This is my first time loaning money, how do I protect myself?
Real Estate Investor · Kingsville, MD · Member since 2012 · 21 posts · 1 vote
Greetings,
I have been to Real Estate Expos and searched the web. There are plenty of ways to find out how to borrow money but very little about how to loan it. I need a sanity check please.
One of the members in my REIA (Joe) is trying to get started in real estate with buy and hold but has no money. I am trying to get started in buy and hold myself but am having a hard time finding that first great deal. I have an ample amount of money in my SDIRA. I want to work with Joe so we both can get started. I spoke with Joe and suggested that he rehab a few houses that I will finance so he can build up his cash reserve. I am looking for a short term financial commitment.
Joe is trained as an engineer so he builds spread sheets and knows how to crunch the numbers. He has found a house that is a a great candidate for his first project.
How do I protect myself?
Do I purchase the house in my LLC and finance the repairs, let Joe supervise the rehab and divide up the profits when it is sold?
Do I hold the note on the house? How do I create a note for the house?
Am I insane for even considering doing this deal?
My thought is that in the worst case I will end up with my first rental property.
Tom
He’s never flipped a house and you’ve never loaned money? This could be a formula for disaster, Thomas Elam. Plus, it’s not clear from what you wrote that either of you have any real estate experience at all.
If your SDIRA allows check writing, that is you have an IRA-LLC, you could use it to buy the home and finance the repair thru it. You cannot form a separate LLC you personally own and then us your IRA to fund a property. That would be self-dealing.
Don't forget, you can't spend more than your SDIRA has. I could think of a hundred things that go wrong other than it ends up owning the property. Plus, do you know how to manage a property in your IRA?
The simplest, cleanest, and probably safest way to do this would be to loan the money by using a broker or lawyer to do the paperwork, depending on how it’s done in your state. Your SDIRA would be secured by the note - the best use of retirement money, in my view.
I think you’re on the right track but the wrong borrower, Thomas. Find some experience borrowers to loan to, get a good broker or lending lawyer, and go from there.
Jeff
Google loaning money how do I protect myself site:www.biggerpockets.com. Start with the first 5 or 6 hits...
He’s never flipped a house and you’ve never loaned money? This could be a formula for disaster, Thomas Elam. Plus, it’s not clear from what you wrote that either of you have any real estate experience at all.
If your SDIRA allows check writing, that is you have an IRA-LLC, you could use it to buy the home and finance the repair thru it. You cannot form a separate LLC you personally own and then us your IRA to fund a property. That would be self-dealing.
Don't forget, you can't spend more than your SDIRA has. I could think of a hundred things that go wrong other than it ends up owning the property. Plus, do you know how to manage a property in your IRA?
The simplest, cleanest, and probably safest way to do this would be to loan the money by using a broker or lawyer to do the paperwork, depending on how it’s done in your state. Your SDIRA would be secured by the note - the best use of retirement money, in my view.
I think you’re on the right track but the wrong borrower, Thomas. Find some experience borrowers to loan to, get a good broker or lending lawyer, and go from there.
Jeff
Thomas Elam I would question not only their track record (or lack thereof) but also the loan to value of the transaction. If your friend has some of his money invested as a cushion that would be comforting. If you finance 100% of the deal and he walks, then what? If he puts down 30% of the purchase price and he pays for repairs out of his pocket that would put him in with something to lose. If your borrower has nothing to lose they might not hesitate walking out and leaving you in a bind. As for lending money with your SDIRA, that can be an excellent way to make great returns.
Hi Thomas,
I’m not sure who said this but it may apply: “To have what you have never had you must do what you have never done.”
There is certainly risk going into business with Joe but you will have risk with anyone. As an engineer Joe should have something of value to put some skin in the game.
Good Luck!
Alison
Thanks for the quick reply.
How do you do the @ThomasElam?
We are both new to real estate. I've been studying and going to seminars for a year. This time last year I was told the power plant where I work was being sold. I knew I would gain control of the money that has grown in my 401K for the last 23 years and I would get a portable pension. That is when I realized that I needed to do something besides the stock market to build an income stream. Real estate seems like a good way to build wealth and provide an income through retirement. Joe was already in the REIA when I met him there.
The google search worked well, thank you Chris.
I go to church with a man who is a certified home inspector and he also owns a contracting business. He will look the house over for me and give me an idea what the rehab will cost. I have a real estate agent that I have been dealing with for the last 4 months that can tell me house values and target potential buyers.
Jeff S Thanks for the recommendations, I appreciate that, you are very helpful. I assume you mean real estate broker. I'm sure I will be able to find someone in the REIA that will be able to recommend a lawyer that will handle the deal and my real estate broker will know someone.
John T, I plan on watching this deal like a hawk. I will be cutting the checks so I see where every penny goes. I have had a number of people tell me that if they had as much money as I do that they would not be a landlord but would just finance others. How does that build wealth? I would just have a bunch of cash. I thought the real wealth building is in owning real property.
