SSS #187: Juicing Returns

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#TeamDiana all the way.

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Livin' La Vida Luna y Luca

Shoutout to @SarahJanePhotographyLLC for capturing this awesome moment.

I got my start in real estate investing back in 2017 with a strategy called Private Money Lending.

Private Money Lending is basically when a person (instead of a bank) provides a loan to real estate investors in exchange for interest on their money.

A typical example would be:

  • Investor wants to buy a property for $200K, but needs $20K for the down payment and another $100K for the renovation.
  • Bank (or Hard Money Lender) finances $80K of purchase and takes a first-position lien.
  • Private Money Lender finances the $20K down payment and another $100K for working capital and takes a second-position lien.

In this scenario, a private money lender can collect anywhere from 8-12% interest on their money.

So if I lent an investor $120K, my annual return would look like this:

  • 8% = $9,600
  • 10% = $12,000
  • 12% = $14,400

8% is an excellent yield. 12% is out of this world. Anyone who says differently is a crypto bro licking their wounds from buying pictures of zombie monkeys.

Why Would Someone Pay These Rates?

Whenever I describe this strategy to non-real estate investors, their first question is obviously, "Why would someone pay these rates?"

There are a bunch of reasons which include, but are not limited to, the following:

  • They can (the deal profitability allows for it)
  • They must (traditional banks like Chase or Wells won't finance these projects)
  • They want to (fewer hoops to jump through when dealing with hard & private money lenders)

A Slight of Hand To Juice Returns

I used private money lending early on in my real estate career as a way to learn how the best operators go about their business while getting paid for that education.

It wasn't until I did a few deals that one of my borrowers explained the difference between origination points and interest rates to me.

Origination Points: A fee based on the loan amount. So if the loan amount is $120K:

  • One point: $1,200 ($120K x 1%)
  • Two points: $2,400 ($120K x 2%)

He said, "As a lender, you should be trying to exchange interest rate % in favor of origination points.

So if your borrower is willing to pay 12% interest, suggest 2 points and 10% interest instead.

In theory, this comes out to the same amount of money over 1 year. However, most deals don't take a full year to complete.

So let's compare 12% interest vs. 2 points and 10% on a deal that only takes 8 months to complete.

  • $120K x 12% / 12 months * 8 months = $9,600 return
  • ($120K x 2%) + ($120K x 10% / 12 months * 8 months = $10,400 return

The interest rate went down, but the total return for the lender went up:

  • $9,600 / $120,000 / 8 * 12 = 12% annualized return
  • $10,400 / 120,000 / 8 * 12 = 13% annualized return

Hiatus

Between 2020 and 2022, I took a break from private money lending. Instead, I focused on deploying all of the funds I raised into my own deals.

The education I gathered from my private money lending days was starting to pay off.

Throughout 2022, I sold off 2/3rds of my rental portfolio and found myself sitting on taxable proceeds.

I was happy to pay the taxes (that means I did something good), but I was reluctant to spend my own principal.

So I originated a loan and used the interest return to pay my tax bill.

For example...

*(LTCG = long-term capital gains)

Juicing Returns

Here's where I flipped the model on its head.

This tweet didn't gain much traction, but one reply did come through from an experienced investor.

Does anyone want to guess what he asked?

It was essentially a form of "why would anyone pay these rates?".

Except he positioned it from the lender's perspective. Instead, he asked, "Do you really want to lend to borrowers who are dumb enough to accept these terms?"

Again, there are a bunch of reasons why a borrower would accept these terms, which include, but are not limited to, the following:

TL;DR

When lending money to real estate investors... charge points instead of interest.

Except if you're lending to me :)