For new house flippers, finding the cash to make a deal happen can seem challenging. While hard money lenders should cover most of your costs, you often need some extra cash. This reality leads many people to ask me how to find an investor to flip houses.
With house flips, investors can cover the gap between a deal’s costs and the hard money. To find investors, ask who loves you? These people A) will often lend, and B) can benefit from the returns a deal will offer. And, you can structure their investments as debt or equity, depending on preference.
In the rest of the article, I’ll dive into some of the best techniques to find investors and structure deals. Specifically, I’ll cover the below topics:
- What is a House Flip?
- Why Do You Need an Investor to Flip Houses?
- How to Find Investors
- Investment Structure Option 1: Debt
- Investment Structure Option 2: Equity
- Final Thoughts
What is a House Flip?
Prior to talking about finding investors, I want to briefly provide an overview of the house flipping process, in general. The more comfortable new investors are with this strategy, the easier it will be for them to explain deals to potential investors. And, the more comfortable potential investors feel with the ins and outs of a deal, the more likely they will accept your offer.
Unfortunately, HGTV shows about flipping houses do a disservice to new real estate investors. According to these shows, you walk right into the perfect deal, spend a few days fixing it up, and sell it for a massive profit. Nothing could be further from the truth.
In the real world, the fix & flip process begins well before you actually acquire a property. To complete a successful deal, you need to put in a ton of work on the front end. This up-front research and analysis ensures that, before you purchase a home, the numbers support a profitable deal. Investors make or break a deal during this initial review period.
In a nutshell, the house flip process includes a few broad tasks. First, investors need to find a distressed property with a purchase price and potential rehab budget to support a profitable resale – the analysis I just briefly outlined. Second, investors need to purchase the home, which may or may not include a price renegotiation after initially going under contract with the seller. Next, investors must supervise the renovation process, bringing the property to a condition that will qualify for traditional financing. Lastly, investors sell the renovated property – typically to primary homebuyers.
If analyzed correctly, the sales price exceeds the total rehab, purchase, and holding costs, with the difference representing the flip’s profit. And, when properly presented, this profit can and should incentivize potential investors.
Why Do You Need an Investor to Flip Houses?
After explaining the house flipping process, the question remains: why do you need an investor to flip houses? As mentioned above, a hard money loan should cover the bulk of your purchase, rehab, and transaction costs for a house flip. But, unless it happens to be a particularly outstanding deal, you’ll still need some cash on top of the hard money loan.
For example, say you find what seems like an ideal house to flip. After running the numbers, you determine that it’ll cost $80k to purchase and an additional $20k to rehab for $100k in total acquisition/rehab costs. And, in reviewing market comps, you believe the renovated property will sell for $150k. With $20k in transaction costs, that still leaves you with a nice $30k profit on the deal.
But, in analyzing your loan application, the hard money lender assesses a slightly lower after-rehab value, or ARV, than you do. As a result, you only qualify for a $90k loan, leaving you $10k short of the money necessary to make the deal happen. Typically, a house flipper would access some form of gap financing to cover this excess cost. Common options include:
- Credit Card Financing: Credit card companies want your money. As such, if you’re a responsible borrower, they’ll provide you pretty good personal loan options. Say you have a $25,000 limit on your credit card, but you only use $2,000 of it every month, always paying it off on time. There’s a good chance the card company will offer you a relatively low interest personal loan for the difference between the credit you regularly tap and your limit. This can be an outstanding gap financing strategy.
- HELOC: Home equity lines of credit, or HELOCs, are another great gap financing strategy. Typically, investors tap the equity in their primary residences. So, assume you have $50,000 in equity in your property. A lender may not extend a HELOC for that entire amount, but even if you secure a $25,000 HELOC, this gives you a tremendous amount of gap financing flexibility. And, with HELOCs, you only pay interest on the money you draw. Once you repay the outstanding balance, you don’t need to pay interest.
