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Private Lenders in Real Estate – My Last Thoughts
Key Point: When you work with private lenders always strive to under promise and over deliver.
The bottom line is to look at what you are offering from the lender’s perspective. What would you be looking for if you were going to loan money to a real estate investor? What security instruments would you want to see in place? What assurances on time would you find appropriate? How would you want them to handle challenges along the way? What would make you want to do it all over again? When you think like this, your pursuit of private lending will be much more productive, profitable, and repetitive.
The idea of using private lenders is nothing new in the world of real estate investing. Successful investors have been raising and using private capital for decades and it is only now starting to filter down to the novice investor as being something of great importance. Does this mean that it should be something you look at carefully? Absolutely. How fast do you want your business to grow? There’s the slow route and the progressive fast track and private lending can quickly put you on the fast track to success.
Like any business decision, the choice to pursue private lenders comes with its upsides and downsides. The upsides are pretty clear, as there is a virtually limitless supply of capital that is out there for the taking. The downsides are few but the use of private capital does usually require that your business be a little more organized to have the most success raising funds. For example, your credibility kit and business plan are of high importance to a potential private lender, even if they might not be as important to other clients.
As far as managing the funding you do secure, be bold but also be smart about it. When making offers, consider that the quality of the deal doesn’t just affect you. When you are setting a budget for the deal, it is good practice to imagine yourself in the shoes of the private lender that is funding your deal. I find that when you look at private money as if it were your own, your decisions remain on a better plane and you are less likely to take unnecessary risks. People get funny about money sometimes but don’t let that in any way discourage you. This is a wonderful resource to pursue, and when you pursue it intelligently, the sky’s the limit.
As we approach another weekend, you may have some time to sit and reflect on different strategies to use for your real estate investing. May I offer some invaluable reading material?
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Managing Relationships With Private Lenders
Like any situation where there is a capital investment, private lenders are going to have certain expectations of you as the source of their eventual returns. The first and best thing you can do is to structure your agreements correctly the first time around. What I mean here is that the majority of challenges that arise with private lending relationships involve too much ‘best case scenario’ and too little of the real world. This can apply to both the repayment terms and also the timing and is easy to avoid.
I need to elaborate just a little on what I mentioned in the previous paragraph. Many private lending relationships can proceed without incident and this is of course the idea. When problems do arise, they are usually because the borrower needs more money or because they need more time in which to pay the lender back. These situations, when they do occur, are often because the borrower is trying too hard to accommodate a lender and suggests they ‘probably’ only need so much capital or ‘should’ be able to get a project done in so much time. It’s easy to see how this can happen and hopefully also why you want to avoid this.
My simple suggestions here are twofold. First, ask for more funding than you think you’ll need. If this means padding your budget a little bit, so be it. Extra expenses do come up with real estate projects and sometimes (in fact, all too often) they take longer than originally anticipated, increasing the necessary carrying costs. It’s always easier to ask for the extra funding up front, because the alternatives are either go back to the lender and ask for more money, or come up with it yourself. Neither situation is ideal, and asking for more money from a private lender on the same deal, could prove to be damaging to your relationship.
Timing is another issue to approach with caution when it comes to private lenders. Many will like the idea of getting a quick turnaround on their investment and may actually push for these short time frames (e.g. six months or less). It is tempting to go for this as an investor, thinking that a short time frame should work out OK. My suggestion is to stop right there and reconsider before going any further. Just like running out of money, having to approach your lenders to say you need more time could also be a relationship killer. However, let’s say that the worst did happen and you needed more time to pay back the lender. Put yourself in the private lenders shoes and determine how you would like to be treated. Consider drafting a formal business letter explaining the situation and respectfully requesting a restructure of the original note. I’ve had to do this before with one of my private lenders and it was surprisingly well received and accepted. I am now viewed with more professionalism and a greater sense of credibility because I was proactive and sought out a solution with plenty of time to spare on our original note agreement.
The solution here is simple. Anticipate as best you can, the realistic time frame you think will be necessary for your deal and then double it. Therefore, the likely worst-case scenario is that your project is completed (at least from your private lender’s point of view) on time, whereas the best-case scenario is that you’ll finish before a deadline.
