Private money mechanics/structure for fix-n-flip?

Question

Hi everyone!

I have a couple of questions about how to best structure a privately financed fix-n-flip deal and how the mechanics of the deal should work. I am just getting started in real estate investing and am excited about this opportunity however I'm not quite sure how to structure things so that it is both legal but beneficial to everyone involved. I will of course speak with a lawyer before we do everything, but I figured I would pick the brains of my fellow investors before I start spending money on legal fees.

First, a little info about the opportunity. I have a family member who has agreed to invest $50k towards a fix-n-flip project at 6% annually. I will be joining a friend of mine who has been doing fix-n-flips successfully for the last couple years. He has a private investor that he's been working with, but he does not have favorable terms and is looking for other opportunities. In addition to the $50k we also have access to an additional $30k, bringing our total budget to $80k. We'd like to keep the $50k in play after our first little project to be used on successive projects.

My questions are;

1) Based on what I've read here on BP and learned through some classes I've taken at a local REI organization here in Denver, it is my understanding that typically a private investor will wire the money directly to the title company to purchase a property on the behalf of a fix-n-flipper. The private investor then get's the property as collateral while the work is being done and then are paid back in full plus interest after the property sells. My questions is why would any private investor do things this way when the amount of time the money is invested is probably not more than a few months for a small project? Additionally, if the flipper wants to use the funds for consecutive projects the purchase prices will most likely always be different leaving the private investor without a set amount they know they will earn interest on. They would have extra funds sitting somewhere that would need to be available but not guaranteed to be used and there would be time between projects when the money is not earning interest. Is this how this usually works? If not, how?

2) My line of thinking is to have our investor loan our LLC the $50k, which we can use to purchase and rehab as we see fit. We can then make interest only payments and provide our investor with the property we are working on as collateral and in between projects we can provide a note for the cash that is in the bank as collateral. We will of course have to minimize the time between projects as much as possible so that we are not paying interest on cash that is not being used. This would make it more appealing to our investor because they would have a set amount of money invested that is consistently earning interest. Make sense? I guess my question is, for those of you who have experience with using private investors for fix-n-flips, does this make sense? Why or why not?

3) Can anyone explain how they would structure the mechanics of my deal?

4) Can anyone recommend a good article, blog, book, etc on this topic?

Thanks in advance for any insight and advice!! It is MUCH appreciated!

Taylor Green · Answer

By "interesting", does that mean no good! Haha! What about this: If the family member was to become a member of my LLC. In the operating agreement it would explain that the member was to receive 13% for the portion they contributed to the loan amount... Would that work? @Ellis San Jose

Ellis San Jose · Answer

@Taylor Green I am glad you are enjoying the reading list. The structure you propose is interesting. I suppose anything will work as long as everyone is happy & everything goes as planned. The family member has to be ok with a note secured by LLC shares not the real estate. If this is a family member loaning money, they may be loaning you money, because they want to help you, and also based more on character & reputation than on actual security. If this were an unrelated person, I would be prepared to answer the tough questions. "Can the property be sold without me getting paid?" "How do I get my money if something happens to you?" "If for some reason you didn't pay me, what could I do?"

Taylor Green · Answer

@Ellis San Jose I am still reading George Coats book your recommended me. It is very good. I will order 'The Big Short' after I'm done a couple other on your list! Would this structure work? 1) I open an LLC that loans out money to a flipper for a 15% interest rate. I would be a member and manager of the LLC. The loan is secured in first position. 2) I then have a family member who would like to join me in lending. He then lends my LLC money and I give him a note for 13%. Does this work? Thanks again...

Ellis San Jose · Answer

Your question of Securing B by just using paper is a distraction. All paper is not equal. One one end of the spectrum there is 1st TD paper with modest loan to value & then there is toilet paper (that's what was created by Wall St. in the bubble). What about a promissory note secured by a promissory note that is secured by 100% leveraged LLC shares? The search for 100% financing means someone is taking more risk. There is nothing wrong with it per se, as long as everyone is aware of the risk & is being compensated for the risk they are taking. Read the book "The Big Short" by Michael Lewis. It talks about how many "educated" people fooled themselves into thinking "all paper" had value as long as Moody's or Standard & Poor's (rating agencies) said they had value. They were layering debt upon debt until with no foundation until it collapsed. It's all about the collateral. Put yourself in "B's" shoes. How would you want to be protected? Have Lender B in first position with a recorded TD & then Equity Partner A can take ownership interest or 2nd position TD or both. Anything else is smoke & mirrors. I have done deals with none of my money in the deal. I give my partner ownership & my compensation is based on performance. If I fail my partner is made whole. My value is finding the deal & then making it profitable. I have also been on the other side of the deal too. All my money in & the other person is compensated for finding the deal, daily operation & performance. We then split the profits.

Taylor Green · Answer

Okay I really appreciate it @Ellis San Jose I do not take anything critical at all, more the opposite, very helpful... Thanks for taking the time... Yes "A" would have first deed of trust. Yes "A" would be an equity partner, I did use the wrong terminology of being a lender. Is there a way to secure "B" by just using paper? Or is that once again a bad deal for "B" because you want more collateral that 1:1. (75k-75k) Thanks for the help.