- Business LOC: Functionally, a business line of credit (LOC) acts the same as a HELOC. However, rather than secure the credit against your primary residence, banks use your business’s operations to secure a business LOC. Obviously, this option only exists for investors with a business. But, if you have a successful business, a LOC secured by its operations can be an outstanding gap financing option.
For this example, though, let’s say that you A) don’t have $10k in cash, B) cannot access one of the above gap financing sources to cover the difference.
This is why you often need investors as a house flipper. In this example, bringing in an investor to provide that $10k would allow you to move forward with the deal. Yes, I used round numbers for demonstration purposes, but the fact of the matter remains: investors can help you make deals happen.
How to Find Investors
After determining you need to bring an investor in on a house flip, you need to actually find one. That is, you need to track down someone willing to fork over some of his or her hard-earned money to help you make a deal happen.
It’s not as hard as it seems! My solution? Love Money. Ask yourself the question, who loves me? These are the people you present with an investment opportunity. Parents, siblings, aunts and uncles, grandparents, close friends – these are the people who love you, and they represent an outstanding pool of potential investors.
Two major barriers typically stand between a house flipper and a potential investor: 1) introductions, and 2) trust. In other words, people often – incorrectly – believe that they need to be introduced to institutional-grade investors to have a shot at securing funds. In reality, plenty of people have savings sitting in low-interest bank accounts and would jump at the opportunity to generate higher returns – not just high-net-worth investors.
And, related to this fact, presenting investment opportunities to people who love you clears another huge hurdle: they already trust you. You’re not some unknown entity approaching them out of the blue with a deal. They’ve known you for years, love you, and implicitly trust you.
But, it’s important that you frame any investment opportunities correctly. Most critically, you are not asking for a hand-out. Rather, you’re offering a win-win situation to a potential investor. Savings accounts today rarely offer more than a half percentage point in interest (and often less). Accordingly, plenty of people look for alternative investments to generate higher returns with their savings. So, here’s the win-win:
- Win 1: You secure the capital necessary to move forward on a house flip.
- Win 2: Your loved one who invests with you earns far higher returns than he or she would’ve by simply letting cash sit in a low-interest bank account.
Simply put, you’re offering an opportunity – not asking for help. For many people, asking others for money – especially loved ones – can make you feel sheepish. If you fall into this category, remember that you’re actually offering a benefit to these potential investors. So long as you are fully transparent with the details of a deal and act with integrity, you shouldn’t feel hesitant about pitching a potential investor.
The Path Ahead
Having outlined my Love Money strategy, here’s how I recommend moving forward with finding an investor. First, pull out a piece of paper or open a Word document. Next, spend 30 minutes or so listing the names of the people closest to you in life. At the end of this exercise, you’ll have a list of potential investors in front of you.
However, before you pitch these potential investors, you have to outline different ways to actually invest in the deal. Broadly speaking, two investment structures exist for deals: 1) debt, and 2) equity. I’ll outline how both work in the next couple sections. And, once you have a solid grasp of the foundations of these different options, you can structure a deal as creatively as you – or your investors – want.
Investment Structure Option 1: Debt
One of the two primary options for structuring an investment is debt. This means that someone lends you money and you return that money plus interest. In other words, you pay someone a return for the privilege of temporarily using their money.
Continuing the above example, an investor could lend you $10k, charge you interest, and have you repay that $10k plus interest. In this situation, you receive the funds necessary to make a deal happen, and the investor collects a higher return than a bank would offer.
And, when it comes to interest, I recommend offering a slightly higher rate than your hard money loan. When an investor lends you money on top of the hard money loan, that investor holds a second-lien position on the underlying collateral – the home. That is, if the deal falls apart and the home goes into foreclosure, the debt investor would get paid out after the hard money lender (i.e. the first-lien holder on the collateral). This means debt investors assume higher risk than the hard money lender, meaning they should receive a higher interest rate to compensate.
