Risk versus reward
I had a really good opportunity for a private money lender, recently. I emailed the information to everyone I thought would be interested. The deal was to loan money to us at 6% interest only. I noted in the email that 6% was three times what the, and I quote, “high yield” CDs and bonds being are offered for in 2020, according to bankrate.com.
The loan was only $40,000.
For collateral, I was going to give the private money lender a first mortgage on a property that had a conservative after repair value (CARV, for short) of $85,000. Now, when I send out an offer like this, I use conservative numbers, not speculative.
Here is what I mean: I had comps that could justify a $110,000 after repair value. But I don’t want my private money lenders to ever think I am using an EARV. Some people say that stands for estimated after repair value. But my good friend, Glen Samels, says EARV often means exaggerated after repair value.
I don’t want to be that guy.
This time around, two of the responses I got really had me thinking.
You see, we are keeping this property as a rental. The first response thanked me for thinking of them but let me know that they were only interested in short-term deals —– meaning less than a year. They are more like hard money lenders.
The other response said that the risk-to-reward ratio was not a good fit. This private lender would need closer to 9% to make the deal work.
Don’t get me wrong —– more is almost always better. And if you can get a higher rate of return with less risk, you should do that.
But both these people wanted a higher return with a shorter term. Let’s think about that.
One of the biggest struggles of being a short-term lender is finding suitable investment to deploy capital in a timely fashion. If you are getting your loans back quickly, you have to find a place to reinvest just as quickly. Otherwise, your money is making nothing sitting in your account.
Let’s say you find a house flipper who needs $100,000, and you make him an interest-only loan at 9%. The flipper says he can rehab and have the house sold in five months.
To figure out that dollar amount of interest owed on this note, you take $100,000 and multiply it by 9% to get $9,000. An interest-only note has interest paid annually. So, if the loan were to go an entire year, $9k is what it would bring in.
But since the flipper only needed the funds for five months, you don’t get an entire years’ worth of interest on this one. So, to figure out what you do receive, take the $9,000 and divide it by 12 months. This give you $750 a month. Multiply that by the 5 months, and your total interest for this investment is $3,750.
If you can’t find another suitable investment to put your money back into, your return for the year is only 3.75%, not 9%. (You get that by taking the $3750, dividing it by the principle of $100,000 and multiplying it by 100%.)
If you can find another deal for the year, awesome. But if you don’t, that 9% is just an illusion.
To receive a better annual return than an actual 6% in this scenario, you have to keep your money deployed for more than eight months of the year.
Is that possible? You bet. Is it a lot of work? Yes. Is there a risk of not receiving the 9%? Definitely. And I would say it’s a big one. What if the flipper took 7.5 months, causing you to miss the deal you had lined up behind him, and you couldn’t find another deal to fund for the year? Your effective return would be 5.62%.
In this case, the guaranteed 6% annual return has more reward with less risk… and way less work.
More is almost always better than less. But I think that it makes more sense for short-term lenders to diversify and have some loans that are longer and guaranteed like the 6% one, along with some loans that they use to try to make those higher returns. That would make for a better risk-to-reward ratio.
Joe and Ashley English buy houses and mobile homes in Northwest Georgia. For more information or to ask a question, go to www.cashflowwithjoe.com or call Joe at 678-986-6813.