If you’ve been reading my site for awhile, then by now you’re probably aware of my passion for diversifying income and having a diverse asset allocation. By this, I’m talking about investments beyond traditional stocks and bonds – into things like Private Equity funds, peer-to-peer lending, and real estate.
A well diversified portfolio of stocks and bonds are a great foundation, but a portfolio that solely relies on this strategy has a few flaws:
- In the short term, the stock market tends to rise and fall together – despite diversifying across many equity types. 2012 has been a great example of this. Sure, my portfolio is up nearly 20% this year, but so are all diversified stock portfolios. And next year, if the market is down 20% – mine will be down too. Investing in dividend growth (DG) stocks is a good hedge against this, since the dividend is less likely to be cut despite drops in capital value, but if you need to (or want to) sell a stock at that time, you’ll potentially end up taking a significant loss.
- Dividends are great, but when the S&P only pays out 2% on average, the income just isn’t that great. Even more high-yielding DG stocks are only in the 3-5% range.
I’m not proposing that DG stocks aren’t a good investment (they still make up the heavy majority of my overall diversified portfolio), but I do think they can be supplemented with some larger income generating methods.
Part 1 – My First Rental Property
A few weeks ago, I finally made decided to actively pursue a rental property. I created a plan to pay cash on a distressed home, fix it up, and rent it out for a high return.
At first, I had visions of doing what I’d read about by MMM and Lacking Ambition – finding a fixer-upper, do most of the work myself, and subsequently build in an immediate large amount of equity in the process. Then I’d rent out the house at a competitive rate and turn a high profit.
Unfortunately, after about a month of research and consulting with my real estate agent who specialized in foreclosures, I learned that the local market for this type of investing was overly saturated and prices were being driven up by too many fix-n-flippers looking to make a quick buck. We tried anyways, but his prediction proved to be true. The only areas open to fix-n-rent are in the lower scale areas of town. Although I have no fundamental issue with this, the fact is that when you rent a house for $700-800/month you often end up with tenants that can barely making ends meet. I had no desire to get into the business of evictions…
I explored every price range from $50K-$200K for a property. I searched every property type from single-family houses, to condo’s, to town houses. And I walked through houses ranging in age from from 50-year old beaters to 5-year old ready-to-move-in homes. And after a few weeks, I found the deal I was looking for.
It was a foreclosed single-family residential (SFR) just a few miles from my house. It was in my home’s school district, and was a house and neighborhood I would happily move into myself. The HUD listing price had just dropped from $180K to $162K that day, and so I pounced on it. I figured the cost to fix it up would be ~10K if I did the work myself, but that the after repair value (ARV) would be at least $200K, and the rental comps showed I could easily charge $1350/month.
I offered $163K the day the price dropped, giving an extra thousand on top of the listing price to ensure I got the property. The next morning my agent called… I had been outbid.
A few days later, my agent called with another house on the east side of town. It was a newer house built in 2007, and was in great condition. It had recently sold for $190K twice in the past 3 months, but both times the buyer’s financing fell through. HUD had grown weary of this, so they dropped the price to $172K.
I drove out there that day to view the property, and discovered it was a 4-bedroom, 2.5 bath home in new condition having only been built in 2007 (and sold for $235k). Again, it was a house I’d happily live in it myself. Doing a rental comparison of the area, I found I should be able to easily rent the house for $1300/month, and potentially for $1400/month. The only downside (sort of) was that I wouldn’t get to improve my carpentry skills by fixing anything up, since it was already in near-perfect condition.
Well, that’s not true. There was a second downside: the neighborhood was a heavily controlled HOA area, and the HOA fees came out to be $90/month! Since this would eat into my profit, I decided to take a chance and offer only $162K. My realtor warned that this low-ball bid would potentially cost me the house, but that he’d write it up that night and submit it.
The sales comps on the house showed that the house was worth $195K-$210K as is, so I would be banking an immediate $30-$50K in equity if my price was accepted.
The next morning my realtor and I traded some text messages:
10:21AM (agent): I’ve been on the phone with HUD all morning. They aren’t happy, but I think we might get it.
10:24AM (me): Awesome. That’s why you make the big bucks. Make it happen.
