Why will a private investor accept a low return on their all cash investment?

Question

I am a Realtor® and have a property with about $75K in equity. I want to purchase a second investment property but do not want to tap my equity. I have a few friends/colleagues whom I can approach for private funding. Here is my question/example using easy numbers (not a real scenario):

Buy $100,000 property cash that rents for $1000 per month grossing $12,000 per year which is a 12% ROI.

or

If I put 20% ($20K) down and finance the rest the return jumps to 60% ROI (just based on actual cash in.)

So I understand why it is beneficial to me to leverage myself with financing but why is someone going to lend me $100,000 of their cash at maybe a 5% or 6% when they understand this same scenario?

Troy Fisher · Answer

I had this conversation with a newbie whom I am giving advice on today.  She couldn't fathom why a PI would accept a 12% return.  Especially when I told her I wouldn't get out of bed for anything less than 20%!  I explained to her that the most passive way to gain interest is to leave it in the bank. (1%)  Than you can move up to CD's (3-4%?), then getting a little more active and being receptive to a little more risk PI for 12% (Yes I simplified the ladder), 20% for being active in an investments (going out to a meeting and meeting once a month with a Investor) 50% for working hard (mentoring/hand holding/accountability partner), and 100% (doing it myself) for having every part of the deal. I expect the cost ratio of my work/payoff to be higher.

Someone who is trying to grow their capital is going to work harder and want higher returns, and as that capital base grows, and they have more of it, they can change their risk tolerance down, and take less and still make the same.

Jon Holdman · Answer

Sorry, but that calculation is not even close. Your gross rents are indeed 12% of the cash you invest. Out of those you have to pay a bunch of expenses - taxes, insurance, routine maintenance (much caused by the tenants), property management, major capital items (roofs, furnaces), vacancy, utilites (at least when vacant), CPA fees, legal fees, lost rent during evictions, major tenant damage, etc., etc., etc. A more realistic estimate of your cash flow if you pay cash (no mortgage payment) is that you will make $6000 a year in this example for a 6% cash on cash return. If you're willing to do the management yourself and pretend that return is coming from the property instead of your labor (as many investors do) you might make $8000 a year for a 8% cash on cash return.

I absolutely would not lend you money at 5-6%. I might lend you money at 12% if the property had a strong equity position and you could pay me back in a year.

A bank might lend you money at 5-6%. They do it because 1) people lend to them at 1-2% (savings accounts, CDs) and 2) they're backed up by the feds. So they're making 4% on the money they have on deposit by lending at those low rates and have very little risk.

I absolutely would not lend you money at 5-6%.  I might lend you money at 12% if the property had a strong equity position and you could pay me back in a year.

A bank might lend you money at 5-6%.  They do it because 1) people lend to them at 1-2% (savings accounts, CDs) and 2) they're backed up by the feds.  So they're making 4% on the money they have on deposit by lending at those low rates and have very little risk.

Daniel Dietz · Answer

Robert,

I am just now forming my business plan for seeking Private Investors. (If you search my posts you will see some detailed ones about who and how I am targeting them).

An EXTREMELY simplified answer to your question, and one that considered a LOT during this is this;

• I am targeting people in mid to later working years or retired professionals and small business owners who likely have either large cash reserves or retirement portfolios.
• They have the funds to invest, but likely have never been approached in a Professional way. Their investment (that is NOT how I word it to them) with us would likely be a smallish (less than 25%) of their portfolios. In some cases MUCH less of a percent.
• For the most part they would have almost NO interest in doing Real Estate or Land Lording themselves, but would be familiar with the fact that it can be a good solid investment IF done right.
• In essence, do they want to get say a 1-3% return on the 'safe portion' of their portfolio', or would a say a 5-8% return suit them better?

This IS a very different scenario of approaching a Private Lender that is out actively seeking a higher return on their funds. It is more of an opportunity for those less or unfamiliar with the concept. Also, out of my list of about 150 names right now (who I only plan to talk to about a half dozen to ten initially) I know ALL of them personally, and have a comfortable relationship with them in which they have a least some feel for how I have done with my own investments as I have a VERY visible business in my town for the last 20+ years.

Good Luck, Dan Dietz

Joe Fairless · Answer

@Robert Walmsley it's a tough question because it's a bit vague but let me answer the question I think you're asking which is why would people invest in your deals.

Here are just a couple:

- they want to get into real estate but don't have the time (because they're making money at their full-time job)

- bad credit so they can't get approved for a mortgage but want to invest in real estate

- to get in on something larger than what they could purchase on their own (this happens if you syndicate a deal by bringing in multiple investors)

Xing Zhu · Answer

They may also be using leverage that you are not aware of. They might be borrowing at a much lower rate.

Similar situations happen all the time. Longing high yield papers and shorting US treasuries at the same time has been a method for many investors. This way by they make good profits "consistently" until a black swan shows. The biggest failure of this strategy was witnessed in the case of LTCM.

Some other lenders are probably just happy with the yield without leverage. Lenders' income is more passive than your rental income.

Robert Walmsley · Answer

Thanks for the feedback, I will do some more research and rephrase the question at a later time.

Trent Currie · Answer

Robert the question being asked is far to vague for any real guidance. If I were you I would hone in on an actual investment where you have done the math and know it works. Then post your basic business plan for that investment and then others can help give advice on approaching people.

Robert Walmsley · Answer

I know that scenario is not accurate in terms of a true estimate of cash flow, I just wanted to keep it simple to exemplify the staunch difference between all cash and leveraged cash, I apologize.

I guess my real question is how to approach private lenders/investors I know and sell them on the idea of lending money, secured by a property of course, at a lower rate than I would get from a hard money lender and at more favorable terms regarding the loan length.

Kyle B. · Answer

@Robert walmsley

If I understand you correctly, you are asking why someone would lend money at 5-6% when they could purchase the rental themselves and get a 12% return, is that correct?

A few reasons. First off, your actual return is not going to be 12%. Your gross income is $12k but you will have expenses in the form of ongoing maintenance on the property which will lower your overall return. Secondly, the lender is investing in a more passive, lower risk investment. You being the equity owner of the property are taking on more risk hence should have a higher return. You will be the one who has to deal with tenant issues. You can always higher a property manager, but that will lower your returns even more. The lender will only have to worry about receiving their monthly payment from you.

Finally, you are taking on more risk. If the investment goes south, then you could potentially lose your 20% equity investment and the lender would take control of the property. They of course run the risk of losing money as well, but will at least take the property from you if you default on your loan. You however, run the risk of losing your entire investment.

Essentially it boils down to investment risk preference. Someone who prefers a safer, less passive investment will have to accept lower returns.

Hope this makes sense!

Why will a private investor accept a low return on their all cash investment?

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