In lending, you can be as passive or as active as you want to be. If you want to be really passive, put your money into a CD and let the bank pay you 1% (more like .5% after inflation and taxes), 5-10 years down the road. In my opinion, a completely passive investment strategy is problematic and not at all lucrative. In more successful lending you have to be at least somewhat active (even if you’re just turning money over to operators to invest in commercial property projects like the storage unit business one we’re doing in Fultondale) to be worthwhile. Even then, you have to vet the opportunity and operators – again, not passive. When we start to talk about the advantages of lending in this blog post, I want to make a clear distinction that this conversation is about commercial properties – not owner-occupied, residential properties. Those rules get a lot “stickier”, and it’s not my preference.
Lending for Commercial Properties, Almost like a Bank
Let’s say you are lending to an investor who intends to buy a home and rent it out. You’d first want to think about how you would structure the loan. Well, you’d do it just as a bank would – professionally and with a mortgage.
You would create a promissory note, which details specifically:
- how payments will be made
- on which day of the month
- when payments are considered past due
- when penalties will be incurred
- plus, when you can foreclose on the owner of the property
- and so on
Leave no detail unsaid – just as a bank would.
Consider what a bank would ask from you if you were to borrow money. Most notably, your tax returns from each year. This information may help you decide when to call a loan if revenue falls below a certain level.
As a lender, even if you don’t own the property, you still have control over the property – you’re acting just as a banker would.
Another Advantage is Control over the Loan
Control is one of the primary advantages of lending. You put together your own structure and how you’re going to be paid back. You set the “rules” and can decide which fees and rates will be charged, such as closing or refinancing fees. Fees are an important part of making money especially on short-term loans.
Lending can be more passive than taking ownership, but regardless, you have to be savvy. You could also arbitrage other people’s money and get “points” for doing your due diligence (just like a bank).
Say you’re loaning to a flipper and getting a 12% annualized return, but they’re only going to need the money for six months. With that in mind, you’re only going to make 6%.
But with points, they’re paid regardless of the length of the term. If the term goes six months and you get 6% plus 2 points, now you have 8%. Annualize it and now you’ve got 16%. Points on a shorter term loan are important when you’re lending to a flipper or a wholesaler.
Even on a loan with as low as an 8% return, if you had 2 points, you’re up to 10%.
Find the right people
When you arbitrage people’s money, you can accelerate the lending business by finding people who are excited to receive 6% on a return and those who are actively seeking opportunities (flippers, wholesalers, buy-and-holders, etc.) and are used to short-term capital costing 10% (plus points).
As a lender, you are paying 6% and in return you are offering that up to those actively seeking opportunities at a rate of 10%. At some point, when the individual looking for opportunities hits their stride and is generating positive cash flow, they may start to seek out traditional lenders with lower rates. Again, it depends on the level of activity and involvement desired.
Why You Don’t Need a Bank Loan
You might ask, ‘why in the world would someone ever pay 10% to borrow money when you could go to the bank and make a commercial loan for 5.5-6%?’
Do you know how long it takes to get a commercial loan approved? If you’ve found a property that you can buy quickly with cash, it makes the deal that much better. Remember, where do you make your money? At the time you buy something. If you’re coming to a seller with cash and they know you’ve got the cash, they don’t have to worry about the property going away because they can’t secure the financing right away.
Just remember, always, always, always research who you’re working with and the property.
And finally, make sure you’re not overleveraged. A quick example: if you are financing something at an $80k acquisition and $20k rehab with the expectation that it’s going to sell for $150k, you have to determine if you’re loaning on a certain percentage of the acquisition and rehab or at the after repair value. Find out what your comfort level is in regards to how far you want to leverage.
In summary, the advantages to being a lender, instead of owner:
- More passive
- More control, but you still have to treat it like a business
- You can do your own due diligence
- Possibility of arbitraging other people’s money
- You can charge fees and make short-term loans more worthwhile
Next week, we’ll discuss the advantages of owning a property rather than lending. Stay tuned!
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