Legal? Logical? What do you think?

Question

I've been running over some ideas to raise capital and have come up with this...let me know what you think.

Note:  This will only work as long as I can get investor loans on properties, so for potentially 10 properties (realistically it would only be 8 or 9 since I'll have a primary residence)

These dollar values are all made up and for explanation purposes only.

Pitch:
So here's the deal, you (the investor) put up (roughly) 50% of acquisition costs for a rental property.  In this case, acquisition costs will range from 20-35% of purchase price since I will be getting an investment loan.  I then purchase the property (with joint funds) and quitclaim deed into an LLC.  The LLC will have an operating agreement drafted by an attorney that outlines ALL of the details below to a "T".

Details:
You (the investor) will get stake in the property for your initial investment amount.  This will be the first money paid out upon sale/transfer.  You will also receive 8% annual interest, paid monthly on your initial investment.  You may also have the option to purchase upside in the property for a lower interest rate.  (This means in exchange for paying 7% instead of 8%, I'd be willing to cough up a 10% of any capital gain on the property.)

There will be additional details about holding time and early exit penalties etc. included in the OA.

Here's a hypothetical example:  $100,000 single family house.  20% down requirement.  $10,000 outside investment, $10,000 my money, $80,000 bank loan.

The cashflow is the same as if I were to purchase the property by myself with $20,000 of my own funds, with the exception that I would be paying the investor a monthly interest payment (in this case it would be about $67).

The goal of this setup from MY perspective is to put less cash down up front allowing me to purchase more properties or obtain my desired # of rentals more quickly.  In order to do this, I am sacrificing a bit of the monthly income.

From the INVESTOR's perspective, they get a great rate of return and a possible upside if prices increase significantly.  They sit back while I do all the work and get their monthly interest payments.  I have a vested stake in the property so I would not just take their money and turn the building into a slum.  If property prices fall, they would get first claim on proceeds of a sale (I would prefer to cash investors out based off an appraisal rather than selling, but selling is an option).

Potential downside for me...there could be a "run" on funds...so multiple investors could request an early exit at the same time, leaving me haning (this would be deterred by early exit penalties and long notice times).

Potential downside for them...if the property drops in value significantly over the investment period to where there is no equity in it, both they and myself will lose all initial investment money (likely due to foreclosure or short sale).

Please don't focus on the percentages or dollar amounts, just the idea in general.  I've determined numbers that I think will get people interested, but not kill my profit.  The numbers included here are simply for illustration.

Any thoughts are much appreciated!!!

Josh Sterling · Answer

I thought prime was 3.25% right now?

We have a couple private money loans to our LLC currently. These are all from family/friends. They are not tied to any individual property, however we did give a personal guarantee. We make a loan for about 30k (enough to purchase a house in our market) and make the repairs with our own funds. We pay 8% on a 20yr. Term and allow the lender to call the loan due at any point with 12 months notice. They love this because it is like a 12 month CD to them, and we feel comfortable that we can generate the funds within 12 months if needed, either through cash flow or the sale of the property of our choosing. The key is to avoid getting too much financing with the same 12 month option, as to avoid a run on funds.

Jake Kucheck · Answer

So the goal is to fund high risk investments (2nd TDs) with low yield capital (7-8%), and have the sources of these funds be people that you currently have good relationships with.

For your business, it might work.  For your personal life, if they find out that you've pulled off this kind of swindle, it probably wouldn't cause them to look upon you favorably, nor invest with you again in the future.  I don't see the upside here, but it is both legal and logical (but also flawed).

Michael Seeker · Answer

I did not really clarify this, I will have the required $ for the down payment (as well as the income to guarantee the loan).  I will only be buying when I have enough $ to do it myself.  At the same time, I'll also be flipping or looking for flips and/or other deals that I can do.  So I'd like to maintain a certain amount of liquid funds in order to keep my options open for other deals as they come along.

So basically the rental property is just a way to secure the loan for an investor to give me $ at an agreed upon interest rate.  I could go the unsecured route, but I would feel more comfortable asking/marketing to these people with a secured loan.

@James Vermillion - You're right, these people have all been around me since I started investing in real estate and have seen what I've done so far.  With that in mind, coupled with my well paying "fall back" job, it is a much less risky proposition for them than if some Joe Schmoe came and knocked on their door asking for 20 grand or something.

Nathan Emmert · Answer

Sorry, meant conventional NOO rates are 5%... miss-terminology.

