Lending Money to a Rehabber? Protect Yourself!

March 18, 2015

Thief With MoneyI recently received the following question from an investor who is considering lending money to a rehabber. I’ve been there and done that and learned a number of very expensive lessons. Hopefully, he–and you–can avoid some of my mistakes. (It’s a long post, but well worth reading!)

I recently came across an ad on Craigslist for a house flipper looking for investors to help finance some of his projects. He specifically needs funds for the renovations and will fund the purchase price himself or through another investor. He says he has a proven track record and is willing to show his documentation. He mostly operates in the $100K to $200K range. 

He typically will need about $15K to $30K for the renovations, which he will mostly do himself. The projects typically take about 10 weeks from start to finish. He spends about a month with renovations and then 6 weeks to sell. 

In exchange for lending him the renovation costs – within 48 hours after closing I would receive the original investment plus 25% of the profits. He said he usually nets about $20 – 30K on a deal. So 25% of 20K would be a net profit for me of 5K. 

I’m very interested in doing this but am wondering what type of precautions should I take? I obviously will have an attorney look over the paper work. I’m not sure if I can put a lien against the property, if that is even an option. 

How do I protect myself? How would you proceed going forward?

Thank you for the question.

I was involved in a very similar situation a couple of years ago . . . and ended up losing $15,000 because I made some mistakes. (Dumb mistakes, really.) And I lost another $14,000 in another deal a few years before that—but it still involved “lending” someone else money for a rehab. (Different mistakes.) I discuss them both below. I’ll call the more recent rehabber “Dave T.” And I’ll call the other investor “Marty W.” So you’re getting the benefit of a $29,000 “education” here.

You can avoid making most of the mistakes I made.

First, a disclaimer: I’m not a lawyer, so this isn’t legal advice. And that leads me to my first recommendation.

Involve a Lawyer

The first step, of course, is to have a lawyer familiar with real estate and real estate investors review the paperwork. And use a good one. Not a pre-paid legal services type. I do have Prepaid Legal Services. They’re OK for some things. But not for this. (Both of my situations described below absolutely baffled them.)

Do Your Due Diligence

Second, do your due diligence on the investor. I did that, and “Dave T” came up clean. I checked with the leaders of two local real estate investment associations. Both knew him and said he was a good guy. He invited me to look at his ongoing rehabs one Saturday, and I did. The rehabs looked good. The crews were competent. I checked on some of his previous rehabs, and they’d sold and been profitable.

Still, pay to do a background check on your rehabber. I use a company called BeenVerified, but there are a bunch of others out there. Those background checks won’t pull up everything, but they’re a place to start.

As I found out, none of my research into the rehabber’s past guaranteed that he’d continue to operate profitably. I suspect that he ran into a series of bad rehabs. I lost $15,000, but there were people who lost $50,000, $75,000, and more on some of his other rehabs around the same time. There are limits to checking out how a person has done in the past. What you’re concerned about is how he’s going to do with your money going forward. Still, don’t skip this step; red flags in the past shouldn’t be overlooked.

Put a Lien on the Property

Third, you absolutely must put a lien against the property. Yes, it is an option. In fact, it’s more than an option. From your perspective, it is an absolute requirement.

Depending on how many people he’s borrowing from (the “other investor” or a hard money lender), you might be in second, third, or even fourth position. Second is OK if the numbers are solid. Third is somewhat risky. And fourth position (meaning the other three get paid off before you do) is extremely risky. Try for first or second position.

Note: That’s one of the mistakes I made. The guy I was dealing with said he’d record the lien, but never did. It’s not much consolation, but that’s how he handled his other investors, too. So, stupid as I was, I wasn’t the only one.

So you must make 100% sure the lien is recorded. You do that by never, ever handing the rehabber the money. You always go through your attorney or an independent third party. And the money doesn’t get handed over until the investor proves he owns the property and until the lien is recorded. Your attorney or you title company can help you with that.

Now you’ve gotten to the point where you’ve lent the money with the loan secured by a mortgage on the property. That doesn’t guarantee you’ll ever get your money back. It’s possible, for example, that the investor just got his numbers wrong. Or (as happened in 2007 and 2008), the market collapses and what would have been profitable in January is a loss in September. Or, more likely, there are undiscovered repairs that have to be made.

