Access Wealth Strategies

In Part 1 we discussed why the market is ripe for hard money lending, now let’s look at why hard money lenders are willing to fund deals traditional lenders reject.

Hard Money Lenders Can Charge Much High Interest Rates

Hard money lenders demand much higher interest rates (10-18% or 2-3 times higher) than banks do because they fund deals that do not conform to bank standards.

Banks have very specific standards because they are highly regulated and need standardized systems to make many loans. In contrast, many hard money lenders are individuals or small groups who are willing to work in narrower markets with niche products.

It’s All About the Asset / Collateral

If you could own an asset (e.g. real estate) that is worth $200,000 for only $100,000 (getting it for half price), would you do it?

Hard money lenders provide short-term loans (usually 6 to 18 months) based primarily on the value of the hard asset (such as real estate) that is collateral for the loan. In contrast a traditional lender bases the loan on the borrower’s ability to repay with the collateral as a secondary factor.

The two best quotes I’ve heard from hard money lenders are:

“Only lend if you’d rather have the asset.”

“Drive by the asset and think: do I want to own this?”

The “asset” referred to above is real estate, typically a single family home. Now think from the hard money lender’s perspective: You’re making a loan based on the asset, so what’s the worst thing that could happen?

Answer: The borrower defaults and does not pay you back.

So what happens when a hard money loan is defaulted upon?

If the hard money lender has properly recorded a first lien on the property / collateral, then the lender can follow the legal procedure to foreclose on the property – i.e. the hard money lender becomes the owner of the property which was the collateral for the loan.

Let’s see how the math works out in an example:

Imagine a new home bought in 2005 for $400,000 (inflated price in the bubble) and is now worth $200,000 (realistic market price today). The home owner who owes more on the home than it is worth today and who lost their job in the recession has stopped paying the mortgage and been foreclosed upon.

A flipper can buy this home at the trustee sale auction for say $120,000. The flipper buyer gets a hard money loan for 80% of the purchase price, or $96,000, and pays the remaining $24,000 cash himself.

So, assuming the home is really worth $200,000 (realistic price a retail buyer would pay today), the hard money lender’s basis in this property ($96,000 loan amount) is roughly 50% of today’s retail price ($200,000)!

That is a VERY secure position for the hard money lender.

So, in the “worst” case where the borrower defaults on the loan, the hard money lender gets to own the asset that’s worth $200,000 today for only $96,000 (ignoring fees and other legal costs).

How to Win Even If You Lose!

Hard money lending in this market is lucrative because you get to “win even if you lose”:

(1) If the borrower pays you back with interest as promised, you’ve received double digit yield on your money in a short period of time (6-18 months). This is an attractive yield compared to 0-3% on bank CDs and not much more for corporate bonds.

(2) If you “lose” and the borrower fails to pay you back, you can take ownership of the collateral property for what amounts to about half the current market value (e.g. $200,000 property for $100,000).

So, as a hard money lender, you can receive a double digit yield in most cases AND have the security of making even more money if the borrower defaults and you get the property at a cost below the REO or trustee sale price.

Do trillions of dollars of failed loans and losses lead to great lending times?

With the recent collapse of the credit markets, the economy, real estate prices, and the stock market, lenders around the world will take massive losses on their loan portfolios. Large lenders such as Washington Mututal, Indymac, and related entities have already failed.

The write downs on collateral and loan values could make most (if not all) lenders insolvent. So doesn’t it seem strange then that lending on real estate assets could deliver both a high yield AND safety (low risk)?

As strange as it sounds, hard money lenders are well positioned in this market cycle to generate the highest income with the most security. Let’s look at why.

Why Are Hard Money Lenders Needed In Today’s Market

In today’s market with a huge inventory of distressed properties such as foreclosed homes and even commercial real estate, investors and “flippers” are buying these properties at a huge discount.

There’s only one problem: These distressed deals usually require a quick close (sometimes as little as 1 day at a trustee sale auction).