11:01AM (agent): I’m good but I didn’t think I was this good. You’re under contract. I need $1000 earnest money and your signature on the contract by this afternoon so I can overnight it to them today.
This is one moment that I wished I had a car instead of a bike! I now had 29 minutes to ride to the bank, get a cashiers check, find a place to hold an 11:30 conference call for work, and be home by noon to watch my daughter. So I hopped on my bike, rode like mad to the Wells Fargo, and got the cashiers check. I then scurried over to a Starbucks to get online for my conference call, held the meeting from their outdoor patio, ended it a few minutes early, and raced home just before noon.
My exciting and busy life as a real estate mogul had commenced!
Part 2 – Private Money Lending
During my search for a rental house, and in my past real estate experiments, I’ve learned 2 few things.
- Success is all about connections
- Most real estate investors are willing to work hard, but few have the money to scale their business
While driving between houses in my real estate agents Hummer (yes, BNL in a Hummer burning gas at 10mpg), and as he discussed his recent trip to Boston where he and friends rented Ferrari’s and other high-end European cars I’ve never even heard of, I managed to turn the conversation back to real estate investing. I learned that my agent was also a fix-and-flipper on the side. Intrigued, I asked how he funded his deals. Considering he makes over $300K/year in real estate, surely he must pay cash, right?
Sort of. Much like others in this field, he uses other people’s cash instead of his own. And he borrows the money from a number of hard money lenders at 2-4 points, and 12-15% interest rate. I half jokingly laughed and replied that I would gladly beat those terms.
Quick explanation: For those not familiar , “points” basically means that he pays me a percentage of the loan up front. This helps pay for processing fees, and lost money from having my money inactive between investments. For example, 2 points on a $100,000 means he pays me $2000 up front.
A few hours later, after a long day of looking at houses, he brought the loan idea back up. He told me about a deal he has lined up to buy a house for $72K, which needed $20K in work – but that he thought he could sell for $120K within 3 months. He offered me a 12% interest rate. I counter offered him with 2 points plus 12% interest – still better than any deal he can get from the big time hard-money lenders in the area. We had a deal.
And with that, my new career in hard money lending had also begun.
On this particular deal, if he does sell it in 3 months I’d be looking at lending out $92K for a 3 month return of $4600. That’s a 5% return in 3 months, or roughly a 20% annualized return. Thinking overly optimistically, if I could repeat this deal 4 times per year, I could nearly pay my family’s entire annual expenses off this $92K.
Of course, there are risks. But since the money is backed by a first lien on the house, and since I’m only funding 76% ARV, if he did foreclose I’d be buying the house at an extreme discount.
Let me know if the hard money business is interesting to you guys – I’ve been researching it a lot the past few weeks, and would be glad to write a post about the associated risks and risk mitigation that I’ve been learning about. I’ll also be meeting with an attorney before I sign the contract – so I could use that time (and my money) to ask any questions you all have on it…
Putting It All Together
Once both of these deals close later this month, I’ve made a plan to combine my rental business with my private money lending business. Here’s how it works:
First, since I’ll be paying cash for the rental property, I can then open a no-fee HELOC on the rental property. A quick investigation shows I can get that opened at about 4% interest with a 50% loan-to-value. I may be able to do even better once I shop around more. But the beauty of the HELOC is that you only pay the interest when the money is actually loaned out. As soon as you pay all or a portion of it back, the interest payments are immediately reduced.
With the HELOC opened, I’ll use that to fund any future hard money loans. The spread between the 4% rate I’ll pay and the 12% I’ll charge will spread of 8%, plus I’ll continue to get 2 points at the beginning of each loan.
I’d like to target 2 hard money loans per year, averaging $100K in value and 4 months in duration. Of course, I realize some of that is out of my control.
If this can be done, I should be able to turn this single property into a cash flowing machine that can pay nearly all of my family’s annual expenses.
- $10,800 in annual rental profit (after taxes, insurance, HOA fees, and assuming some vacancy time and some repair)
- $9300 in annual hard money income (after paying HELOC interest, assuming 2 deals per year as described above)
Although this may be somewhat optimistic, this would effectively be creating a 12.5% ROI of my $160K investment, all while being backed by hard assets (the rental house I’ll own, and the house with a deed of trust for the hard money loan).