Private Money vs Bank Loan?

Question

Hey Guys,

Recently bought my first duplex.  I have been working on buying my next.  I CAN get another loan from the bank, I have the credit and funds, however I have been researching the possibility of using private money.  I have possibly investors lined up.  However I'm not exactly sure how the numbers work for myself and the investor,

Here are my questions

1. Is it better to leverage private money or bank?  Why?  Advantages and disadvantages?

2.   What should the investor expect in return? Is there a formula?

3.    Should the investor get ownership?

Thanks!!!!!!!!!!

Paul

Aaron H. · Answer

Scenario A: You find a house for 100K that's turnkey ready, and will generate 12K/year in net cash flow after all expenses except the mortage. The bank wants 25% down, so you have 25K invested, and then you make whatever's left over from the 12K after you pay the mortgage (let's say it's 6K left). And the bank will take 30 days to close, they require a credit report, etc.

Instead, you go to your friend John, who's a doctor and has a lot of cash but not a lot of time. You convince John to give you the 100K to buy the house (you put in no money). You'll deal with finding the house, placing tenants, managing the property, etc. In exchange, you agree to split the profit 50-50. So of the 12K, John gets 6K, you get 6K. He's still making a 6% return, and he didn't have to do anything. You're making 6K for finding and managing the deal, and you didn't have to put any of your own money in. Alternately, maybe John would rather have a guaranteed rate of return instead of equity - so you tell him you'll give him 7% interest on his 100K, plus a first-position mortgage on the property (so he can foreclose on you if you stop paying him). Now, you pay John his guaranteed 7K/year out of your 12K profit (just like you would pay a bank), and you keep 5K. If you have a bad year and only make 10K, John still gets his 7K, and you only keep 3K. You have a great year and make 15K, John still gets his 7K, you get 8K.

Scenario B: You find a distressed house that all fixed up would be worth 110K. It will cost you 50K to purchase, and 25K to renovate, so 75K all-in.

You go to the bank. The bank says "it's only worth 50K right now, so we'll only give you 75% of that, or 37.5K, and you're on your own for the rehab. We'll charge you 6% interest, and we'll take 30 days to close the loan." So now you have to come up with the other 37.5K on your own to get the entire 75K you need to do the deal.

Instead, you go to John and say "give me 75K for a year. I'll pay you 10% interest." John gives you the 75K the next day, so you go buy the house and rehab it. Now it's worth 110K. You wait a year until the bank will let you do a cash-out refinance (i.e. the bank's "seasoning" requirement). Now they'll give you 75% of 110K because it's all fixed up, or 82.5K.

Now, you pay off the loan from John, plus interest (75K + 7.5K = 82.5K), with the money you got from the bank. Now, John has his original money back, plus a year's worth of really good interest (10%), you bought the property with zero of your own money, and you have a (hopefully) cash-flowing rental that easily covers the new bank mortgage, and you still have 25% equity left in the property.

Again - you can structure a private deal any way that makes sense to both you and the person lending you the money. Some people want a share of the profits, some are happy with a fixed interest rate loan, some want points or a down payment up front, some want to fund the entire deal and are happy getting a lump sum check at the end.

Aaron H. · Answer

The answer to all 3 is "it depends":

1) Depends on the loan terms, the deal itself, and your goals. If you get an identical loan from both, but the bank wants 6% interest and the private lender wants 8%, the bank is better. If the bank wants 25% down, won't underwrite a property that needs a lot of rehab, and doesn't like your credit report, but a private lender will fund 100% of the deal at 10%, which is better? Broadly speaking, you'll pay more for private money than a bank (both points and interest), and usually have significantly shorter loan terms. But, private lenders come with less hoops to jump through, and can be more flexible.

2) Whatever you negotiate. Every private lender is looking for something different. There's no formula - ask them what they expect, and go from there.

3) No rule - you can structure a private money deal as debt, equity, or a combination of both. It, again, is down to what you negotiate.

Derriel Cribbs · Answer

Hi Paul, and welcome!

Aaron is right on with all points. I would just like to add that each deal can often bring a unique scenario. If dealing with private investors (i.e. not banks) it is so important to talk to them and find out what their expectations are. You may offer too much of the pie to them -- not out of greed, per se, but maybe out of eagerness to get the deal. If you give up too much of the pie you cut yourself out of some much needed resources in case a deal has unforeseen issues or things you didn't anticipate. And that happens. Like, a lot. The important thing is to always be fair and build that relationship on a good foundation so that it can be nurtured. I have a guy that lends private money in some of our deals and he puts up all the money for the deal and only asks for 33% profit after the sale of the flip. He never wanted to invest in buy-and-hold, but over the last year or so as he talks to other people, he is now leaning toward diversifying into some holds. I like that think that the relationship of trust we have grown has made him feel more comfortable investing with me, and that in turn gives me more of an advantage when chasing deals.

Basically, what Aaron said, but make sure to ask private lenders what their goals and desires are, it shows you are vested in helping them as much or more than yourself, which goes a long way towards getting deals done.

Good luck!

Paul Sassin · Answer

Thanks!! That helps!! I appreciate your time!!

Paul

Aaron H. · Answer

You can do it either way. If you're planning to flip the property and sell immediately, you could pay John back his full 100K, plus half of whatever you make in profit on the sale.

If you're holding it for a long time as a rental, John wouldn't get his money back in the short term - he'd leave it in the property, and just collect half of whatever you make in rental income, earning a return on his investment. Then, if you did end up selling it (say in 10 years), John would be entitled to half the profits (or however you structure it, you could negotiate a different split for sale vs. rents, it's all up to you).

Scenario B is how you refinance to pay off your initial investor if they don't want to leave money parked there indefinitely.

Note that you can mix and match - maybe in Scenario A, instead of John giving you the whole 100K, he just puts up the down payment (25K) and you get a bank loan to buy the property. You still get to do the deal with none of your own money, John still gets to collect half the profits and earn a return on his (smaller) up-front investment. But in that case, you've leveraged John's money with bank financing, instead of using all cash.

Paul Sassin · Answer

Appreciate the feedback, Aaron! One last q in regards to the first part of scenario A (John gives the 100K and you split the profit 50/50).  Does John actually own 50% of the asset and only make his 100K back at time of sale and is paid the 50/50 split until then.  Just trying to connect the dots on how John is paid back his 100K investment.  Thanks again.

Paul Sassin · Answer

Thanks for the Reply, I really appreciate it!

I believe I understand what your saying but I still don't understand how to structure a private deal in a way that could help me avoid the standard bank issues.   I would love to avoid 20%-25% down payments for each unit I buy.   I could afford a few more down payments but I would be maxed out at some point and I would love to keep cash in my pocket right??.  I'm Just not sure how I could take care of the investor, while still meeting my goals of owning the property and getting a good cash flow going.

Please help me with one last question.  How would I structure a private deal that would work out for me, and the investor.  A simple example would be great.

THANKS!!!!!

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