed satisfactorily before they issue the reimbursment funds.
You may want to hold retention on each Draw.  This is an additional incentive to make sure your Contractor finishes the project and/or you have enough funds available to finish it yourself if needed.  Retention might be 10% of each Draw held back and paid as a final payment at a certain date after the punch walk acceptance payment.  This acts as a warranty to ensure all parts of the project are working as designed.  
You may develop such a great relationship with your Contractor after a few projects that you determine this retention isn’t necessary.  However, if you are using funds from a Lender, they will always require the condition of retention.

All the Best!

Originally posted by @Mike McCarthy :

@Gordon Olson it’s slightly different from what you’re asking, but I would do everything you can to start building credit. Get 2 credit cards and use them for EVERYTHING you buy. Pay them off every month, on time and in full. In 6-12 months, you’ll end up with a decent credit score that a bank will help you without a problem.

In general, you want to stick with conventional (bank) mortgages. They are subsidized (or at least backed) by the government, which means you will get better interest rates (4.5%). There are also programs (FHA) which allow first time homebuyers some extra perks (5% down payment, etc).

Private lenders are looking to make money (obviously) and won’t be able to give to the same rates and perks a government backed mortgage will. They of course have their place too - and for things like flipping, commercial properties, etc - definitely worth pursuing... but I’d say not for a home purchase or first rental purchase.

Thanks Mike. I am perhaps a bit impatient to get going so I haven't really wanted to go this route. But at least my realtor friend had already made me aware of this and your mentioning it makes me take it more seriously.

@Mike McCarthy - I agree that getting a credit card or two is often the easiest, fastest way to build a credit profile.  But credit cards can be a double-edged sword.  If the credit card accounts are too new, they don't help improve credit; they actually can hurt the score in the beginning.  Credit card seasoning is longer than 1-2 years; the magic number is closer to 7 years before many underwriters will consider it a mature account. 

Obviously you can't get to year 7 without going thru year 1 so you're exactly right, the time to build a credit profile to invest in real estate is RIGHT NOW for most people.  

The caution would be for the person who is trying to purchase their own home in the immediate future and they don't have any credit.  If they go out and gain (2) new credit cards, it might send a small red flag making the underwriter ask, "why does this person suddenly need so much credit?"

Also, every credit card inquiry shows up on a credit profile and each time the score can take a slight hit.  This isn't the case for installment loans such as residential mortgages and auto loans.  They bundle those as one inquiry every 14 days.  This means you can go out and test drive multiple cars over the weekend, all the dealerships could pull your credit, and 1 inquiry would only impact your profile.  The same if you were house shopping at multiple new build neighborhoods.

If @Gordon Olson is trying to purchase his first home to live in, going to his local Bank and qualifying for an agency loan is probably the best solution based on the reasons you mention.  But, in his first post he states that reading @David Greene  BRRR book has inspired him to get started himself which implies he's looking to buy an investment property to fix up and rent out, not live in.  This means he needs non-owner occupied financing and therefore doesn't qualify for the first time home owner agency loan. 

He shouldn't ignore the local community bank.  This is a relationship business, and he needs to build a relationship with his local banker.  He also needs to build relationships with other capital sources if/when his deals don't fall within the box the bank is looking to fund.

Gordon's plan may very well be to house hack his first deal by living in it a few years while he upgrades it a little at a time which would fit the community bank model.  This also has the positive effect of building his credit during the hold period (as long as He makes payments on time) because it creates a mix of credit accounts; the credit card previously mentioned and the mortgage on the house.  He might even go out and buy a used truck to haul drywall and paint.  If he finances that purchase, it could help build his credit a little more.

Isn't real estate investing fun?  So many variables to think about and no real wrong answers. There are multiple ways to achieve the same result, and one isn't much better than the other; we each get to choose our own path.  Bigger Pockets makes it so much easier thanks to people like you and the rest of the community who share opinions and ideas.  I learn something here every day.