I realize that Joe has no skin in the game. However this could be an opportunity for us to make money and get ourselves going in the real estate biz. Hopefully we will make some money and repeat the process. And if things fall apart I know a couple of general contractors and a property manager to finish the job.
Tom
No, I meant a mortgage broker, though in CA mortgage and RE brokers are one and the same. I don’t know if you close through title and escrow in Maryland, and use mortgage brokers like we do, or use closing attorneys, or some combination.
My point was simply to address your question about creating and holding a note. You want to use the professional appropriate for your state who can also explain the process. Do not try to do this yourself.
Jeff
Thomas Elam you stated "John T, I plan on watching this deal like a hawk. I will be cutting the checks so I see where every penny goes. I have had a number of people tell me that if they had as much money as I do that they would not be a landlord but would just finance others. How does that build wealth? I would just have a bunch of cash. I thought the real wealth building is in owning real property."
How do banks build their wealth? The same way...lending money. Interest adds up. Interest on interest adds up even more. Fees add up. If you can compound your money at 15% it will double in less than 5 years. Look what happens if you receive 16%, 17% or more. For this reason many investors use more than one strategy to build wealth including holding rentals and notes receivable. The rule of 72 is a fast easy calculation to show the power of compounding. Having a pile of cash is not a bad thing! If it bothers you that bad, send me a check:)
A related thread for you:
Thomas Elam,
You asked how to do @Thomas Elam.
Hold down the shift key and type @ and the first 2 letters of the first or last name. Look below this box, and you will see the name, click on it.
Raymond
Thomas Elam A bit off-subject here, but which Baltimore/Maryland REIAs have you found useful in terms of networking and/or educational? I'm considering joining at least one this/next week, and would appreciate any feedback. Thanks in advance.
I have joined the Baltimore REIA and am happy with them. You can take a $1.00 test drive to see if you like it.
Raymond B.
Thank you Ray
All REIAs have some networking potential. The best in the Baltimore area right now is the Baltimore REIA as Tom mentioned. MAREIA is also worth checking out.
I also suggest the meetup with Kenny Gills and Bill Ames, BWI Meetup in Columbia MD. and another one, I am not sure of the name With Kenny Gills and Charles Blair. Right now the only one I go to regularly is the BWI meetup in Columbia simply because it is the closest to me.
Thomas Elam
The best way to protect yourself is don't make this loan.
This is a case of the blind leading the blind. It sounds like you trust Joe, however it is important to understand trusting his integrity is different than trusting his skills and knowledge.
There are so many things that can go wrong on a rehab. An inexperienced rehabber can actually devalue a property while working on it. If you have to take the property back it could be worth less than when it was purchased. Your first loans should absolutely be with someone who is experienced.
Good luck - Ned
You have received a lot of great advice here. Your cleanest option is not to loan Joe the money under a note, but for your SDIRA to fund and own the property with a Joint Venture Agreement spelling out profit/revenue splits to Joe. That way if things go wrong and the relationship sours you are not chasing Joe, or worse possibly having the time and expense of a foreclosure. That being said, I look first for integrity in anyone I am funding or Joint Venturing with, which it sounds like you have found that in Joe. However, much can go wrong with a rehab, even for experienced rehabbers. The net result of a rehab going wrong almost always equates to being over budget or a poor job that is not marketable without it being fixed. You two could become great partners in the future, but I would never fund somebody's first rehab unless, and only maybe, it is no more than a cosmetic carpet and paint type job - and even then only with a firm handle on what the expenses will be. In general, you do not want a first time rehabber learning the business with your money involved.
Two more thoughts here. Joe's current position of being capable of finding the deal but without a financial contribution might be more suitable to him wholesaling to build up cash rather than a buy and hold position. Your SDIRA can likely get higher returns than funding a house and rehab entirely with cash. Your SDIRA can borrow a portion in order to achieve leverage, but only from select local banks because the loan to your SDIRA has to be non-recourse.
Hi Thomas Elam,
I'm curious about what you want to get into. Do you know all your costs, ARV, and how much the subject property will comp out to?
i suspect that your lending your money will be the easy part. the seasoned private money lenders ALWAYS know all the numbers (costs, time, and profit) before they lend money. do you already have terms in mind and how you plan on working this deal?
I agree, Thomas Elam, that you should absolutely NOT make a rehab loan to a newbie who has never done a fix-and-flip, may have little idea what a good fix-and-flip deal even looks like, and has no skin in the game. Joe should go on an austerity plan, and combined with his decent engineering income, save funds as rapidly as possible.
If he wants to rehab, he can use a professional hard money lender to fund his first deal. The HML has many checks in place to ensure that Joe is not getting into a bad deal. They know where successful flips are occurring in your area, by neighborhood, and they know the numbers inside out. Joe's initial job will be to find a great deal (purch+repairs <= 65% of AVR). If the deal is good enough, there should be a HML that will lend 95-100% of costs.
