Which is Best For You - Active or Private Money Investor
To say the real estate market is experiencing some pain would be an understatement, but as you know with pain comes great opportunity. The real estate market is offering significant yields/returns for wise investors along with many opportunities that are more likely fool’s gold. As they say if it was easy everyone would do it.
The following are my insights into the work required, the risks and the rewards of either being an Active Real Estate Investor or a Private Money Investor.
We are going to first look at the Active Real Estate Investor.
If you have spent any time on the site it should be clear that I have chosen to be an active real estate investors as I am doing deals almost every month (See Acquisition Reports).
Work:
The first thing any active real estate (new or experienced) has to realize is being successful requires lots of hard work. You can’t just spin up the MLS or make a phone call and say I will take the best deal you have and boom you are done, far from it. There is a lot of subtle work required but for this article I will break it down into 3 phases: Identification, Final Selection and Make Ready.
From my experience the most important part of the process is Identification. It is the least sexy, most boring and most frequently ignored by investors of all experience levels! I understand why this happens as it can be like watching paint dry or grass grow, but if you miss this step or you buy just anything you are not an investor you are a gambler. You might get lucky once or twice but you will eventually go bust.
From my experience most of the listings in the MLS or offered by agents are not even deals let alone good deals. You have to remember the seller wants to get the maximum price for their property and thus finding a deal let alone a good deal takes time, hard work, patience and a quick trigger finger. In this market true deals are snapped up quick and thus you won’t get a second chance on most properties.
I can only speak from my experience but on any given day I will review the MLS at least twice with my criteria. I frequently review 200+ properties in a matter of 20 minutes or less. I would estimate that out of 200 properties maybe 1 – 3 could be deals and it takes a lot of practice to sift through the mountain of properties.
Most buyers (Note I am calling them buyers not investors) may look once a week, get a report from an agent, drive 5 or 6 properties and then buy something. Or worse they will look in the MLS find the cheapest property and buy it at or near list price. Neither strategy works in the long term (in my opinion).
Again Identification is absolutely the most important step so please if you are a new investor do the work, put in the time, develop your criteria and be confident when you finally make an offer.
The second phase I call Final Selection because this is where you have combed through a mountain of properties down to the final 2 or 3 properties that meet your criteria. Truth be told if your final list is 10 or more properties you are a buyer not an investor as no market should offer that many deals at any one time.
If Identification is where the most work is put in then final selection is where the most money is earned or lost. The saying “You make your money when you buy” is very true. Equally important to understand is the question “How much money did you make on a property you didn’t buy”. This is a very delicate balancing act.
During final selection you are balancing price, terms, close date, repair estimates, expected yield, etc. against other possible investment options. You might be negotiating on 2-3 deals at one time and be anything from the sole bidder to one of many. It takes a lot of time, steal nerves and the ability to move on and not over pay if a deal gets too pricey. Many folks will take the opportunity as a challenge and get into a bidding war for a property. This is always a mistake because if you over pay a good deal goes south very quickly.
The final and most important step to get right is Make Ready. I call this the most important step because at this point you own the property and thus you are fully committed. Your money is spent so step up and get to work! In this market most of you will either be creating a rental home or you will try and flip the property.
I believe this market is great for buying and not for selling thus if you are buying to flip I will wish you luck and ask you to pay extra attention to details and margin of safety. However, if you are holding as a rental you will still need to pay attention to this key phase. Getting the make ready right is critical. Which means fixing the correct things, not over spending and leasing to the best tenant and a fair rental rate is where you will start to earn the yield on your investment.
With buy and hold you will not see a return on your capital until it is leased. Equally important is the management post lease as expenses come in all sizes and a poorly managed property or a poorly selected tenant can turn a great expected yield into a negative yield very quickly!!! Let me say it more plainly, just because your spreadsheet says a property is supposed to return 15%+ doesn’t make it so. Your work is only beginning after you buy a property and it will take active management to insure you earn the expected return.
Risks:
Being an active real estate investor means you are putting your money/capital on the line with the expectation of a future return. As they say the future is promised to no one so your job is to understand the risks and try and mitigate them. For this article I will discuss the 3 risks of the buy and hold strategy as that is the model I have chosen to follow. I think the general press has done enough to highlight the risks with flipping real estate. The 3 risks I will discuss are: Buying the Wrong Property, Paying too much and Tenant Selection/Poor Management.
Buying the wrong property has many subtle angles that can catch an investor off guard. For example buying a property that requires too much work to make rent ready or a property that is difficult to rent are sure ways to produce a bad return.
Now don’t get me wrong I buy these types of properties all the time but I make sure I get my price. You don’t want to pay market rates for a property that will require too much work or take a reduced rental rate to fill. These facts will significantly lower your return. In the end if any facts about the property cause your initial assumptions to be wrong you risk a nasty surprise.
Paying too much is the most basic of sins with real estate investing but it happens all the time. You spend all this time working and slaving away and you finally get a bite. But wait there are multiple offers and you haven’t had a deal in 60 days so you stretch 3-4-5K and with every step your return/yield shrinks. This is happening more and more as people look for yield on their cash. Some cash buyers are ok over paying because they are only getting 1-2% so they are happy thinking they will get 7%-10%. Don’t be that person. Real Estate offers too many risks for such a skinny return. What happens if you are hit with a surprise 2K expense? Boom negative cash flow for the year. I lose deals all the time to people willing to over pay and that is ok as I just move on. Don’t get me wrong it hurts but I would rather lose a deal than over pay.