Most traditional lenders would not be much help in these scenarios – not that they are willing or able to lend money on real estate purchases these days. Even if they were, it would take too long (45-60 days) and require perfect credit from the borrower.

Of course, deep-pocket buyers could pay all cash to buy the distressed properties all day long if they wanted. But what if they want to buy but don’t have enough cash of their own? Or, they do have the cash to buy one property but want to buy multiple properties at the same time?

For some experienced flippers, the number of properties they can buy at one time can make a huge difference in their bottom line profit.

Enter the hard money lender, who can fund deals quickly and is willing to overlook the borrower’s less than stellar personal credit, as long as the property meets their deal criteria.

Typical Hard Money Loan Terms

• Short term: 6 to 18 months
• Application or due diligence fee around $500 to $1000
• Origination points 0% to 5%
• Interest rates 10% to 18%
• Prepayment fee (if the loan is paid off earlier than expected)
• Recorded first trust deed (lender has first lien on the property)
• LTV of 60% to 80%

Why would hard money lenders fund deals that traditional lenders reject? We’ll discuss the 2 main reasons in Part 2. Meanwhile, please add your comments and questions below.

In Part 2 of this series on achieving a 10% or more consistent cash flow on invested capital, we established that this type of cash flow is difficult to achieve passively – i.e. with the investor outsourcing the selection and management of the underlying asset, whether it’s a business venture, real estate or something more “unique”.

At the end of my last post, I outlined a few things that investors could do “semi-passively” to get closer to the dream.

The good news is, if you are willing to “front-end” the work of asset selection and management, and learn to identify and hire good asset managers, you could be living the investor’s dream in a few years.

Here are some examples.

Franchises

Franchises have a very high success rate of over 90% and the return on investment is typically double digit. However, a franchisee probably needs to take an active role in the business in the first 2-5 years to build up the business, implement the systems, and hire and train the right staff. Later on, the franchisee can pull back and enjoy the passive cash flow from his business while periodically checking on his management team.

Distressed Assets

A big opportunity in today’s economy is to identify and buy distressed assets at a significant discount to their current market value.  This typically requires access to a channel (deal flow) for buying these assets at a big discount.  The investor then needs to assemble a management team capable of “improving” the asset and realize its full retail value (or close to it).

We are seeing more and more businesses specializing in distressed real estate (foreclosures, short sales, REO’s) in certain markets and taking investor capital to turn these assets multiple times a year.

Alternatively, some “long term” investors are holding these distressed properties after they are “fixed up” to rent them out while waiting for the rebound in valuation.  In this case, they get break-even cash flow or better while they wait for what is hopefully a significant capital gain.

You can do the same thing to distressed businesses (brick-and-mortar or online), though it would probably require even more work and expertise.

Self-Renewing Assets

I have heard of someone buying land in the California central valley and planting a pistachio orchard. While it requires about 5 years of start-up time with no income and only expenses (water, maintenance, mortgage etc.), eventually it will become a self-renewing passive income source for quite a number of years.

The investing principal here works for orchards, fruit trees, forests, etc.  Once the trees or plants mature, it takes much less maintenance to keep up and you could literally “eat the fruits and reinvest the seeds“.

Laddering and Annuities

You’ve undoubtedly heard of CD or bond laddering - the practice of buying a pool of assets with different “maturity dates” (when you get paid back principal plus interest or gain) so that eventually you will have regular (say, monthly) maturity events, simulating “cash flow”.  Note that this strategy also requires a start-up period with no cash flow while you build up your income ladder.

Most investors use this laddering strategy with mainstream products like CDs or corporate bonds that pay low interest rates (3-4% at best).  Similarly, you can pay a lump sum to an insurance company and get an annuity (cash flow) yielding about the same amount. Obviously this is far below the desired double-digit return of 10% or more.

You could apply the same laddering principal, however, to higher-yielding assets such as private notes secured by some underlying business or real estate (see “Hard Money Lending” section below).

