Other People’s Money – How Far Can It Go?

Other People’s Money – How Far Can It Go?

Most real estate investors agree with the strategy that it is best to use other people’s money when promoting a deal. I’m not talking about financing that involves debt supported by rising asset values. Rather, I’m speaking of sophisticated developers who put together capital stacks that require as little personal equity as possible. They will use private placement memoranda to solicit friends and family members as well as accredited investors. They will seek institutional investors and mezzanine financing.

On a smaller level, house flippers often use “hard money” lenders, agreeing to high interest rates and points so as not to inject equity into projects. They do so knowing that if all goes well, they will be in and out of the deal in a short period of time, maximizing the profit and allowing them to be ready to jump on the next project whenever it comes available.

In these situations, other people’s money works great. The investors and lenders understand the promoter’s needs and goals. Generally, speaking the investors and lenders are sophisticated. But so are the promoters and developers.

But when one side or the other is not sophisticated or experienced, the transaction is doomed for disaster. In one recent situation, I represented a restaurant owner who had been leasing a building that he sought to purchase. The purchase agreement was convoluted as the building was under contract to a flipper and my client sought to take an assignment of the contract. The Assignment Fee was to be $150,000 which the flipper agreed to fully finance. In other words, zero dollars were to be paid at closing to the flipper. Other people’s money.

The client wanted to fully finance the purchase price AND the closing costs. In other words, the client needed to find a hard money lender to provide more than 100% financing to acquire the property he was leasing and the flipper had to take a second mortgage for his Assignment Fee. The client thought he had found a loan, at 11.5% for almost all of the cost but when he understood the points, the monthly payment amounts between the 2 loans and the amount of cash still required to close, he realized that he could not afford the deal. So, despite the fact that he was using other people’s money to do this deal, he still couldn’t make it happen. Clearly, when a buyer is not sophisticated or experienced, other people’s money is not enough to close a transaction. Equity is going to be very important and will protect all parties involved.

On a smaller level, house flippers often use “hard money” lenders, agreeing to high interest rates and points so as not to inject equity into projects. They do so knowing that if all goes well, they will be in and out of the deal in a short period of time, maximizing the profit and allowing them to be ready to jump on the next project whenever it comes available.

In these situations, other people’s money works great. The investors and lenders understand the promoter’s needs and goals. Generally, speaking the investors and lenders are sophisticated. But so are the promoters and developers.

But when one side or the other is not sophisticated or experienced, the transaction is doomed for disaster. In one recent situation, I represented a restaurant owner who had been leasing a building that he sought to purchase. The purchase agreement was convoluted as the building was under contract to a flipper and my client sought to take an assignment of the contract. The Assignment Fee was to be $150,000 which the flipper agreed to fully finance. In other words, zero dollars were to be paid at closing to the flipper. Other people’s money.

The client wanted to fully finance the purchase price AND the closing costs. In other words, the client needed to find a hard money lender to provide more than 100% financing to acquire the property he was leasing and the flipper had to take a second mortgage for his Assignment Fee. The client thought he had found a loan, at 11.5% for almost all of the cost but when he understood the points, the monthly payment amounts between the 2 loans and the amount of cash still required to close, he realized that he could not afford the deal. So, despite the fact that he was using other people’s money to do this deal, he still couldn’t make it happen. Clearly, when a buyer is not sophisticated or experienced, other people’s money is not enough to close a transaction. Equity is going to be very important and will protect all parties involved