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Securing Funds From Private Lenders for Real Estate Deals
Previously, I discussed being prepared to gain business capitol. The first step is to act like a person who is actively looking for it and constantly networking. Secondly, you should have a credibility kit assembled and ready to go; ready to hand out when the opportunity arises. That doesn’t mean leaving it sitting on a shelf at home or desk at work ready to send, but physically on you to offer immediately to a potential private lender. Timing can be critical.
Once you have your foot in the door, you’ll need to be ready to seal the deal with a prospective private lender. It is important that you capture their interest first, before ever putting a live deal in front of them. This is for two key reasons. First, you want them to see value in your business, not just a single deal, since this lends itself (no pun intended) to future deals beyond the first one. Second, and perhaps more importantly, capturing their interest before putting their funds into a specific deal keeps you in better compliance with securities laws. Hence, handing out the credibility kit and capturing their interest immediately.
OK, I know I just popped open can of worms there, didn’t I? Securities laws? Before you get nervous, let me give you the quick highlights. When you capture interest from a private lender, they’re only seeing value in a business model before committing any funds. They aren’t being presented with a specific opportunity until after they’ve agreed to provide some funding for your business. This means they haven’t been formally solicited for funding, which is more closely governed by the laws that concern investments. Just stay away from randomly soliciting funds for a specific deal and you should be OK. I of course may be missing a detail or two so be sure to run all this by your attorney to make sure you are doing everything correctly.
Now that I that have covered the bases, I will now discuss what you need to agree on with your lenders. Example terms for an agreement with a private lender include the following:
The length of the loan
The amount that is being borrowed
The return that is expected
The means by which the loan will be repaid (usually a fixed return rate or sometimes profit sharing)
Recourse if the loan is not paid back on time
Something to keep in mind when you outline the terms of the agreement is the ability to go back and renegotiate the terms at a later date. As I have pointed out before, Murphy’s Law is everywhere and it certainly doesn’t hurt to put in a safety net for all parties should something go awry. The private lender may also view this too as smart business on your part and respect your attention to details and keeping their best interest as well.
There may be some other agreed upon terms, too, but these are the main things you need to work out with a private lender. Ways to put all this to paper can vary and I highly suggest you work with your attorney to get it all put together because your lender will probably be having their attorney review it.
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Real Estate Investors Working With Private Lenders
You might have the best business plan in the world and all the drive to be successful that a person can have, but there are always limits to what you can do with your own resources. We’ve all been there. You start out, pick up a property or two here and there, market like you should, and at some point you hit a wall. The well of capital runs dry and that leaves you with some serious decisions to make. This concept of “What now?’ is not often addressed in real estate books or seminars and leaves many investors frustrated when they reach this point in their business. So, what do you do?
The idea of raising business capital is the answer to this dilemma and there are several ways to do it. One is to work with either local or national lenders to establish business lines of credit. Some of these are very simple and require no more than a business entity and decent personal credit. Others may require asset verification and can become larger and larger over time. A second option is to attract and raise private money.
Private money has been a foundational element of new businesses for a long time. What do you think fueled the ‘dot com’ boom in the late 90’s? Much of the capital that poured into the tech industry during this time period was private money and a lot of people and businesses got wealthy as a result. It is not at all uncommon for a business to seek and raise capital to support its growth and development, so why should your business be any different? When investing correctly, I believe that you can offer private lenders a much safer return than any stock in the stock market.
If you need capital or simply would rather not use your own, then this is a topic you need to pay close attention to. Since many investors attract capital from individuals who are not formally licensed to loan money, the term that is often used in real estate is a ‘private mortgage lender’. Over the next few posts we’ll explore some of the intricacies of raising such funding for your own business and how your credibility affects this process.
Finding Private Mortgage Lenders
One of the greatest things about using private lenders is that they can come from almost anywhere. They can be friends, family, or Joe Blow down the street. They could be conspicuous high earners like doctors or lawyers, or the millionaire farmer who still drives the ratty old pickup truck everywhere he goes. They could be obvious (like your professional team members) or completely unexpected, like someone you’re sitting next to on a plane. You just never know and you need to be prepared for whatever circumstances come your way.
The critical first step to finding private mortgage lenders is to start acting like a businessperson who is looking for venture capital. Chances are a private lender is not going to come up to you one day and ask if you need money. I’m sure that has happened in the course of investing history, but it is not common and you shouldn’t expect it to work like that. Your microphone should be on at all times, and you should be networking your business regularly. Be ready to talk shop, promote what you do, and be ready to talk the business of private mortgage loans when the topic does come up.
