Everyone knows the old adage “the house always wins”. This saying references the odds that are stacked against you in a casino. The deck is always stacked for the house with advantages that can range from as little as 2% all the way up to 25%. Even experienced gamblers will eventually lose to the house if they play long enough.
Some of my favorite investing tips have to do with evaluating the potential risks and benefits of a deal on the table. I love asymmetrical investing where my potential upside exceeds the potential loss.
Here’s an example:
If I buy a stock, I’m evaluating its history and future potential against its current price. If a $100 stock started trading 10 years ago at $10/share and now it is at $100/share, the trend is up. Further evaluating the Price/Earnings ratio gives us a comparison of the stock price to the reported earnings and an idea of whether or not the company is profitable. Studying this company’s future in the corresponding sector will give an idea of whether or not demographics and demand for this service or product are favorable for the anticipated investment hold period. But the final answer is: we don’t know if the stock will go to $0/share or $200/share. It could be worthless or double in some period of time,,,or both if it is held long enough. The risk and benefits are symmetrical (sort of) and the house is the only sure winner. Who is the house in this example? The stock broker, your investment advisor, the company, wall street – they all make money regardless of whether or not the stock goes up or down and whether you make money or lose your investment.
Let’s look at another example with some more favorable outcomes. Private Lending is an excellent example. Most of the readers of this blog will be familiar with buying a house. You find the one you want, get approved to borrow money for the purchase, go to closing with a downpayment of your own money and the bank finances the rest. After all of that, it is your house (subject to the real owner – the bank- if you don’t pay your mortgage). You make payments for 15 to 30 years until it’s paid in full – or you sell it and start over.
Private Lending is the same process but the actors are re-arranged and some of the terms are different. So now YOU are the bank. You provide the cash for a borrower who will own the property. They pay you interest on your money and if they fail to make payments, you own the house.
So let’s see some numbers….
Let’s assume that the borrower owns a single family home. He has no debt on the property and rents it out as a cash flowing investment. The borrower is a real estate investor. He wants to expand his portfolio to more “doors”. He wants to pull some of the “dead equity” out of the property so he takes a private loan against the property from YOU. Assume the value of the home is $100k. YOU lend $60k to the borrower, accepting the house as collateral. The terms can vary from months to years depending on the situation. The terms for these deals are double digit fixed and many times included additional “points”. The borrower can use this money to purchase 2 more homes and fix them up to sell or keep in the portfolio. The Lender (YOU) gets a very nice return on the investment. And if the borrower doesn’t pay? YOU just bought this $100k house for $60k. There are some caveats to taking over ownership of the house in the event of a default but, simply put, you can keep the house and rent it out or sell it for a profit. The investment returns typically go way up in the event you get the house instead of your principal plus interest.
So the risk is minimal and the upside benefit is double digit to triple digit. That’s asymmetrical risk/benefit. Private Lending can also be done INSIDE a self-directed retirement account making all those gains tax-deferred or tax-free. These deals do require due diligence on the part of the lender (underwriting per se) but the limited actual time commitment makes these passive income deals very high dollar/hour returns. Many call this:
“The Best Seat at the Closing Table.”
If you would like to know more about this method of building passive income, please email me or, better yet, come to our next meeting to rub shoulders with other lenders and borrowers in these types of deals. And PLEASE don’t try to do this on your own! This quite a simplified explanation of how private lending works and we recommend that anyone new to this seek direct guidance throughout the entire process, which we provide each one of our clients. One of the most important things to remember is to only use borrowers that you KNOW, LIKE and TRUST (and never a dangerous, unfamiliar internet company). Come meet some of the borrowers that we have selected and getting things rolling today! Until next time…