The other day I watched Fix or Flop on HGTV. The star of the show, Terek Moussa, was considering purchasing a property but first needed to call one of his outside investors for some cash. Terek’s scenario is not very different from several of the clients I work with at Anderson, television show excluded. There are plenty of Investors seeking capital secured by real estate and if you are looking to be the lender, one rule stands above all others, protect your interest.
Protecting your interest is not as simple as it seems. Deals can come together in any number of ways depending on the desires of the parties. The following will cover a few of the ways lenders can protect their capital when loaning to a rehab investor.
The Partnering Pickle
I typically recommend both lenders and rehab investors avoid partnerships with anyone unless the partners are willing to spend five thousand dollars or more to prepare a thorough operating agreement. The problem is most people are not, preferring to use an off the shelf operating agreement that does not take into the myriad of issues typical with partnership ventures. Here is a partial list of the advantages and disadvantages of partnering to rehab properties.
- Property is not encumbered by a loan thus, freeing up equity for traditional financing opportunities;
- Money partner has greater profit potential beyond just interest; and
- Investor has full control over the LLC funds after the sale of the investment
- Investor who controls the LLC owes a fiduciary duty to the other members;
- Money partner has no control over the LLC;
- When property is sold, money partner is not guaranteed to receive any profits;
- Once money is contributed to the LLC the investor decides how it is used;
- Investor can encumber the LLCs asset to the detriment of the money partner;
- Money partner is forced to pay income taxes on its share of LLC profits regardless if monies were received;
- Investor could pay himself a large management fee and essentially take all of the profit;
- Investor could lose interest in project and money partner has no recourse against the property
- Money partner has no right to a return of its capital once invested in the LLC; and
- Money partner could be forced to make additional contributions if investor asks for more money
Traditional Note Approach
If partnering is not to your taste, then consider the traditional promissory note approach. If an investor needs money for a rehab, and you are willing to loan the money, adequate security is an absolute requirement. Most private lenders understand the importance of securing their loan against the investment property via a deed of trust or mortgage. This approach ensures the private lender receives payment on the sale of the property and can foreclose if the investor defaults. However, this alone is not enough as some investors discovered late last year when they lost all of their secured equity.
Three private lenders collectively loaned a rehab investor several hundred thousand dollars secured against the property via a second deed of trust. Before you starting saying you would never take a second deed of trust consider the property still retained over $200,000 in equity after the filing of the second. The private lenders believed they were secure in their position that is until rehab investor called and requested an additional $500,000. Understand the additional capital was needed because the investor decided to tear down the house one weekend and build anew. The private lenders lost everything within two days.
Do not make this your story and require rehab investor provide you a personal guarantee and outside collateral. Experienced and successful rehab investors should have other assets. If the rehab investor is living from job to job, then you are taking a risk loaning him money. One curveball and rehab investor could be removed from the game with your collateral. In addition to the personal guarantee, request a deed of trust against other properties owned by the rehab investor or a collateral assignment of investment accounts.
Some investors are not content with simple interest and want more. In this scenario, I will recommend the private lender or rehab lender offer simple interest with contingent interest. Contingent interest is a mechanism whereby the private lender can share in the profits on the property sale without becoming a partner with the rehab investor. Here is some sample language: the Borrower hereby promises to pay to the order of the Lender principal based on fifty percent (50%) of the appreciation of the Property with appreciation equivalent to the gross proceeds from the sale of the Property less Capital Improvements…
Using a contingent interest agreement does not relieve the private lender from requesting adequate security and the same approach discussed under the traditional note should be considered.
Private lending offers tremendous benefits provided the private lender is a savvy negotiator. Working with experienced real estate attorneys who understand the tax and legal issues surrounding your deals is key to staying out of trouble.