When most people think about investing in real estate, being the lender rarely comes to mind. It can be very attractive from a risk reward perspective with typical yields in the upper single digits to low double digits and without the same burden of owning real estate directly. There are two primary ways to source private lending investments. 1. Direct to borrower 2. Partnering or investing with an existing lending company such as ours. I wanted to share five quick tips on what to look for and do if you intend to lend direct to a borrower to help better protect yourself and your investment.
- Get to know your borrower: You are lending to a person and understanding who they are is critical. I suggest getting credit and doing a background check. If they have had issues in the past, ask them directly what the challenges are. Make sure they can intelligently explain both the numbers and the project. It is important that they have a clear action plan to get from start to finish. Ask for references and/or review documentation of a past project they have completed.
- Know the value of the underlying asset: You are going to place a 1st lien or deed of trust on a property. Make sure that you don’t take the borrower’s word for the value. I suggest getting an appraisal done or getting a broker price opinion. If the project is a fix and flip, make sure whoever evaluates the property gets the scope of work and budget. This will allow them to tell you what the property should be worth upon completion. My suggestion is that you should not lend much more than 65% of the after repair value
- Release construction money in draws: You should always agree on the budget and draw schedule prior to funding. The draws need to reflect the cost and work that has been completed by the borrower. It may sound obvious, but I have seen many private lenders get in trouble by releasing funds to advance work. Also, make sure that you or a third party inspects the property each time you are about to release the draw. Don’t rely on your borrower’s word or pictures they provide you. Depending on the size and duration of the loan, you may also want to verify that the borrower is current on taxes and have your title company do a run down to ensure no other liens are attached to the property.
- Make sure proper licenses and insurance are in place: For construction and renovation projects, you want to make sure that you are provided a GC’s license either from your borrower or a contractor they may hire. You will want to get general liability and property insurance naming you as the loss payee. Speak to your local insurance rep about proper coverage amounts and appropriate types of insurance.
- Hire a good attorney who represents hard money or private lenders: This is critical and they will protect you on several fronts. First, they will make sure that you are a secured lien holder and paper the documents that ensure your borrowers will have a high level of accountability. In addition to this, they can be a great source to help navigate any issues from title and closing to zoning and environmental. The best news is that your borrower customarily pays for legal fees.
These suggestions are just a few items that are important to follow to help protect your investment. Tip #5 is probably the most important because the attorney can guide you through each step and help you underwrite the loan. We have deployed over $250 M in private loans since 2007 and while working with many borrowers and investors, we continuously try to improve our own process. You want to always plan, structure, and document for the worst, but obviously hope for the best.
Authored By: David Hansel, President of Alpha Funding Solutions