Michael, when you see you will have the required money up front... are you referring to Down payment or Income (Debt to Income ratio)??

If you already have the down payment, what do you need them for?  My understanding was you didn't consistently have 20% for down payments?

Banks frown upon "unseasoned" deposits of money being used as a down payment.  You will also likely need to disclose that part of that down payment you're making is really a loan to avoid committing bank fraud.

I like the idea, having private investors at a decent rate is great... I just think there's a few hoops to jump through to get the big banks to pony up the other 80%.  It'd be far easier to have your friends/family loan you all 90% (or if you're paying 8% maybe 100%).  Given appreciation, purchasing of distressed/undervalued properties, or simply equity pay down you could do a 10 year balloon to fully cash them back out.

You have good and bad there... because of no down payments, your buying is only limited by their funds... you can grow quickly, you can grow beyond 10 mortgages quickly.  The down side is you aren't taking advantage of the historically low interest rates.  I guess in theory you could make both plays to ensure you get your 9 (or 10 if you don't own a house) mortgages at 5% for 30 years fixed.

James Vermillion · Answer

Michael,

I do not see any of the problems with your plan.  The fact that these people know you and what you are planning to do with the money often means they perceive less risk than if they were to do the same loan with a stranger, lowering the return they would require.  But I understand you are not looking for opinions on the yields, rather the idea. Like Josh, we have done several loans that are not linked to a specific property and are personally guaranteed by both myself and my business partner.  These loans worked out very well for both us and the lenders.

Jake Kucheck · Answer

Michael Siekerka- I get it.  You've found this niche that you're super excited about, and so naturally you want to defend it.  At least that seems to be where all this emotion is coming from.

However- your gambit is flawed because it relies on irrational actors- those folks willing to be paid less than market value for assuming risk.  The problem with this is two-fold: irrational actors are of limited supply and might only remain irrational for a limited duration.  Thus- you only are able to pull this off for the amount of time you have a supply of irrational money.

The market for a 2nd TD that you are trying to sell (if it exists) is really more like 20 and 20, and you are offering 8 and 10.  Of course, if you are able to pull this off, that's great for you, but crappy for them.  I prefer things that are scalable and equally beneficial... you know... how markets work.

Operating outside of markets is fine, but I just wouldn't choose to do it with my friends and family.  Perspective is not set in stone, and the day it is discovered they could be earning more than double the yield and double the upside for assuming the same amount of risk will be the same day your capital dries up.  After all... you are encouraging them to go outside their comfort zone into what they believe is a "high-yielding" investment- it seems only natural that they might do some research into the alternatives either before or during their investment.

Michael Seeker · Answer

I am bringing RE knowledge and experience to the table that they do not have and don't desire to acquire.

I believe I pointed out the upside to both me and the investor.  I can provide a more detailed example if you aren't seeing it, but it's already there.

If you feel it is flawed, please point out the flaw(s), otherwise your response is of absolutely no value to me or anybody else.

This is all about perspective.  I've already run the idea by people who feel that the terms are either acceptable or generous, so I don't want opinions on the numbers.  If it makes you feel better, replace the 8% number with whatever %-age return you would feel comfortable with.  If you want to critique this, please come at it from either my point of view or a potential investors point of view, not your own (I don't want your money).  I know damn well I'm not going to get Donald Trump to throw me a bone on something like this, so no need to come out of left field and tell me why he wouldn't be interested.

Michael Seeker · Answer

I agree Nathan, however I wouldn't do it in the first place.  I'm mainly looking for family members and/or coworkers who have large sums of $ just sitting in bank accounts earning 0.0000025% interest.  This situation helps me and it helps them.

To your LTV point, for purchasing the properties, I will have the required $ upfront on my own.  As far as the bank is concerned, I can afford it on my own and I am responsible for the monthly payments.  I know they could call the loan if they wanted to, but I think they have higher priorities then that right now and will for a long time.

I do appreciate the feedback, I'm looking for people to pick holes in this idea!

Nathan Emmert · Answer

You're essentially using private funding as a 2nd mortgage to go from 80% LTV to 90%.  You need to make sure your bank is comfortable with that as it changes your Debt to Income view.

For private funding, I'm not sure 8% is enough... I know HML is 12 - 15% with a few points up front, prime is 5%... I'm guessing private money to be in 8 - 10% range but could be wrong.

If I were to do it, I'd want some upside from appreciation beyond just the 8% return.

Legal? Logical? What do you think?

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