In our nine years of loaning money for real estate investment projects we have seen a lot. Much of it good, although we have seen our fair share of the bad as well. Investors in this space have to take on risk in order to complete these types of deals and without their entrepreneurial spirit frankly our company wouldn’t exist. Here at CPL Investments we really like deals and projects where we can provide more than just capital. Through the years we have come to realize some common pitfalls that real estate investors have fallen into when operating in this space. Listed below are the five most prevalent pitfalls that we see in this business.
Reason One – Poor Management of Cash Flow
It is important to realize that when investing in these types of real estate projects whether they be fix n’ flip, buy and hold or new construction that your income is earned once the deal has been closed, meaning that you have rehabilitated or built the property and have now sold it or rented it out to a tenant. This means that every expense prior to this closing date will need to be paid out of your own pocket. Some examples of these fees include, realtor fees, closing costs due to the title company, the down payment for a loan, interest payments and any unexpected costs that may push you over your budgeted amount. This is why it is crucial to plan ahead and realize the amount of equity or cash out of pocket needed to get this deal to the finish line before making an offer on the property.
- Contingencies: For the more experienced real estate investor who knows how to calculate the equity needed for each deal, cash flow problems may start to arise when you start to work on multiple projects at a time. Perhaps a deal starts to go awry and the cost to finish it is now way over budget. Or perhaps one of your properties is sitting on the market for longer than expected and you have to continue to make interest payments on this property for a few extra months. It is important to plan for this growth that you have decided to take on. Contingencies should be built into every deal so that you aren’t tempted to rob “Peter to pay Paul”, using one property’s loaned dollars to pay for another interest payments. Even though you are now working on multiple projects at a time they should continue to be looked at as individual projects and the necessary cash should be allocated to each one individually.
Reason Two – Partners
Partnerships are a great way for individuals to combine their efforts and resources towards a common goal. However, partnerships also open up individuals to a whole slew of problems. We here at CPL Investments have seen quite a few partnerships collapse over our nine years of operation, so many that we have decided that it necessary to include it in our five reasons. This is not to say that all partnerships are destined to fail, but there are some things that one should consider before starting a partnership.
- What Role Will Each Partner Have and is it Written out in an Operating Agreement?: Each partner should know what their role is and how they are going to be compensated for their contribution to the project. Many of the partnerships that we have seen fail are simply due to the fact that one, if not both of the partners fail to perform their expected duties. When we call to discuss the issue with the partners, we will often learn that these expectations where never solidified in writing and were just loose parameters. We now require that partners create and provide us with their Operating Agreement beforehand that clearly lays out each partners role in the partnership and their contribution to the project. We strongly recommend that you hire an attorney to draft up an agreement for any partnership that you wish to participate in, the upfront costs are well worth the protection. If one partner needs to exit the partnership the process for doing so will be in the agreement. The agreement can also provide partners with certain legal protections if a partner were to break the agreement.
Reason Three – Stacking Investors
Stacking investors or using multiple outlets of private money for the same deal can be a very slippery slope. Stacking investors is typically something we see from the more experienced flippers but anyone that finds themselves in a tough situation financially may choose to take this route.
- Private Lenders: Sometimes investors will want to complete a project, but they don’t have all the necessary funds available to do so. The majority of lenders will require some sort of down payment as 100% financing is typically seen as incredibly risky. The investor will then reach out to family and friends and sometimes wealthier private individuals for a loan at a reasonable rate to fund “their” equity in a project. Often times these loans are strictly based off the character of the individual and the individual lending the money will not take a lien on the property or collateralize anything in order to make the loan. This can lead to problems as sometimes these individuals see their loan as a favor and not truly a business investment. If these private individuals need their money back due to a family emergency, hospital bill, divorce, etc. they may call on the investor to return their money promptly mid-deal. Sometimes an investor will get cold feet before closing the deal and this can leave you scrambling to find another source of funding quickly before your Purchase Agreement expires. Lastly, to comply with securities laws it is up to you to make sure that the investors that you are using are considered “Accredited Investors”, it would be wise to meet with an attorney prior to accepting any capital for a deal.
- Margins: Even if the project is completed using private money, borrowing 100% of the money needed to complete a project can be expensive. It is important to calculate the total cost of borrowing all of the money need to get the project done. Each passing day of interest is going to lower your profit margin on the deal. If you are able to borrower money from a family member at an affordable rate this may not be the biggest concern in the world. But many of the sophisticated private lenders out there that will do this sort of equity financing will require a lien be placed in secondary position on the property and will charge a higher interest rate to compensate for this additional risk.
