We all understand that private lenders must adhere to certain ethical standards. We also understand that real estate investors who seek funding must also adhere to ethical standards. I recently got involved in stopping a transaction between a new investor and a new private lender. The new real estate investor was about to take a big and unwarranted risk with a new private lenders money. Neither of these people had enough education to realize what they were doing. As a result of the story below, I am going to teach a class to my real estate investors association so that this doesn’t happen under my watch.
I was speaking at an event in Texas, and I got an email from a new investor. She found my contact number and since we both live in Pittsburgh, she figured that I could help her find private money to help her with her real estate deals. There is nothing out of the ordinary about this sort of email. The email stated that she was new to investing and that another investor had told her that the first thing she needed to do was to raise some private money to buy her first property. I swear that my skull nearly exploded at that moment. I wasn’t planning on answering my emails that day, it had been a long day of teaching and I was tired. So I quickly wrote her back and asked her to call me the following day after I was back in town. I couldn’t sleep that night because the irresponsibility of anyone who would tell a new investor to raise private money to make their first purchase kept running through my head. Who would offer such bad advice?
The next day I was able to speak with the lady who had emailed me. I was able to confirm that she had never been involved in real estate before, and after a few moments it became more and more obvious that she had no training at all. She had no idea of how to evaluate a property and less of an idea of how to create a profitable transaction which would allow her to pay her private lender back. It was worse than that; she had already found a potential investor for her project. The guy was an elderly friend of her family who trusted her completely. He would be using his IRA funds to pay for her deal. Again, I was trying to keep calm. I realized that this woman was as much of a victim as her future private lender would be. Luckily the IRA funder didn’t know how to transfer his money to a self-directed IRA and she had no idea how to transfer his money into her account. Thank God for regulatory safety catches. I was getting angrier by the second. I wasn’t mad at the lady or the family friend who trusted her enough to risk his golden years, It was the idiot who told her to raise private funds to buy property that I was really mad at. This was truly irresponsible advice. She had no idea what she was doing. She was instructed to go gambling with a friend’s money. The investor offer this brilliant advice was apparently an experienced real estate investor. I wanted to slap him silly. If this lady hadn’t contacted me looking for a private lender, then she was about to blindly risk someone else’s money. I teach my students that you only go after private money when the deal is at least as safe as any deal where they would risk their own money.
When a novice investor convinces some poor stooge of a private investor that he or she can produce profits with no plan at all it’s a total crap shoot. She was just as likely to produce a return for her investor as she was to lose it all. Any investor who would back this novice would be just as likely to make money in a casino. That is no investing strategy at all.
After a few more questions, I found out that the “investor” who suggested that this woman get a private lender was also trying to sell her a property. As it turns out the property was in a bad neighborhood and well above market price. Nobody should buy that property at his price. He was a total rip off artist, and worse than that he was guiding an unsuspecting novice investor towards a truly immoral act. He was telling her to use someone else’s hard earned money to invest in his bogus deal. No bank on the planet would ever approve this deal. The end of this transaction was going to be ugly. She was going to lose some private lenders money and be out of real estate investing in a very short time. The private investor was going to end up losing his principal, and the sleaze bag who proposed this deal was going to be the only one to make any money. He was going to rip off a private investor through an ignorant third party. I wanted to scream.
The numbers on this property told the entire story. The property was for sale at $53,000. The highest comparable sale number I could find was at $32,000. This was a big red flag for me, but the novice investor had been told that this was a great deal. The seller also told her that the property needed “some work”. I don’t know exactly what “some work” entailed and I didn’t care. Even if his asking price was down in the 30k range, there was no bargain to be had. Rent comps in the area were $450 per month. Factor in a vacancy rate of 15%, a repair budget of 15%, and this deal was only going to produce $3,780 before taxes and insurance. With financing in place at 5%, the principal and interest would eat up 3,408 of that, leaving $372 per year for taxes, insurance, and any unforeseen problems. She would be luck to break even. This is all assuming that her funder would accept a pathetic 5% return, and be willing to hold the note for 30 years. Because the property was being sold so far over market value it would be impossible to sell the property and get out of the investment. As a rule, investors should NEVER buy a property with private money unless the property is well below market value. This ensures that if anything goes wrong the funder can liquidate the property and get their money back with a profit.
So after a firm lecture about the errors of her ways for even asking a stranger to back a project that she could neither evaluate or formulate a reasonable expectation of how to get the funder a return on his money, I set the novice investor into one of my club’s introductory classes and put her on the path to success. I then called the rat fink of an “investor” and read him the riot act. It was not a pleasant conversation for him.
Fortunately this disaster didn’t go any further than my desk. The lesson of this entire fiasco is that private money investors need to interview the real estate investors and verify that they have some track record of success and a fully functioning plan to not only preserve their principal but to get them a good rate of return on their money. It is up to us to educate private investors so that deals like this one never move forward.