As you might expect, a big part of your success with private mortgage lenders will be your perceived credibility. You’ve probably heard of the term “credibility kit” before. A basic credibility kit for the real estate investor has a number of advantages, including:
- Being able to present a basic summary of your business to others.
- Being a foundation for your marketing program.
- Offering an organized business summary to bankers, private lenders, and other team members.
All of these advantages are equally important. I believe it is important to briefly discuss some of the primary components of a credibility kit, so you can begin to assemble yours as soon as possible. There is no universally recognized template for such a kit but the following list will give you a good idea of how to get started. A good credibility kit includes:
- A nice cover letter that introduces you and your business
- A summary of your business philosophy, focus areas, and experience
- Examples of how you market your business
- Deals you have completed (if applicable)
- An excerpt or full copy of a business plan
- Testimonial letters and recommendation letters.
These components together paint the picture that your business is for real, has focus/direction, and is well organized. All of these convey serious credibility and this is why the credibility kit is such a useful tool for your business. Not only will your own kit make you accountable to its contents and help you focus your efforts as your business grows in success, it will also give you a tremendous amount of confidence.
This type of kit is perhaps most useful because private lending prospects will likely want to see something about you before offering their funds. When you have something to offer them that describes who you are, what you do, and a little about your business vision, you’re well on your way. Once you can engage a prospect in the subject of money, you need to know what terms are to be agreed upon and that is my next subject for discussion.
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Tax Saving Tips for the Real Estate Investor
In addition to simply forming a business entity, there are some other useful vehicles for saving on taxes. This is not a discussion of business write-offs, but rather of techniques or tools for keeping more of your revenue. Examples include:
- 1031 tax exchanges
- Use of living trusts
- Dividend paying whole life insurance
- Retirement accounts
- Self Directed IRA
In the case of exchanges and trusts, these tools allow for transfers or upgrades of assets without being subject to substantial capital gains taxes. Sure, there are rules and regulations for how to do this properly, but again that is a better question for an accountant or estate attorney.
In the case of whole life insurance or retirement accounts, these tools allow you to use capital housed in them to invest in real estate or other commodities. The return that is paid back to them can be structured to where it is tax deferred or, in some cases, even tax-free. Be sure to ask your team members about these kinds of tools for your business and also keep your eyes peeled at your local REIA meetings because these also are common discussion topics.
Winning the game of business and tax savings is not about beating or outsmarting the IRS. This is old school thinking. If you have to write a big ugly check to Uncle Sam then this means that you had a decent year. Go make more money and hope that you’ll have to write a bigger check next year.
Key Point: Remember, your duty, as a business owner and real estate investor is to focus on revenue, not cost control.
Many of us have the mindset that sticking it to the ‘tax man’ is good, which implies an adversarial relationship with the government’s tax system. That just isn’t the case when it comes to running a business. Without a doubt, the best way to minimize your taxes is to be a business owner. Companies are taxed at a lower bracket than individual earners and, to boot, are taxed on net income, not gross income like everyone else. That itself is a huge plus for bringing more organization to your business.
When it comes to how you are viewed in the eyes of the IRS, the exact stats are staggering. Corporations and LLCs that claim certain business deductions are some 7-10 times less likely to be audited than a sole proprietor who makes the same deduction claims. Why? A corporation is a business that usually has its own tax identity and thus is less likely to throw up red flags to auditors. Individuals have every right to run their own businesses without the use of an entity, but they also must be more cautious when it comes to deducting expenses. The IRS simply keeps a closer eye on sole proprietorships, due to past and present abuse of the business deductions that are allowed. Whatever you do, keep good financial records and you’ll have little to worry about.
In summary, when the government makes it clear that incorporating or registering an LLC is a proven way to reduce your risk of tax audits, why not go with it? These entities can also be better ways to protect assets, and once you have assets worth protecting, you can and should want to do everything you can to get the job done.
So, continue investing in your education as a real estate investor, too. There are many opportunities out there, be selective and choose proven avenues that will help you use the information and actually make money using it. I encourage you to check out the tools I can provide, it’s the same material I use everyday in my own business.