For example, “Dave T” told me about a rehab he was doing on townhouse in Washington, D.C. It turned out that there was a problem with the sewer line between the street and the house. He’d built in a 10% “cushion” on his $100,000 rehab (his properties would sell for $530,000-$650,000 or so once done), and it all vanished with that one unexpected repair. Or perhaps something isn’t up to code and when the rehabber or his contractor goes to pull the permits, the city requires an expensive update, upgrade, or modification.

When I rehabbed a property once, I got one bid of $50,000 and another for $130,000. The higher bidder was proposing a certain way to address asbestos flooring in the kitchen. The lower bidder was proposing another strategy. That alone added close to $30,000 to the higher bid.

Where the lien should protect you is: If the investor sells the property, you’ve “clouded the title” with your lien. It’s got to be satisfied—that is, paid off—before the transfer of title. If there’s enough money (remembering that the first mortgage gets paid off first, then the second, then the third, and so on), you’ll get your money. If there isn’t enough, the investor will have to negotiate with you and perhaps the other lien holders to accept less than you’ve agreed to.

Stay on Top of the Rehab

If you’re in the same town or city as the rehabber, drive past the property every week. Make sure that construction is proceeding. (If it isn’t, maybe the investor has run out of funds. It may be too late for you to get your money back, but don’t let it come as a surprise when, 6 months later, the job still isn’t done. And your lawyer may be able to suggest some steps to make your position more secure—such as placing a lien on the investor’s other assets.

Brawley Profit ProjectionsIf you’re not in the same town or have someone else drive past every week. Another true story of how I lost another $14,000: I provided “Marty W” (who had a glowing recommendation from a real estate guru) $14,000 to rehab a property in Spartanburg, South Carolina. I’m in Northern Virginia—460 miles away. At the time, at least, “Marty W” was hanging out in Boca Raton, Florida. In this case, the paperwork was done properly. However, the rehabber apparently ran out of money and never got around to rehabbing the property. Tip: Check on your guy’s current projects. Apparently, “Marty W” had bought a bunch of lousy properties.

Another problem: “Marty W” gave me some wildly inflated comps. I was given comps on properties that sold for $65,000. Marty’s worksheet claimed a “Fair Market Value” (the after-repair value) of $70,000. In truth, this property, rehabbed, might have sold for $20,000. I got that figure from a Realtor who knew the area . . . but after my money was gone.

This was back in 2006, before “virtual” or long-distance investing became popular. Anyhow, I never received any word from Marty that there was trouble. It’s just that the repayment date came and went and there was no money. If I’d been in Spartanburg, I could have seen this property, compared it to the comps, and soon would have seen that no rehab was being done.

So: You either need to be there or you need someone good and trustworthy—“boots on the ground”—to watch out for your interests.

Make Sure the Title Company is Aware of Your Lien

Here’s another thing to worry about, and another possible solution: A few years ago, I had an option on a property. I filed a “Notice of Agreement” at my local courthouse. That was intended to cloud the title—to alert anyone checking the title before a sale or transfer that I had an interest in the property. Although I decided not to proceed (this was during the market collapse in 2007), I had not removed my Notice of Agreement. It was still there.

However, the property was sold/transferred twice without anyone noticing my Notice of Agreement. Only when the third owner attempted to sell it to a fourth—in 2014—did the title search uncover my Notice of Agreement. The point is: Even with a lien or other instrument that should appear along with the title, those can be missed.

How do you address that issue? Stay on top of the property. If you know the title company that your investor is planning on using, send them a certified letter with a copy of your documentation alerting them that you’re a lien holder on the property. Your lawyer should be able to suggest other methods, too.

Have Access to the Rehabber’s Books

If the rehabber is just promising a set return–say 10% or 20%–on your money, you don’t need this. But if a rehabber is promising you 25% of the profits, then you must have a way to verify what the profits were. You want to make sure that all the costs are what they’re claimed to be. And you also want to make sure that those expenses went for your rehab–not some other rehab.

Conclusion

There’ nothing you can do to ensure a 100% return of your money and the promised profits. Sometimes, despite everyone’s best intentions, it doesn’t work out. There’s always risk. What you need to do is minimize all the risk you can. And, as discussed above:

  • Have a good lawyer—one who knows real estate—involved from the beginning.
  • Do your due diligence, though understand that at best that gives you an accurate history, not a view into the future.
  • Put a lien on the property.
  • Stay on top of the rehab.
  • Make sure the title company is aware of your involvement and your standing in the transaction.
  • When you’re being paid a percentage of the profits, condition your loan on your being able to access the rehabber’s books.