August 13, 2014
Guest article by Augie Byllott:
In the world of investment real estate there are myriad ways to buy, sell and finance real estate. The following information is about a particular segment of the business, private lending and most specifically targeted toward the financing of non-owner occupied real estate. With the enactment of the Wall street Reform Act more commonly known by the name of its authors, Dodd-Frank, lending to owner occupants has become a potentially hazardous business fraught with, as of this writing, many unknowns that could negatively impact small lenders.
For many years, private individuals seeking better returns have provided the fuel that keeps investment real estate viable for many small developers, builders and those who buy, fix and sell foreclosures, short sales, probate properties and junkers that are not considered financeable by banks. Their funds have facilitated the acquisition and renovation of literally millions of single family homes, helped small builders to create new housing stock and kept many trades people employed. In a nutshell, private money lenders help the economy while earning above market returns on their capital.
During my first 15 years in the banking industry I had never even heard the term private lending let alone knew what it was, then, I was approached by a talented young builder who had acquired enough property to build 15 houses but needed capital. His plan was to build and sell one house at a time and use the proceeds to repay the loan plus interest that was at least 5 percent more than I could earn at my bank. After reviewing his plan, some of his previous work and the blueprints of what he was going to build I developed a comfort level.
We documented the arrangement and he was off and running. I am happy to report that a formerly vacant piece of dirt now has 15 families living in homes each worth over $500,000 today! That was about 20 years ago. Oh, I more than doubled my original investment in a few short years so I was pretty happy too!
Private individuals seeking to avoid the volatility of the stock and bond markets may find the safe haven they are looking for in the world of private lending. This is sometimes called hard money lending though the two can be somewhat different. If you are prudent and diligent, you can earn solid returns while minimizing risks as a private lender.
Like any business venture private lending requires specialized knowledge; higher and more predictable returns can result when investing in private money loans but it also requires more effort and patience than that needed to push a button and execute a buy or sell order for a stock.
At its core, investing in private loans is a lot like investing in a bond that pays a fixed rate of return and pays off at maturity. If you make a loan to a borrower for $100,000 at 8% interest, and require interest-only payments, you’ll earn $8,000 income each year. And when the borrower fulfills their obligation, the loan will pay off at or before maturity and the original principal will be returned.
Liquidity – Do not consider becoming a private lender if you need the money before the maturity date. Even though most loans payoff, many do not pay off as expected. You can sometimes sell loans using an online loan exchange, or broker them to another private investor via a hard money loan broker. But even performing private money loans are typically sold at a discount. If you want to sell notes, even if they are performing, be prepared to take a little haircut.
Collateral Valuation – The underlying collateral for a private loan is very important to the overall security of the transaction. Lenders should carefully evaluate the value of the collateral and use several sources to confirm their valuation. A common practice among private lenders is to “drive the comps yourself.” That means do not just look at photos on an appraisal and assume you have an accurate value.
With the appraisal in hand get in your car and drive to the subject property as well as each comparable property and confirm for yourself that the property value is realistic. Consider multiple sources of value. In addition to an appraisal and driving the comps yourself, consider using an automated valuation model or a Broker Price Opinion (BPO) as well. Some properties are easier to comp than others.
Advances – On occasion loans require the investor/lender advance additional funds for a variety of reasons. Advances may be required to cure delinquent property taxes, cure a senior lien position, hire an attorney, pay to defend bankruptcy claims, or even remodel a property if a foreclosure takes place.
Title – Be sure your borrower obtains a lender’s title policy that will insure your lien position as a lender and offers fraud protection against forgery. Title insurance is not like homeowners insurance. If you suffer a loss with your homeowner policy, you submit the claim and get a quick reimbursement. Title insurance is an indemnity policy and as such you are reimbursed for a proven loss only and not the potential for a loss. The result may be that even though you will eventually lose money due to a title issue, you may not receive reimbursement for months, or even years later.
Borrower Credit – Carefully reviewing the borrower’s credit application and capacity to make monthly payments is the key to a successful loan investment. Private money loans are often made based on the collateral, but the best loans are those that give equal weight to the borrower’s past credit track record and capacity to make payments and repay the loan when a balloon payment is due, or when the loan matures.
Private Lender Insurance – You will need to make sure the property owner has appropriate hazard and liability insurance in the amounts you desire as an investor. The insurance company must also be notified to include the private lender as an additional insured on the policy so in the event of loss, the check is sent to you first.
Documentation – Documenting the loan, creating the appropriate security documents and disclosures to the borrower can be complicated and time consuming. There are a myriad of state and federal regulations to be followed, and a violation of these regulations could invalidate the loan and result in lost interest and/or fees. Consulting an attorney or mortgage professional can help you do things right.
SERVICING YOUR LOAN
Once a loan has been originated, payments need to be collected from the borrower, and various tax, regulatory and informational statements need to be sent regularly to the borrower. Lenders can do this themselves or hire a loan servicer to collect payments and provide reporting for a fee.
PRIVATE MONEY AND FORECLOSURE
If a borrower fails to pay as agreed, lenders must be prepared to foreclose on their collateral. This can be an arduous and time-consuming process that requires a significant amount of expertise and expense.
There are also alternatives to a foreclosure; among then are for the lender to accept a deed-in-lieu of foreclosure or a short sale of the property whereby the lender agreed to allow the property to be sold for less than the loan balance.
As you can see, investing in loans is not as easy as it may seem on the surface and certainly more involved than buying a publicly traded security like a stock share or a bond. So, how do you invest in private money loans? How do you get started? How do you take the plunge?
The answer is: very carefully. Learning the private money lending business takes time. But once you understand the nuances and study the business, it can provide returns substantially greater than other investment choices.
There are professionals in the business of helping investors make loan investments. In the past, they have been referred to as hard money lenders, loan brokers, or mortgage loan originators. These are professional business people who are skilled and in most cased licensed by their state at originating private money and conventional loans.
The best part about using one of these sources of assistance to invest in loans is that the fees are typically paid by the borrower and therefore you get the expertise without paying for it directly. You pay for it because of the additional fees you would likely have collected had you originated the loan yourself.
For example, if the borrower was willing to pay 3 points up front for a $300,000 construction loan, you may earn the entire $9,000 fee up front as the sole investor and originator. If you use a loan originator instead, you may still get a piece of that commission; typically 1 point they keep the remainder.
If you’re just starting out, the services of a loan originator can be invaluable and they will help walk you through the transaction. Many investors who are not real estate professionals maintain life-long relationships with their loan originators just as a corporate executive might maintain a relationship with an investment advisor.
Augie Byllott is a full time real estate investor who specializes in all facets of residential real estate investing. He is also a nationally recognized Author, Trainer, Coach and Speaker who teaches creative real estate investing to people from all walks of life. Augie believes in creating win-win scenarios through the use of Intellectual Capital and Transaction Engineering. Visit him at www.PACTProsperity.com