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Real Estate Business Entities
Some entities are better suited for different business applications than others. My next post will discuss a few other helpful tax saving tips that can be well worth the effort as an investor and businessperson.
Sole Proprietorships
A sole proprietorship is basically a business that is run by a person and operates under that person’s social security number. There is no separate entity formed. The advantage of a sole proprietorship is that a person who files their taxes in this way can start claiming the tax benefits of being in business, without having to file for a corporation or LLC. A sole proprietor’s business identity is usually a ‘doing business as’ (or dba) kind of arrangement and is less organized than a formal business entity.
As I mentioned before, the tax advantages of being a sole proprietor are not that different from other kinds of business structures. There are two key differences that you should be aware of, though. First, sole proprietorships open you up to personal liability for the activities of the business and put your assets at greater risk. Second, the IRS is far more likely to audit you (or at least pay extra close attention to your business tax deductions) when you are a sole proprietor than a separate business entity. For many investors who don’t yet have assets that they have acquired, a sole proprietorship is something to at least consider.
Corporations
A corporation is one of the easiest and most effective ways to give your business a more defined identity and also allow it to enjoy some of the more tangible benefits of being in business. Corporations (and LLCs too for that matter) are fairly easy to establish and also easy to maintain. Most states allow corporations to be filed online and the setup process is far easier than you might think. If you want to start a business, that’s all that is necessary to form a corporation. There’s no application process, approval needed, or minimum amount of capital to do this.
Once you form a corporation, you can then set up a bank account in the name of the corporation and start routing expenses and revenue through it. This allows you to more effectively separate your business actions from your personal affairs, which is an important distinction when it comes to taxes and the IRS. Expenses run through a corporate account are generally much easier to claim as tax deductible, even though, this is not an excuse to manage company funds improperly.
Unlike LLCs or limited partnerships, corporations are generally not the best entities in which to hold assets and many asset protection specialists would recommend a corporation for business operations and one or more alternate entities that would house the assets, in your case real estate. The bottom line is that, like other formal business entities, corporations make it easier to account for company expenses and are also less prone to extra scrutiny by the IRS. Given their relatively low expense to establish, they are worthy of serious consideration.
Limited Liability Companies (LLCs)
The limited liability company (or LLC) is a fairly new kind of business entity but has been around long enough to be ‘battle tested’ in legal settings. LLCs have some advantages other entities do not. LLCs are fundamentally partnerships so they have members, rather than officers and directors like a corporation. They can be set up to emulate the tax benefits of corporations but also can be effective entities in which to hold real estate assets. LLCs are seen as generally being much better for asset protection than corporations, even if the tax advantages between the two are probably a draw.
Operating an LLC gives you a similar level of identity and authority to that of a Corporation. Clients will note that you have a company and can even look you up in some states to verify that your company actually exists and is registered with the state. Like for corporations, don’t overdo your stated title within your company. What you do is far more influential than what your official title is within the organization. Remember, you are working on Main St., not Wall St.
Limited Partnerships
Limited partnerships are common business structures for larger projects, as they are ideal for situations where moneys need to be raised to fund a deal. Basically, a limited partnership works like this. A general partner manages the partnership, carries a small percentage of the ownership, and a high percentage of the liability. Numerous limited partners carry the majority of the ownership but have almost no liability. In this way, actions brought against the limited partnership (such as a lawsuit) end up in the hands of the general partner, who owns next to nothing, as far as the total partnership value.
Limited partnerships are great tools to raise money and protect the interests of the contributors. They aren’t necessarily of much general use to the average real estate investor who buys houses here and there. Typically, these structures are more suited for land projects or commercial real estate and may be worth exploring based on your individual needs.
I hope this look at various business entities enables you to choose the best organization of your business. Also, don’t forget that I can still provide you with what I know the most about – the how to’s of real estate investing. Please check out this incredible offer:
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Understanding Your Role with the IRS and Basic Asset Protection as a Real Estate Investor
Demonstrating and honing your skills and professional expertise is vital to your success when working with clients and peers. It is equally as important to maintain credibility with Uncle Sam. After all, taxes are an inevitable part of running a business and, while they can be effectively reduced in many ways, they also need to be accounted for. The way in which your business is set up can have a big impact on how you are viewed, tax-wise, and thus directly and indirectly influence your professional longevity.
