What's going on BiggerPockets? Matt Faircloth. So today we're going to talk about private loans and
it's something that I talk about quite a bit in the book, Raising Private Capital, but I'm going
to talk about private loans specifically for pitfalls of private loans. As you guys could,
during your first, second, third, or maybe your 15th private loan deal about just pitfalls and
traps that you can step into. And I want you guys to stay away from these things, so I'm
going to talk about things that could slip you up on a private loan deal and could maybe take away
your profitability or just cause unnecessary risk for you on a private loan project.
So this is maybe for your first deal or your 10th deal, it doesn't matter whichever one it
is. I'm going to give you guys some private loan pitfalls that I've seen that seasoned
investors make. And I don't want you guys to make them. And just check out my book, Raising
Private Capital through BiggerPockets If you want to learn more about private loans, private equity,
how to structure stuff, how to exit from deals, how to find investors, all that is in my book
Raising Private Capital. So check that out. So private loan pitfall number one, and this is
somewhat obvious, but I've seen people do this and this is doing a no doc, okay. And this maybe
happens with a relative or with someone who's a family member or a good friend or something
like that. And then just say, "You know what? I trust you, Sally. Here's $80,000 out of my cash,"
probably they're not going to be able to do it out of IRA because the IRA custodian's going to want
documents, but let's say someone just offers to just give you 50 grand on a loan and you just
do it on a handshake loan agreement. I know that there's people that trust and love you for who you
are, and blood's thicker than water and all this other kind of stuff, that would be okay with a no
doc loan. And just because they're okay with it doesn't mean you should be okay with it because
there's ways that this can come back and bite you in not having documentation, many ways.
Let's say you're doing business with your mother or with your relative or whatever.
And they end up, God forbid, they end up passing away. Well, that loan that you had
with them then becomes an asset to their heirs. And so you need to have documentation for that.
Let's say the project doesn't go very well and you need to be able to pay them back,
or let's say that... Everybody that watching this is upstanding citizens and good deal providers for
their projects. But let's say that you're going to loan to someone and they're perhaps not. They ask
you to do a no doc loan to them. There's a chance that they could get away and not return your
capital because you don't have any collateral. You don't have a mortgage or a note.
The docs are mortgages. We'll talk more about these in a second, but a mortgage and
a note. And a note's a promissory note saying, "I promise I'm going to pay you back. And this
is the interest rate." The mortgage is a document that says, "I pledge this collateral at 123 Main
Street, and you can come and foreclose on this property because I'm putting it up as collateral."
Meaning something you can take if I don't pay you back, as something almost like a security. "Here
you go, take this, you can come in and inhibit my right to sell it or to refinance it and foreclose
on it if I don't pay you, that's the collateral that I give you as a lien." This mortgage creates
the lien on that property. Okay. So that's what a no doc loan is. Don't do those. Okay?
Here's number two. Okay. And I've seen a lot of investors do this as well. And this
is miscalculating your... Let's call them miscalculations and I'll tell you. Okay.
What I mean by that is, let's say that you set up a private loan with a friend you went
to high school with, Steve, or with your uncle Charlie, whatever it is. And he said, "Okay,
I'm going to be done with this project in six months." And uncle Charlie says, "What if you're
not?" "Uncle Charlie, I'll be done in way less than six months. And if I'm not done, I'll pay
you an extra 3%," or, "I'll pay you a fee," or, "You can start foreclosure after six months. No
problem. Because that's how confident I am that I'm going to be done in this amount of time."
