your retirement account.
Leveraging the Power of Other People’s Money
Many people have an aversion to borrowing money, and for good reason — it costs money to spend money you don’t have, and when you spend money you don’t have, you don’t have money to pay back the money you borrowed. It certainly does cause a lot of problems for some people.
However, very lucrative businesses and individuals have made their fortunes on borrowed money. The not-so-secret secret is to use that borrowed money to earn far more money than you’re paying to borrow that money. That’s called leverage. You use a little of the money you have and a lot of other people’s money (OPM) to make a much bigger investment than you could otherwise afford on your own. Do it right, and you can pay off the loan and pocket a handsome profit.
With house flipping, your goal is to move as much house as you can with as little of your own money as possible. If you invest $100,000 of your own money in a property, for example, and you flip it for a profit of $20,000, you make a 20 percent profit on your $100,000 investment. On the other hand, if you invest $20,000 of your own money, borrow $80,000, and sell the property for $120,000, you earn closer to a 100 percent profit, because you’re seeing a $20,000 profit on $20,000 of your money. (I say closer to 100 percent, because these numbers don’t account for interest on the $80,000 borrowed, holding costs, and other factors.)
To look at it another way, suppose you have $100,000 to invest. Many people assume that using that $100,000 to finance a single flip is the smart thing to do, because you avoid paying interest on borrowed money. However, by leveraging that $100,000 with borrowed money, you stand to earn a bigger profit. For example, you can combine that $100,000 with borrowed money to flip a higher-priced property — perhaps a $500,000 house that you know you can sell in the $575,000 to $600,000 range.
The following sections show you how to gain leverage by using other people’s money to finance your flips. And if you don’t have money, I show you how to persuade private lenders to put up some initial investment capital to get you started.
Persuading a bank to finance your flips
Since the mortgage meltdown of 2008, banks have tightened their criteria for approving loans. However, they’re still eager to loan money. After all, that’s how they earn their money. You just need to be able to persuade the decision makers at the bank that you can make the loan payments and pay back the loan on time with interest. The key is to earn their confidence in you.
To gauge their confidence in approving a loan, lenders look at your five Cs: collateral, character, credit, confidence, and cash flow:
Collateral is the property you intend to purchase. When you’re flipping houses and attempting to obtain loan approval before looking at houses, you’re not in a position to describe the collateral, but you can put together a plan that shows the price ranges of the houses you intend to purchase, appreciation percentages for the area, and how you plan to renovate and sell the properties for a profit.
Character is the way you present yourself to the lender. You need to convince the lender that you have the knowledge and resources available to profit from your investments. A strong plan and presentation can convince the lender that you have the right stuff.
Credit is your credit report, credit score, and credit worthiness (how much you can afford). A clean credit report shows that you pay your bills and aren’t over your head in debt. See “Checking and correcting your credit report,” later in this chapter.
Confidence is how strongly you and the lender believe that you can deliver what you promise. Pitching a solid plan can build the lender’s confidence. How you portray your project either gives the lender confidence in your abilities or sends the lender running to the hills.
Cash flow is your current monthly income minus your monthly expenses — the amount of money you have free each month to take on your project. Consistently having significantly more monthly income than monthly expenses shows lenders that you’re a competent money manager and can afford loan payments of a certain amount.
Before approaching a prospective lender, do your homework and draw up a business plan showing that you know what you’re doing. Here are a few ideas on how to proceed:
Show the prospective lender a sample of a property that someone else recently flipped in the area — for example, a property that the person bought for $80,000 on August 8 and sold for $146,000 on November 16. Persuade the lender, through your knowledge and enthusiasm, that you can do the same.
Present a property you would purchase now if you had the money and explain how you would fix it up and sell it.
Tie up a property on paper (either through a purchase agreement or an option to buy) and present this property as an opportunity. It sounds risky, but it often works, and it forces you to find the money to close on the deal! (Your agent or attorney can help you with the necessary paperwork.)
If you’re not comfortable drawing up a plan yourself, ask your agent and attorney for help. They can assist you in creating a plan and point you in the direction of other lending institutions and private investors they know.
Passing the hat among friends and family
Charity should begin at home. If you have a rich Auntie Ellen who has a stash of cash she’s willing to invest and you don’t mind calling in some favors, hit her up for the money. With family members, you may be able to secure a short-term, no-interest loan, assuming that you’re not considered the black sheep of the family.
GRANNY AND ME
My first real estate investment partner was my grandmother. She put up the money, and I did the rest. We made a deal — every time I sold a house, I had to take her out for lunch. We measured our success in how frequently we had lunch together.
Partnering with friends or family members can be one of the most fulfilling experiences, but when it comes to money, friends and family can be more brutal than bankers, especially if your flip flops. In most cases, I generally discourage investors from taking on a partner, especially family members, but with Granny and