Basically, it works like this. When you decide you’re going to go into business as a real estate investor, there are any numbers of ways in which you can do it. You can simply leave things as they are, operating as an individual and simply enjoying some tax breaks for the properties you are able to accumulate. That said, there are some significant disadvantages of this approach, even if it is the easiest way to go.
First, you lose out on some substantial tax deductions when you operate your business individually. Expenses that are at least partially deductible for businesses are generally not deductible for you if you are not operating as an organized business. Examples include:
- Marketing expenses
- Utilities pertinent to your business operation
- Phone and Internet
- Vehicle expenses/mileage
- Supplies
- Meals or entertainment with clients
Your team accountant has the final word when it comes to deductions but these kinds of expenses are typically a) available to businesses and b) not available to individuals so consider this lack of business structure carefully, if you are thinking about it, because it can greatly impact your bank account.
Another clear disadvantage of not using a business structure relates to liability. Business entities allow properties you own as investments to be titled in a name other than your own. Many states have homestead laws that allow liability protection for one’s personal residence but these rules usually don’t apply to investment properties so you need to be careful. You are investing in assets which ideally have tangible value so that can make you an attractive target if your business operations don’t do much to protect the assets you accumulate.
Since there are some clear advantages to protecting your business assets, as well as enjoying additional tax breaks, what options do you have for organizing your business? There are several ways, and you should decide which is best for you with the help of your team accountant and/or real estate attorney, as this is their place to shine. Let the professionals do what they do best.
As I suggested, there are several options for business organization. These are:
- Sole proprietorships
- Corporations
- Limited Liability Companies (LLCs)
- Limited partnerships
I’ll briefly discuss each of these entities in my next few posts, however my best advice to you is don’t go forming any entities until you know why you should be forming them. If you have yet to do a single deal then why do you need a business entity? Go make a big fat check and then consult with someone to get your business set up properly. Although having an entity is important, it is not required to start doing deals.
Real Estate Customer Service – Dealing with Problems
In a previous post, I alluded to the retail concept of customer service and the adage often used that “the customer is always right” and that one must bend over backwards to accommodate a customer. In real estate, my version of customer service is a little different. I want to be pleasant and congenial but also exhibit a level of professional authority when necessary.
A ‘the customer is always right’ approach to managing tenants is a recipe for disaster, as is going the extra mile to make a seller happy with your asking price. You can be accommodating, but must still operate according to the principles that will make us successful as real estate investors. Perhaps the best way to achieve this happy medium is to be armed and ready with other concessions that can be offered in lieu of giving up something more fundamental like price or monthly rent.
Recall what I said earlier that Murphy lives everywhere. Unfortunately things do not always go as planned with clients or tenants and problems do come up when you least expect them. The most important thing you can do when problems arise is to first identify the root of the problem. Second, be proactive to solve the problem. The longer you let the problem fester the worse the problem gets and the more it keeps you awake at night. If you are unsure how to solve the problem to a particular situation then get advice from someone who does. No, I’m not referring to your brother. I’m referring to your attorney. Sure you’ll have to pay for this advice but, depending on the problem, it could be cheap insurance to avoid a bigger financial hit down the road.
Another way to look at the customer service issue in real estate is that you aren’t usually dealing with a lot of repeat customers. That’s not to say you should take a rigid stance because of this but look at the facts. If you have a property for sale, you want the ideal buyer and, if you’re marketing it properly, you should have plenty of interest. Why bend over backwards to accommodate one client as if they were your only viable buying prospect? Treat clients equally, in terms of how you approach them, but you can only sell to one and you must make the decision that is best for your business.
To be clear, however, every one of your clients should feel like they are important to you. This is when the mission of customer service as an investor is accomplished. Even if you don’t buy a property from Client X or sell a property to Client Y, their experience in working with you should be a positive one. That gives you a level of professional authority that is unmistakable, especially since your competition will not likely be doing the same thing.
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Real Estate Customer Service – Working With Team Members and Other Professionals
How you interact with team members or other business professionals is really where you have a chance to shine. Different than your regular clients, you may be dealing with team members more often so how you approach customer service and time management will likely be very apparent to them than to a client who is selling a property. Some of the basic essentials ring true for any type of customer service but there are also some elements that are more unique to this type of client relationship.