After Joe has done a couple of successful flips, then you can start funding him.
Another great possibility is that you work together on wholesaling deals. You could fund the marketing dollars for a direct mail campaign ( say about $1,000 per month to start). Joe could do the technical work to set up squeeze pages and post ads on CL/backpage/etc. to find buyers. You can also buy names off of LeadSource for recent buyers with 99-100% equity (tip to Michael Quarles). Joe could run comps, take/return motivated seller calls, inspect homes, and negotiate deals (you could also help with the final deal negotiation since you're the older more seasoned guy that might do well with homeowners). You would split the wholesale fees (targeting $7K-15K per deal). A budget of $1k/mth on marketing should generate 1-2 deals per month after you get it going and get some experience dealing with motivated sellers. Ultimately, this can also feed properties to a fix-and-flip business. If Joe is unwilling to do this, then maybe he's not the go-getter you want to work with anyway. Deals on the MLS are scarce these days, and investors that are unwilling to get in the trenches and find motivated sellers will be on the sidelines.
In the meantime, you could use your SDIRA to make loans to EXPERIENCED rehabbers. These should be easy to find by calling realtors in your target area, at your REIA, driving targeted neighborhoods looking for rehabs in progress, or right here on BP. You can offer them better terms than HMLs, something like 11% and 3 points on 6 mth notes (a 17% annualized return), vs a HML company at 13% + 4 points + processing fees. Through this, you will also get a great first-hand education in how to execute a successful fix-and-flip.
I believe you also need to be careful about how profits are distributed when an SDIRA is used to finance a purchase & rehab. If the SDIRA is the source of 100% of the financing, I think that 100% of the proceeds have to go back into the SDIRA. Again, I'm not an expert on this - there is probably a lot more info about investing with an SDIRA here in BP. Worth a search to make sure you don't go down the wrong path...
Ted Akers The plan is to finance the project in my LLC as you suggest in a joint venture. Joe will find the property, manage the rehab then market and get it sold. The LLC will get back all expenses plus 10%, Joe will receive the remainder of the money as his compensation. I do not want to get into leveraging. I believe if I can't pay with cash than I can't afford it. I have heard too many stories of someone getting over leveraged and loosing it all. Cash is king.
Dev Horn Thanks for that suggestion, I assumed that Joe would be paid as I would any other contractor. I'll look into it with my SDIRA provider.
Tom
I guess I’m confused, Thomas. The title says you will be loaning money and asks how to protect yourself. It seems however, you’re really partnering.
If I read this correctly, your LLC (owned by your SDIRA?) will fund the entire deal (purchase and rehab expenses?) and only earn 10%? Your partner, who has taken absolutely no risk, will get the remaining 90%?!?!?
How do I sign up for a deal like this?
Do you realize you could likely earn at least 10% on a straight loan, secured by the property?
With due respect, except for the collective lack of experience between you and your partner, with enough equity this would be a very low risk deal for a greater annualized return.
You note too, you don’t want to get into leveraging. In this case, you’d be providing the leverage!!
You might either rethink this one, or at least clarify.
Jeff
You are correct Jeff, this has evolved into a joint venture. Lets say I use $70,000 out my SDIRA. I get my initial investment plus 10% $70,000 +$7,000=$77,000 back at the sale. If the house sells for $100,000 Joe gets $23,000. Joe is doing the work, should he not be compensated this well?
I'll echo my concern again that this transaction should first be discussed with the custodian of your SDIRA (which must approve all investments made with the SDIRA). IRS does not want people to invest IRA $$ and then pull non-IRA profit out of the transaction. You may be able to structure it as a note, a loan to Joe, with a 10% interest rate. But I THINK (again, not an expert in this area) if the SDIRA $$ are used to directly purchase the property and are used to repair it, then any proceeds from the subsequent sale of the property must go BACK into the SDIRA.
Joe could perhaps be paid as a contractor (if that was his role), but I am just not sure how he would split the proceeds resulting from an SDIRA investment.
This article doesn't make my point exactly, but it speaks to some of the issues involved in purchasing RE with SDIRAs:
http://www.foxbusiness.com/personal-finance/2012/05/08/how-to-use-self-directed-ira-to-buy-real-estate/
Of course Joe should be compensated. Traditionally, in a deal like this, you would provide all the money and your partner would provide all of the labor. You would then split all the profits 50/50 (and keep your half in your IRA). Of course, nothing says it has to be this way but don't minimize your value here.
Unless your money fell from the sky and hit you in the head, I bet you obtained it like most of us did -- by working your butt off. The value of your labor is stored in that money and now, Joe, your partner, gets the benefit of your previous hard work.
I’m not trying to be weird or philosophical, but simply trying to keep you from feeling guilty by believing you are not earning your half of the deal because you “only” funded it and provided no extra labor.
There are more practical reasons. Here’s a related thread.
Jeff