All the Best!

Originally posted by @Wren Martin :

Obviously you can't get to year 7 without going thru year 1 so you're exactly right, the time to build a credit profile to invest in real estate is RIGHT NOW for most people.  

Perfectly said!  And thanks for the detail Wren, you hit a lot more of the specifics with obviously a lot more domain knowledge!

@Wren Martin

Thanks for the addtional info, I appreciate it. More precisely I AM trying to house hack with my 1st property. The challenge I'm having is with the whole credit situation. I MAY be able to get a mortgage through my credit union but I cannot currently afford a 4-5% down payment, let alone a 10% down payment. In contrast a private lender's interest rates wouldn't be helpful either over a span of months let alone years. And depending on the type of loan (conventional vs. FHA which my credit union doesn't offer) I still have to have a sufficient credit score to even prequalify at this point.

I'm not discouraged though. I'm just expecting there to be a way finance a deal SOMEHOW. I just don't know how yet. So how practical would a private lender loan be in a case like this? Any other suggestions? Thanks all.

Updated over 2 years ago

Sorry, I didn't mean to say 'prequalify,' I meant to say 'get preapproval.'

@Gordon Olson I thought of you the other day when dealing with another client and wanted to mention what they did to build some fairly quick credit. If you have any family or friends with good credit who will put you on their credit such as a credit card account you would immediately have that show up on your profile.  If it's something like a credit card that has been around for years it could really help you.  Just make sure it's not a credit card that is not maxed out as that will have a negative affect.

You might do a Fix and Flip or two before you jump into your house hack.  This would give you valuable experience and possibly a source to earn the down payment you require.  You can also wholesale houses to other local rehabbers.  You may not have the financial resources to close on the property yet but you can find the deals and put them with other investors for an assignment fee.  This is how a lot of investors get started. 

All the Best!

Wren

@Wren Martin Thanks for thinking of me, Wren.

Wouldn't I still need to get pre-approval though before I can do any of these?  I've already considered wholesaling as I know it can be pretty lucrative. But in either case i can see where the experience gained in lining up properties for someone else to flip or flipping them myself can be invaluable. 

@Gordon Olson  as a wholesaler you don't need to get pre-qualified to buy a house because you will never close on it.  A wholesaler finds a homeowner who wants to sell and who will sell at a discount to market value; typically someone in a stress situation but not always.  Maybe the house just needs some work to bring it up to market value and they don't have the capital available to fix it up. The wholesaler will make a deal to purchase the house at the discounted price and turn right around and sell their position, which is the right to purchase.  They will either mark-up the sales price to include their assignment fee or just sell the position straight out for an assignment fee.  I like the last option for someone starting out as doing a double close can be a little complicated for new investors, although it won't be after you've done a deal or two.

To become a wholesaler, you just need to create a business plan to go out and find the deals.  This could be as simple as driving for dollars, which means cruising thru neighborhoods that you are interested to invest in, looking for any signs of distressed houses or vacant houses.  Researching "Who" the owner is.  Contacting the owner and developing a relationship.  You might have to keep reaching out to the owner for a long, long time until it is the right time for them to sell.  Then you put the house under contract and Flip the contract.  To be a successful wholesaler, you need a good marketing plan, consistent and dedicated action every single day/week, and patience as it takes multiple touches or contacts to connect at the exact right time. Some people send out letters and postcards regularly to stay top of mind.  Others might call on the phone or knock on the door.  I think the best business plan includes a little of every contact method; in fact, if I could get their cell number I would even include a few texts.  I've heard it said that most people only buy something after the 6th or 7th contact.  I believe this ratio works about the same for someone who is selling their house. I think you must connect with them 6 or 7 times.  I know there are people who will sell their house on the first contact;It happens, but not as often as on the 4th, 5th, 6th, or more.