Okay. Well, things happen in the world of real estate and there's things that are outside of
your control. And there's a lot of dynamics. So maybe you hit that six months and uncle Charlie
can then charge you that extra 3% or decide he can come and foreclose on the property. It's funny how
people are when you sign the loan agreements and everybody's all friendly and happy and popping the
champagne. But if something gets miscalculated, seeing how things change and now it's maybe not as
friendly of a conversation anymore. And especially if you put in things that are miscalculations that
can push the loan back a bit further, or can push you into hot water here. This is something
that you really, really want to avoid. Okay. And miscalculations also, they play on closing
out the loan, on let's say, termination. Like I was just referring to. Miscalculations also
play on you saying, "You know what, I only need the money for a short period of time. So I'll
gladly pay an extra 3% interest or 5% interest, whatever it is, on the interest rate." You can
miscalculate that interest rate and end up paying people just more than what the market is or more
than what's fair based on interest rate. Okay. And a lot of these miscalculations come by you
being overly cocky about your project, okay. By you not really considering the worst case
scenario about saying, "Well, okay, what if this hot market that I'm in doesn't continue to keep
going. And what if I end up having to dive bomb the property and sell it for 20% less than what I
had underwritten for in my original projections." Or, "What if the BRRRR strategy doesn't work,
or what if the bank can't get me completely out and I've got to pay them a bit."
So that leads me to number three. Okay. And that is getting too aggressive and ending
up holding the bag at the end. Okay. And I'll explain what that means. That's you holding the
bag. Holding the bag. Okay. Now what that means is, let's say you're doing a BRRRR deal. Okay.
Meaning you found a private money partner or a lender and they're going to put in 50,000 bucks,
that's going to cover your cost to buy the property. Then you're going to to renovate it at
40 and so you're going to be [inaudible 00:06:20] for 90. Maybe you throw some of your own cash in,
maybe you don't, maybe you find a way to work that out with them. And you think the property
is going to be worth 150K when you're done. And so let's say that's 150K on completion. They
put in 50 and then 40. So that's 90. Okay. You should be able to refinance this to produce
enough to pay that off, even with interest too, right? Let's say the interest takes you in another
5k. Okay. So this valued at even 75% loan value would more than take that out. Okay. Let's say it
doesn't get valued for that. And it gets valued at 110. Okay. Uh oh, right?What are you going to do
now? So that's where you get left holding the bag. Okay. Now there's different conversations,
and my book Raising Private Capital talks about circumstances like that, about what to do in this
situation, where you come in and your BRRRR's not going to get you out. Like 110K is probably
only going to get you, maybe on a good day $80,000 on a refinance, which means you're
going to be left holding 15,000 bucks in debt to your private money partners. So what do you do?
A couple different things you should have done to cover yourself is maybe you should have brought
some money to the table of your own money. Maybe you've got to factor in and have this conversation
about what happens here. And I think the biggest mistake you made was by assuming the top of the
market, was by assuming that that was going to happen and not predicting that you were going to
come in much lower. The time to be aggressive and optimistic and stuff like that is when it comes
to encouraging yourself and finding new investors and shaking off the dust and counting how many nos
it takes to get to a yes. Those are the times to be optimistic and rosy colored glasses.
The time to not do that is when you're underwriting a deal. This is the time to
be a contrarian, to be super conservative, and to think about the worst case scenario,
because you typically can outperform the worst case scenario, but it's hard to underperform or
to go even worse than that. Because if you didn't think of that, then you should have
been thinking even worse, that the appraisal should come in even conservative at 110K,
and what should happen if you only get 80 and you owe the investor 90? Okay.
So a lot of different conversations about what to do about that 15K. Like I said,
maybe you shouldn't have borrowed as much. Maybe you shouldn't have bought the property,
if you really didn't have that 15K to come in, maybe you should have negotiated this 50 down a
bit. But the way to avoid holding the bag is to just be way more conservative when it comes to
underwriting your deals. Which is tempting to not do in today's market, because things are really,
really aggressive and crazy. But my encouragement to you guys is to be as conservative as you can
when you're underwriting a deal to avoid this kind of thing.
There's a ton more pitfalls of private loans that are there. And we can talk about it more
in the notes. But I want you guys to put in maybe a brief story about how you guys got
bit on a private loan, either as a lender or as a deal provider, or things that you always
do to cover yourself on private loans. There's all kinds of stuff like personal guarantees,
some states there's something called a deed in lieu of foreclosure that's legal,
some states it's not legal. We can talk about that in the notes,
so leave some comments down there and we can get into a good conversation. Thank you, BiggerPockets
for watching. Check out my book Raising Private Capital. And have a great profitable week.