Are Private Money "Cash Outs" a Good Idea?

Cash.

I like it. A lot.

So should you.

And I like to walk away from any real estate closing I can with it in my pocket. That's the whole point.

However, certain situations arise with raising private money where it might not be the best idea to "cash out.' Here's what I mean:

• Buy a property with price of $100,000

• Property needs $20,000 in fix-ups

• Est. Sale price: $180,000

• You get: $140,000 in private money

• $140,000 in private money less $120,000 cost basis in property = $20,000 private money surplus.

• LTV: $140,000/$180,000 = 77% (a little high, but not outrageous).

What to do with that $20,000? Hmm...

Vacation to Hawaii?

Casino?

Lottery?

Ok...back to reality...

There's a school of thought that says you can put it right in your pocket. After all, you borrowed it against a property, so you should be able to do whatever you want with it, right?

Wrong.

If your private lenders (in this case) don't know how their funds are being allocated, you aren't doing it right. You must disclose to your investors where there money will be going at all times.

Now, if the investor signs off or is aware that you are going to pocket that extra $20,000, then Ok. Some investors won't care about cash out off the top at the beginning of the deal, as long as the LTV is reasonable and you are taking care of the investment.

What's the big deal with this anyway? How come it's not a big deal to do a cash out refinance with a bank loan but it is with a private investor?

Two reasons:

1. Disclosure - you must disclose to your private investor where their funds are being placed.This is just a good business practice and required if you want to earn a reputation that will net you seven figures (or more) in private money sums

2. Banks aren't loaning their hard earned money - they are loaning money created out of thin air by the "money multiplier" effect of fractional deposits (part of Federal Reserve banking), they are loaning shareholder money and they are loaning depositor money. The banks lending decision would be a lot different if their loan approval committee members were loaning their own funds instead of somebody else's. You cannot think of your private investor and the bank in the same context. One is an institution, the other a person.

And, here's special bonus reason #3

Downside protection. Going back to our example, lets say that you weren't able to sell the house for $180,000. Maybe the appraisal gods didn't like the house. Who knows.

So you have to sell the house for $160,000. Well, that's still not bad. $20k profit after paying back the lender. But, we forgot about...ancillary costs of ownership. Holding costs, taxes, etc. It's never a good idea to run your investment properties close to the "red line." There is an entire graveyard of investors who over-borrowed with private investor money who are now driving semi-trucks and wondering what hit them.

Raise as much private money as you need (which includes a cushion) but no more than a project can reasonably handle. Better to take that extra $20k and invest it in another property.