For example, let’s say you secure the above $90k hard money loan at 8%. As such, you and a potential investor agree that 10% is a reasonable rate for the $10k investment. If you sell the flip after six months, that means you’d owe this investor the original $10k loan plus $500 in interest ($10k loan x 10% x 6/12). Now, instead of a $30k profit on the deal, you deduct interest and collect $29.5k.
NOTE: Though beyond the scope of this article, debt financing also has a tax advantage, as you can deduct interest payments from your taxes. Consequently, this tax advantage reduces the effective interest rate you pay on debt financing.
Before opting for a debt structure, house flippers should consider two additional items. First, make sure to design any debt repayment plan for after a house sells. In other words, agree to repay the investor’s loan plus interest with the proceeds from the flip sale. That way, you don’t have to worry about regular debt service when projecting a deal’s cash flows.
Second, house flippers – and real estate investors, in general – need to understand that, even if a deal falls through, you’re still liable for the debt. From the house flippers perspective, this increases risk. Regardless of whether or not you successfully complete the deal, you’re still on the hook for the loan.
Investment Structure Option 2: Equity
Next, house flippers can structure an investment as equity, or ownership, in a deal. In this situation, an investor doesn’t lend you money. Instead, he or she puts money into the deal and, in doing so, buys an actual ownership interest in the property. As a result, this investor will collect some percentage of the deal’s profits based on that ownership percentage.
For example, let’s say that, in return for the above $10k investment, you give the investor a 20% stake in the deal. Without a special profit allocation, that ownership percentage will translate into a 20% share of the profits. In this situation, that means that, if you do, in fact, earn a $30k profit on the deal, you’d owe $6k of that to the equity investor ($30k total profit x 20% interest). Now, instead of collecting $30k on the deal, you’d end up with $24k.
At face value, this example makes it seem that equity is a far better choice for investors than debt. Instead of earning $500, this equity investor would earn $6k – $5.5k more.
But, equity investments come with far higher risk from the investor’s perspective. With debt, the house flipper must repay the investor, regardless of outcome. Conversely, a house flipper is not liable for an equity investment if a deal falls through or closes for less than projected. For instance, let’s say that the housing market drops significantly during this rehab. Now, instead of receiving the $10k original investment plus $6k in profit, the equity investor only recovers $9k from the deal – a $1k loss. As equity investors, that’s the risk you take. That is, you have no recourse to force the house flipper into returning all of your initial investment.
The opposite is also true, though. While you risk greater losses as an equity investor, you also stand to earn larger profits if the deal exceeds expectations. For example, say that, rather than a profit of $30k, this house flip results in a $40k profit. Now, the equity investor would collect $8k ($40k profit x 20%).
Bottom line, equity investors assume more risk. This exposes them to greater potential losses while also letting them share in increased profits.
Now that I’ve explained both how to find potential investors and ways to structure an investment, I want to tie it all together. As stated, you should be completely transparent when proposing an investment opportunity. Personally, I recommend sequencing an investment pitch as follows:
- Part 1, Deal Overview: Provide a general overview of the property and the deal’s numbers (acquisition, rehab, and transaction costs; projected ARV). This allows the investor to frame the broader investment opportunity.
- Part 2, Investment Options: Next, create two to three potential investment options and the associated returns. For instance, you may create one debt option, one equity option, and one hybrid option including elements of both debt and equity investment. For each of these, include the investor’s projected returns.
- Part 3, Risks and Concerns: No investment opportunity is 100% guaranteed. And, suggesting that a deal lacks risk is disingenuous at best and downright fraudulent at worst. Part of working with investors is being transparent about any potential risks. Then, they can assess those against their own risk tolerances and decide whether or not to invest in the deal.
And, as you begin to pitch potential investors, just remember: you’re offering opportunities – not asking for charity. Related, if you’d like a free copy of the Do Hard Money property value analysis tool, text me your email at 435-294-0433. This can be a great resource to help potential investors see whether or not a house flip represents a good deal or not.