Tenant selection and management of your asset are important because they will impact monthly expenses. Repairs, Collection Issues, etc should be budgeted for and thus you need to manage them monthly. It is not a lot of fun I get it, but nothing you do will have greater impact on your monthly cash flow than staying close to these numbers.
Managing tenants is fun for no one but I can tell you the best way to not have problem tenants is simply don’t rent to them. That may sound like a no brainer but I have seen and heard many landlords say I thought they were nice people I didn’t run their credit, check history or call references, shame on you if you do this. I would rather have an empty unit than chance a bad tenant. When in doubt say no and keep looking.
Rewards:
The rewards are numerous and they take work, time and constant management of risks to achieve. You can increase you passive cash flow, improve your balance sheet with assets and if things go right long enough you can truly retire and live off the investments. But again this is not a get rich quick exercise and it will take full commitment for a long time. I have 10 years of experience in the business and I am still learning all the time.
If you chose to be an active real estate investor like I have get in the game and please make sure to put in the work, don’t be lazy!!!
Now that we have completed the review of an Active Real Estate Investor let’s review a Private Money Investor.
Work:
Just like the Active Investor I believe the Private Money Investor has 3 phases of work. We are talking about investing capital for a specified and agreed upon return so the Private Money Investor better be ready to work or they should just keep the money in the bank or go to Vegas. Always do the work!!!
The initial place where potential Private Money Investors should spend time is evaluating active real estate investors. As discussed above active real estate investors have to work hard and manage risks to be successful. I suggest learning as much as you can about the investor, the deals they do and the projects they under take to see if they could be a potential investment option.
Given you are potentially supplying capital to an active investor you have the right to understand a lot about them, their history and why they do what they do. You should always look for a proven history or some other unique value that gives the investor an increased chance of success. Also figure out what they are doing with their own capital as investing in a broke real estate investor may not be the best option. Also please watch out for real estate investors that have a lot of flashy toys as that should be a big red flag. The active investor is either in the game full time or they are out playing and spending make sure you find the first option and avoid the real estate investors with lots of toys!!!
The Project:
Once you find an investor who has the qualities, the track record, etc your work is not done. You now need to evaluate the project. Just because there are past success doesn’t mean the next project will be a success. Most investors are being asked to fund or partially fund distressed assets because banks won’t finance them. Being a passive investor in first position on a distressed asset is fairly risky in my opinion.
Investing in distressed assets with the idea on a quick flip in our current market are really risky in my opinion as the sell side is difficult to judge or plan for. Things are changing just too fast for my liking. If the project is not some kind of quick flip then you are looking for security in a buy and hold investment. With these types of investments Private Money Investors need to insure there is amble cash flow to support the property post their agreed upon payment. If the property had $300 in cash flow and now your payment is $200 that leaves only $100 and that is just too skinny for me (my opinion only). Thus you need to make sure there is plenty of cash flow to support your new monthly payment for a long time.
The Deal:
The final thing to evaluate is the deal being offered by the investor. Are they offering something with security, a defined return and ample downside protection? What happens if the investor doesn’t pay as agreed? Does the deal offer you a way to get your money back via foreclosure and resale? How long is the term? Is it long with a fixed return? Or something short that will need to be reinvested?
The final thing to understand is does the deal pass the sniff test? Do you understand what the money will be used for? Do you see a margin of safety and multiple exit strategies? Do you understand how both you and the active real estate investor will make money? Remember both parties need to make money in the deal or the deal is destined to eventually fall apart.
Risks:
The most obvious risk is Non Payment as agreed. This is why every private investor should know their options going in and insure they can get their money out if they are not paid as agreed. The private money investor should have multiple exit strategies and they should know them before they invest so there are no surprises.
The next risk is having Limited Security. I tell Private Money Investors the deal should be so good that that they hope the active investor won’t pay them back so they can take the property back. If you loan “X” and you know you have “2.5X” of security you hope the active investor doesn’t pay you so you can collect an asset for a significant discount.
I call this Margin of Safety for Private Money Investors. If the private money investor doesn’t have that kind of security why would they make the investment? Again the active real estate investor should offer this type of security to insure their business continues to grow. If the active investor is not confident and they are not offering this type of extra security why should someone invest with them? Again the active real estate investor has to be confident in their business and thus offer the private money investor a nice margin of safety to protect their downside risk.
I don’t know who said it but I am sure someone did, “Control the downside and the upside will take care of itself”. The private money investor needs to understand the worst case or downside? Is the downside they get an asset cheap? Is the downside they need to foreclose? Is the down side they have to foreclose and sell?
In the end understand and discuss the downside so the upside will take care of itself.
Rewards:
The initial reward is obvious as the passive investor can increase the returns on their cash or equity line or IRA. Rates will vary but they should always be significantly higher than what is paid for savings rates or CD’s.
The private money investor should have done the homework on the investor and on the deal to insure they have a Secured Investment. Again if you don’t understand how both of you will make money in the deal don’t do the deal.
Always – Always maintain a Margin of Safety as the real estate market is evolving so don’t put your cash to work in skinny deals with limited security. Make sure you are in a position to win either way.
In closing Active and Private Money Investors need each other especially in this market. Active investors who like distressed assets can’t get bank loans because of condition even when they buy them near land value. The passive investor has to be interested in identifying a return that is higher than a traditional savings, money market of CD.
Good Investing and please do the work and manage the risks so you can reap the rewards regardless of which model you choose.