After you wholesale a few houses, you might find one you want to keep for yourself.  At this point you should have some down payment saved up from your wholesale assignment fees and you will have a much better understanding of what is a good deal in your marketplace.  You will also know exactly what you want to do with the house you are closing on - Fix & Flip, House Hack, or Long-Term Rental... all 3 have their place and you will probably do all 3 in your career.  

Another benefit is you will have created relationships with all the investors you wholesaled the houses too, some of them may finance your deal because they may have more capital available than time to do deals themselves so they will be excited to put their capital to work with a wise investor who knows how to find good deals.  This source of capital may not even require you to have any credit at all since they are making their decision on a.) you and your ability to find good deals and b.) the house you are buying and placing as collateral.

Another benefit to starting as a wholesaler is you might find a seller who will carry the paper so you don't need to get a mortgage or short-term hard money loan.  You might find someone who will let you wrap their existing mortgage.  You might a property that you can lease with an option to purchase.  There are many ways to buy a home that doesn't require a mortgage, you are only restricted by your imagination and willingness to ask "Would you?" to every potential seller you meet.

All the Best!

Wren

@Wren Martin Thank you Wren! A lot of good info here. I've already done research into wholesaling. Just looking for ways to find buyers, which seems to be a better 1st step than finding sellers.

There's a fire-damaged property via an MLS listing I've been following for some time now. I've already run some numbers on it. I think what I really need at this point is to find a mentor for assistance. It's ok to learn from one's mistakes but it's even better to be able to learn from other's mistakes 1st! :D

@Gordon Olson you can find plenty of buyers by posting your house on Craigslist and here on BP. Flipping a good deal to an investor is the easiest part of this business. 

The Burnout on MLS may not be the best first deal for a couple of reasons. The fact it's listed on MLS and available for every investor in your market to see, and it's still available tells me it might not be priced with enough room to make a decent profit.

Burnouts can be difficult rehabs, many investors avoid them because they are kind of specialized. There are investors that focus on them exclusively and they have probably already seen this one on MLS and don't believe they can make a sufficient profit.

The best way to find a good deal when starting out is to uncover it yourself. Tell everyone you bump into that your buying houses. Ask them if they know anyone who needs to sell quick. Drive neighborhoods and look for distressed and vacant properties, contact the owners and see if they will sell. Call FSBOs (For Sale By Owner’s) ask them why they’re selling. Let them know you would buy if the price is right. Call on houses for rent, ask if they would sell. Look for vacant lots in built out neighborhoods, you can flip buildable lots the same as a house  

All of the above work may not find you a deal right away but it will get you experience talking with homeowners and potential sellers. You will learn a lot about people and you will be putting yourself in the right position when one of your contacts needs help to get out of a house quickly. 

You will be thinking about real estate every day and doing real estate investor work. Your knowledge and confidence will be increasing at a rapid rate. And before you know it you will do a deal and it will have been both exciting and scary until you’re done and then you’ll realize it wasn’t that bad, fun even, and you will be anxious to do the next one. 

It’s just rinse and repeat. Every day you’re looking for a lead of a potential seller. And you put them on your contact campaign. You’re list builds, you’re experience builds, you try a few things that work and a few things that don’t. You improve and fine tune your business and someday you have a system that works for you and your an overnight success in the eyes of everyone who knew you before but you will know that it took a lot of work to get there and it was anything but overnight. 

All the Best!

@Wren Martin All good information! The only question/issue with this is posting properties on Craigslist or here as that may constitute selling a property I don't actually own. Unless I'm wholetailing I can't do that.

Can we post wholesale properties on BP?

@Gordon Olson yes people post wholesale properties on BP, on Craigslist, and on several other platforms every day. You "Own" the right to purchase the property when you put it under contract. You are wholesaling the right to purchase and not wholesaling the property itself. I recommend joining your local real estate investor association/club if there is one in your area. This will give you another location to wholesale your properties, and it will give you the chance to meet and work with potential local mentors. I get a lot of value out of my membership in the local REIA; I'm sure you will too.

All the Best!