As a hard money lender, I get calls daily from real estate investors wanting help funding their next project. Many of them are so focused on one way to do it, they sometimes miss opportunities to make money. It was a few months ago I spoke with an investor that wanted us to fund a deal in Denver. It was a fix and flip and the deal had merit. It would have likely produced a sizable profit. Unfortunately, we may never know. He lost the deal for lack of funding. What happened? He did not understand the different ways to fund real estate deals and was not willing to listen to advice. The fact is that sometimes an investor needs to get creative which could lead to less profit. But, in this case, a piece of something would have been a lot better than all of nothing.
Debt: Debt is the simplest to understand and the least creative. Debt is just a loan. There are multiple types of loans; bank loans, conventional loans, government loans, private money loans, hard money loans, and several others. Debt generally takes no ownership stake in your deal and you won’t need to give up control. In real estate, loans are typically secured by the project, but sometimes you can use other properties or assets as additional collateral. That is referred to as cross collateralization or blanket financing and is about as creative as it comes with debt. Lenders typically want a set rate of return, so when you borrower money you will likely pay fees and a set interest rate. You will also probably have a set amount of time to return the money. Debt is the cheaper of the two options, but is riskier for two reasons:
- Debt holders get paid back first. If there is a problem with the project, the lender is the last one to ever take a loss. In fact, it is common in a loss situation that the owners take the loss and the lenders get paid back in full, including all interest and fees. This is why many savvy investors choose to lend money or work with companies that do.
- Most lenders will also require monthly payments which creates pressure for a project.
Qualifying for debt is typically a bit more challenging than equity. Most banks and conventional lenders base their loan decision on cash flow. That creates a problem with fix and flips because fix and flips have no monthly cash flow. In fact, they have no positive cash flow until the project is done and sold. Other qualifying factors are important too, like credit, reserves, and the collateral. To some lenders, like commercial banks, your credibility is also a factor. Creditability is the lender’s belief you can handle the project, so they will look at experience and possibly want to interview you. Except for a fix and flip or new construction, no lender I know will make a loan on a property with negative cash …