Common thread elements include prompt returns of phone calls or emails, showing up on time for scheduled meetings, and effective follow up when it comes to checking on progress a particular team member should be making for one or more of your deals. These elements are just good business and you should expect it of yourself as much as your clients will expect it from you.
What makes interacting with team members a little different is that the same customer service elements that apply to you should also apply to them. You should expect that they return phone calls or emails promptly. You should expect that they be on time for meetings and be prepared for them when you arrive. You should expect that they follow up with you if they need something. This is also good customer service on their part and you have every right to expect that of them. After all, they are also professional businesspeople and their business, just like yours, also has reliance upon good customer service.
I can share a great example of how lack of customer service from professional team members really affected not only a specific deal, but also our business relationship. I had hired a professional, for the sake of privacy; let’s say a marketing team. Even though I had stated all my expectations up front, I couldn’t get these team members to understand how important it was to make a sales call using my suggestions and techniques I wanted to try. Not only was the follow up lacking, but also I couldn’t get any reports from them showing results. They continually sent me long, drawn out emails that frankly didn’t make much sense and when they said they would call to talk with me, I only got email responses. Now, don’t get me wrong, emails have their place in the business world and it can be a quick and easy way to confirm what was discussed. But, most of the time a phone call is still the best way to communicate with a business partner if a face-to-face meeting can’t take place. My expectations weren’t being met. You see, I hired them! But, I wasn’t getting the customer service or the professional services I was paying for. So, I terminated the relationship and needless to say won’t be involved with that particular business team ever again.
KEY POINT: Only do business with people that want to do business with you. Manage your relationships with this attitude and things will be much simpler.
When this aspect falls short (or at least does so too often), you have the prerogative to change the person you use and sometimes they need to know that. You don’t want to have a quick trigger with team members but you also shouldn’t settle for poor service, as your ability to do business can be affected (your time, money, and reputation) by how well they perform.
Remember your business relies on not only you as an entrepreneur or small business owner being a strong leader, but your professional team members and their ability to provide you and your clients top notch customer service. If you want to read more about how to be a strong leader and real estate investor, I encourage you to check out the materials I still use everyday in my personal business. You can get it all by accepting this FREE gift.
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Real Estate Customer Service – Managing Tenants
It is no great revelation that working with tenants can be one of the more frustrating aspects of any real estate business. Tenants have their own agenda, sometimes see value in skipping payments or annoying their landlords with all kinds of complaints or requests, and certainly don’t see things from a business perspective as you do. This can be challenging to deal with at times and is the primary reason why many landlords choose to use professional property management companies to handle this for them. I certainly recommend it and also know that many of you will be managing some or all of your properties and a few customer service tips in this areas will be helpful, so here goes.
The most fundamental thing to remember when working with tenants is that you are not operating on their schedule. If I had a dollar for every time a tenant called with an ‘emergency’ that ended up being a little more than a nuisance, I’d be have a pretty big piggy bank full of dollars by now. The fact remains that how you respond to tenant issues can set the tone for what lies ahead. If you are immediately responsive, and bend over backwards to accommodate a tenant, they will soon expect it every time and can make your life miserable. I’m not saying to go to the opposite extreme and ignore things, but just be careful here because they aren’t necessarily your friends and they won’t pay you any more rent just because you’re eager to take care of issues they bring to your attention.
An easy way to make sure there aren’t any misunderstandings between you and a tenant is to make sure the agreement you have signed before the tenant moves in outlines EVERYTHING. This includes all responsibilities for the landlord and the tenant, payment due dates and penalties, insurance requirements, etc. Don’t leave anything to chance, put all in black and white up front. That way, if there is an issue that needs to be clarified, you can simply tell the tenant to review the agreement they signed (you can as well) and it should spell it all out. Taking the time and effort to put together an agreement in the beginning and one that you will use again and again is well worth the extended problems that could result if you don’t get it done. Also, if a problem does arise and it was not addressed in your paperwork, then immediately fix it for the next time.
The best landlords I’ve seen are pleasant and cordial, but swing a big stick when they need to. They handle problems that arise when they are able to get to them and don’t accept excuses or ‘niceness’ from a tenant as reasons to cut them any slack. When you can take a similar approach to customer service with your own tenants, your role as a landlord will be much easier and better respected.
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