Ellis San Jose · Answer

@Taylor Green yes I understand what you are trying to do. In my opinion it is flawed. Think also of enforceability & recoverability in the lender "B" perspective. I also want to make sure the terminology is accurate when you say "lender". An equity partner is different than a lender, an equity partner is either on title (better) or have a percentage of ownership, like shares of an LLC (not as good being on title). The idea of collateral 75k for 75k is insufficient. Think pawn shop. You want more collateral (150k collateral for 75k) for an investment not dollar for dollar. Once again this is called "hypothecation" using a note as collateral instead of equity. Is lender A secured with a first deed of trust? If not he is an unsecured lender. If he doesn't have a first TD that's worse. In your scenario it sound like "A" is an equity partner, not a lender. If Lender "B" has a 1st TD of 75k on the $150k property, that's pretty standard & a safe position for "B". If "B" is not secured by real property but rather the LLC shares of "A". That's horrible for B. To enforce a promissory note collection on LLC shares is not so simple or inexpensive. B is the sucker. What if A tells B, hey I lost money or I just don't feel like paying you back, take me to court. B then posts a question on Bigger Pockets asking how can he get his money back. B doesn't like the answer because it involves attorney fees & going to court (which he now finds out will cost $10,000). If I was "B" I would tell you that I want a 1st TD recorded against the property & to keep you LLC shares ( in a nice way of course). That way I would foreclose on the property if anything went wrong. Once again, not being critical, it's just too complicated of a solution that potentially leaves someone holding an empty bag.

Taylor Green · Answer

Thanks @Ellis San Jose helpful as always... Sorry this is a bit long... If Lender B's 75k is backed by Lender A's 75k wouldn't that count as collateral? This is what I was thinking... (no idea if it's legal or even possible) Lender A is in an equity partnership, 50/50 profit split with the flipper. The flipper needs 150k for the entire property, so Lender A funds their joint LLC, as per their agreement. Before the funding takes place, Lender A has an agreement with Lender B to where Lender B gets a fixed rate of return for his investment. Lender A contributes 75k, and Lender B contributes 75k to a joint bank account, which then funds the flipper's and Lender A joint LLC. Lender B is given a promissory note by Lender A, using Lender's A 75k as collateral. The property takes 5 months to complete and makes a 20k profit. Lender A and the flippers joint LLC is then funded with 170k, they split the profit 10k/10k. Then Lender A pays back Lender B (75k + interest @ 10% = 3.5k), as per the promissory note. Lender A is left with 81.5k, so 6.5 k profit. (170k-10k = 160k, 160k - 78.5k = 81.5k) Now, if the property takes a 20k loss. 150k - 20k = 130k Lender A and the flippers joint LLC is funded, no profits to split. Lender A then pays back Lender B (75k + 3.5k = 78.5k), as per the promissory note. Lender A is left with 51.5k, so a 23.5k loss (130k - 78.5k = 51.5k) Lender B investment should be protected up to a 75k loss Lender A has invested. Which on a 150k fix and flip should never happen... Lender A's risk is essentially with the equity partner. The amount of interest payments to Lender B is relatively low. Sorry for the length, I hope it is somewhat easy to understand... Like I said before, I have no idea if this even makes sense.

Ellis San Jose · Answer

I suppose it's possible but not likely in my eyes. What you are referring to is hypothecation. If the JV lender call him lender A has a 75k 1st TD loan on a property worth $150k he is at 50% LTV, pretty safe. Now you are asking a 2nd lender (Lender B) to lend $75k with $75k of debt as collateral. 100% leverage. Lender "A" now has no skin in the game. If the the project crashes & burns the 2nd lender who basically has a 75K note as collateral to sue on to protect their investment. I see no advantage for Lender B to do the loan on the debt. If I was lender B, I would say just step aside & I will be in first TD position on the real property & you can lend me 75k with my paper as collateral. Then if the project fails you can sue me to pay you back with my note as collateral. Try not to get too cute & fancy with your financing structure. Keep it simple and put yourself in the shoes of every party and ask yourself "would I take this deal & why".

Taylor Green · Answer

Just to keep adding to this thread. @Ellis San Jose @Anson Young My question is: What if a lender was to become an equity partner with a fix and flipper, the lender provides money, the flipper does work, split profits 50/50. Could the lender used borrowed funds? Say the project was to cost 150k, the lender provided 75k and found an investor to borrow 75k at a fixed 10-12% rate. Could the lender back the investors capital by securing it against the lenders capital in the project? How could you structure something like that?

Ellis San Jose · Answer

As a private lender I would want to have a my note secured 1st TD on real estate the whole time. The note terms would have a minimum interest paid over an agreed time frame whether you flipped it in 1 month or 3 months or 6 months. I would keep the same note structured like a HELOC & move the TD to the next property as collateral. As I lender I would never want money out that was unsecured. Your relationship with your lender will dictate what they are comfortable with.