Hard Money Lending

Instead of buying publicly traded bonds or bond funds, you can create your own bonds by lending to private parties (usually businesses) who use your capital to generate a return exceeding the interest rate you charge as the lender.

In some markets today, private lenders are able to get double digit interest rates and the note is secured by some hard asset like real estate or equipment.

As a hard money lender your primary concern is the safety of your principal. The key to protecting against loss of principal is to make sure the collateral value far exceeds the amount you’re lending. The lower the LTV (loan-to-value ratio) the safer it is for the lender, who has the option to foreclose and own the underlying collateral should the borrower default on interest or principal payments.

When done well, hard money lending can be a win-win deal for both the lender and the borrower.  You can even structure your hard money lending deals to include back-end profit participation in addition to regular interest payments.  For example, this arrangement can work in distressed real estate flipping deals.

Of course, there are countless other ways to achieve good cash flow by investing a bit of sweat equity up front, limited only by your imagination.  Can you come up with some more examples?  Please comment and let us know.

Note: please do not advertise your investments or solicit investors in your comments – all such comments will be removed.

This post is a continuation of our discussion regarding consistent 10% passive cash flow (Part 1).

We’ve already discussed that many investors want to turn their nest egg into a predictable stream of cash flow that can replace or supplement their active income.

So why is it so difficult for investors to achieve a satisfactory double digit return on their capital (after management expenses and preferably after taxes also) if they do NOT wish to take an active role in running a business?

Remember, all investments are ultimately tied to some underlying business which tries to generate revenue that exceeds the cost of capital invested.

We’ve all heard the overwhelming statistics of business failures, so a truly successful and profitable business is not something to be taken for granted.  It is truly a remarkable feat for a business to take on investor capital, pay investors a good yield for their money, and still remain a consistently profitable business.

Active vs. Passive Investing – What’s the Difference?

A savvy entrepreneur can build a successful business with very little start-up capital and reap the highest reward for that investment.  However, this requires talent, sweat equity and favorable market conditions, etc.

Now imagine a passive investor who does not want to be working in the business or on the business.  The investor would need to hire someone else to do the management work required and pay them reasonable compensation. In this case the passive investor would get a lower return on his investment in the business than the entrepreneur who works in or on the business.

How about having yet another layer of indirection? Perhaps some “fund manager” that chooses businesses to invest in for you?  Or, buying stocks (ownership) or bonds (debt) in the business on a publicly traded market where pricing for these “paper” derivatives of the business can be somewhat independent of how the business is actually performing?

You get the idea – chances are investors in “business derivatives” don’t do as well or don’t have as much visibility into the assets they indirectly own.  All the layers of management will have to be paid off before the investor gets his return. As you all know by now, Wall Street is notorious for charging high fees regardless of the success (or most likely failure) of your investment.

Generally speaking, investment return decreases as more layers of “management” are added between the investor and the underlying asset (business).  The investor also has less control over the underlying asset the further removed he is from the asset.

So, what does this mean for the passive investor’s quest to achieve consistent cash flow?

• Get as close to the underlying asset/business as possible without working in the business.  Have a straight line of communication to the manager of your asset.
• Often, it is better for management to have vested interest in the asset and not just a “hired hand”.  In other words, make your management team your partner, not your employee.
• Invest in distressed assets and partner with someone who knows how to “improve” the assets and realize their full potential, or be a lending partner (i.e. become a hard money lender).
• Consider investing in a proven business system (i.e. a franchise) to short cut the learning curve and outsource most of the management gradually.
• Allow the business to “incubate” before reaping the reward of consistent cash flow.  You may need to invest more time and energy in the business during the incubation period.
• Ladder into fixed income type assets with different maturity dates.
• Invest in self-renewing assets (e.g. orchards, forests, producing oil wells, etc.) that can produce income for years after an initial setup period.

We will discuss some examples in more detail in Part 3 of this series.

Meanwhile, please share your thoughts, questions, and opinions by commenting below.ve