- HELOCs: Finally, I want to discuss HELOCs, with rates staying fairly low these days HELOCs are becoming a source for many of our investors who wish to tap into their home equity. While we never recommend stacking investors, we have found that HELOCs are fairly affordable and are much more reliable than individual lenders. We typically still recommend that an individual not start a project if they do not have the necessary equity available, typically around 20% of the entire deal. But if they want to use a HELOC we will typically approve the deal as long as they have shown that they have accounted for the extra costs of borrowing 100% of the funds.
Reason Four – Overextending / Unsustainable Growth
One of the best reasons to use leverage or borrower money is so that you may work on multiple projects at once. Leverage allows you to expand and take on more than you could on your own dime, it is an incredibly helpful tool when used correctly. The issue is that we have seen investors take on too much too fast.
- Processes: These investors don’t have the necessary processes in place to take on the extra work. They become unorganized and many times don’t fully calculate the costs they are taking on with this extra leverage. Here at CPL we help our borrowers to develop processes and systems that let them see when they are ready to take on another project and when they should perhaps hold off and finish the ones that they have started. With every project there should be budget in place, clean title, contractors/subcontractors ready to begin working, funds available to be transferred to begin the work and the necessary permits must have been pulled. It is so important that each project be looked at as a stand-alone project and these processes must be developed and followed time and time again.
- Building Your External and Internal Teams: When investors come into borrow funds from us here at CPL one of the first questions we will ask is about their team. Who do they know around town that is going to help you get this project done? Do they have a general contractor? How many do they have? If they are a GC, do they have reliable sub-contractors? If they are looking to purchase and rent out a space, do they have a reliable lender to refinance us out of the deal? Are they pre-approved with this lender? If they are flipping a home, do they have a real estate agent that they typically use?
By asking these questions we are trying to determine how experienced they are and how posed for growth they may be. As they continue to grow they are going to need to keep expanding their team as they take on more and more. If they don’t expand their team they will have projects just sitting and they will have to pay interest on a project that isn’t moving forward. They may want to consider networking to build their team prior to starting their first deal. I have listed some of the key members they’re going to want to have on their team below.
- General Contractor
- Real Estate Broker
- Title Company Contact
- Hard Money Lender
- Traditional Lender
Reason Five – Not Sticking to Your Lane
In real estate there are a plethora of shiny objects out there. It’s a wonderfully diverse field, there are a ton of opportunities. Unfortunately, time and time again we have seen investors bounce from one thing to the next and eventually they bite off more than they can chew or spread themselves too thin. Whether it be an investor that has completed a few single-family flips trying to take on a 25-unit apartment complex, or a trailer park or a self-storage facility, we’ve seen it. We often see investors chase these opportunities rather than being the best in a certain area and actively searching for the optimal opportunities for them.
- Focus on What You’re Good At – Becoming a Master of Your Trade: As I mentioned above it’s the investors that specialize in an area of real estate and master that area that are our most successful. They have the best margins, the highest returns and all live very comfortable lives. They have established teams that know exactly what they are going to be doing each and every day. They know the areas they want to do deals in and how much to pay for a property. They know how long the project is going to take and can accurately forecast the expenses for each project. They are known in the neighborhoods they operate within and therefore always get the first call for a hot off market deal. They have ironed out processes and they know when a deal has started to go bad and will immediately cut their losses. These individuals understand that they are truly investors and that investing means playing the long game. If you are chasing every “hot” deal you are speculating, not investing.
- Doubles v. Homeruns: This leads me to my next and final point, our most successful investors are the ones that exercise some discipline while looking for deals, they are concerned with deals that fit within their wheelhouse and aren’t looking for a once in a lifetime opportunity. This means they’ll make about a 20-25% margin on the deal in 180 days or less. They don’t try to list the property way above market value and hope for a buyer. Often times they will list the property below market value so that they can get their money back at their desired return and quickly move on to the next deal. They understand that investing your money into multiple projects a year is the way to go, they understand the impact compounding can have on their returns.
When you are investing you take on a multitude of risks. To lower these risks, we recommend that you accurately forecast and manage your cash flow. That you calculate how much equity you are going to need to put down in order to make a deal work and that if you aren’t going to use your own money, how much are your borrowed funds are going to cost you? If you’re going to use a partner to help with equity or some of the actual labor, make sure that you have a written agreement stating each individuals’ roles and rewards. Specialize in an area and be patient, grow in that area and build your team around that growth so that it may be sustainable. Remember that you are investing, and the goal isn’t to get rich overnight but rather to provide yourself with security, a diversified income stream that you have the freedom to control. If done right over time this income stream will continue to grow in size until you have left a lasting legacy for yourself and your loved ones.
I hope that you have found this article to be helpful. If you think that others may enjoy reading it, please feel free to share it with your friends. If you’re looking for a hard money lender that is local to the Indianapolis area, we would be happy to discuss working with you and would love to help you continue to build that external team. Finally, if you have had any of your own learning experiences in real estate, we would love to hear about them.
You can contact us at (317) 836-2807 or message us online.