Private Money Lending: 8 Questions to Ask Before Lending On Real Estate
Are you looking for an alternative investment strategy that may be 3-4x the returns your traditional investments bring? or maybe an alternative to have your money sit in the bank and gaining less than 1%?
Private Money Lending is an interesting vehicle to consider and one that not many people know about, understand or think they have the ability to utilize.
Many traditional financial advisers are only concerned with the utilization of the stock market because this is how they make there management fees. There is no benefit on there end to refer you in the direction of alternative investment strategies that are more secure and offer much higher consistent returns than the market can offer.
As an investor, your primary goal is to place your money in an investment vehicle that has limited risk with high returns which allows you to have control over the performance of your money. Lending on real estate as a private money lender, offers you these opportunities.
When you invest money through traditional mediums with a financial adviser such as:
you put yourself in a position to exposed to volatile returns and a larger risk if there is a correction or crash in the market. The reason that we find it hard to give our money to financial advisers is because of the limited control we have in the performance of the portfolio. Basically we are giving all of a hard earned money to an individual with the hopes that the monies are being placed in the correct stocks to possibly give us a decent return. To me this doesn't seem like the best way to get a return on our money.
With any investment that you make, you will be exposed to risk, however when you are exposed to risk, you want protection. When you lend your money on a real estate deal, your money will be secured by the real estate in a first mortgage position and you will also be added as an additional insurer on the insurance policy. So if your borrower fails to pay you, you will be able to foreclose on the property and take back the asset.
In our current economy, there are so many different alternative investment strategies that an individual can get involved in. Today, we want to discuss the idea of Private Money Lending, how it can offer your very satisfying returns and also some questions you should ask yourself before you dive in.
Before you begin investing with any strategy, you should have a great idea of how the vehicle works, the concepts, returns and risks to be comfortable with the exposure.
1) What Is Private Money Lending?
Private money lending as it relates to real estate, is the "lending of a private individuals money to a borrower(s) who pledge(s) real estate for the loan by the way of a publicly recorded mortgage. The publicly recorded mortgage secures the loan that is evidenced by an original promissory note. The recorded mortgage secures the promissory note in the event of a default by the borrower."
In layman terms, what does this actually mean?
When you lend your money on a real estate deal, you will receive first lien position on the property or the primary position on the mortgage. If there is a default on the loan due to lack of payment, you will be able to take the property back through a foreclosure, just as a traditional bank can do.
The 2 most important documents for the lender are:
Promissory Note - Evidence of the debt & that is promised to be paid back
Recorded Mortgage - Security for your outlay
We recommend that you get a knowledgeable real estate attorney to produce the necessary documents for you to complete a transaction.
2) How Do I Become A Private Money Lender
The great thing about this investment vehicle is that your services are in high demand. The challenge is finding a competent operator who has found success in the real estate space to decrease your risk as the lender. If you find a great operator, you have the ability to reduce your risk exponentially.
When it comes to lending your own money as debt, there are no regulations, guidelines or requirements that you need to work off of.
As a private money lender, you are not going to be working with traditional homeowners, but real estate investors. Primarily, you will be working with:
Buy & Hold Investors
If you work with House Flippers, your money will be out on a much shorter term, 6 months - 1 year. If you are working with Buy & Hold Investors, they will typically be looking for longer terms, in the 2 year - 5 year range.
As a private money lender, you will be looking for real estate investors in your area, that have a proven track record, who are looking for leverage to scale their operation.
When you are putting together you plan, just remember that you are in control.
You set the rates & terms of the loan
You determine if the loan is amortized or interest only
The rate you choose will determine the return on the mortgage
You are in control of the length of the loan
You determine the LTV (Loan to Value) that are you comfortable lending up to
3) What Returns Can A Private Money Lender Expect?
As a private money lender, you are going to achieve above average returns compared to the traditional investment mediums discussed above. You are also going to receive a fixed return every month, which is very comforting. As we previously discussed, as the private money lender, you determine the rates that you are offering. You will want to make sure that you are in line with some of your competition or other private money lenders in the market.
As a rule of thumb, you can expect to get consistent returns on a monthly basis of 10-12%. You will also structure the term sheet, so that your borrower will pay for all of the costs associated with preparing the loan. You can also consider charging points on the loan or an origination fee. The majority of private money lenders charge anywhere from 0-2%, while if investors are dealing with a Hard Money Lending company, they can expect to be charged anywhere from 2-5%.
An origination fee or points are essentially 1% of the total loan amount. As an example, if you lent $100,000 and you charge 2 points on the deal, you would receive $2,000 dollars at closing. We suggest that you charge points on your first deal or couple deals with new investors until you get comfortable with each other and you can lower the amount of points you can charge.
4) Why Are Investors Looking To Borrow Money From Private Money Lenders?
The first question that comes up often when learning about private money lending is why doesn't the investor just utilize a traditional bank for the financing.
This is a good question, but in most cases, a real estate investor will turn to a private money lender and be willing to pay a much higher interest rate because:
1) Speed of closing. A real estate investor needs funds fast and utilizing a traditional bank can take months
2) Properties condition. Real estate investors are usually purchasing properties at a severe discount which are in need of a lot of repairs. Traditional banks will typically not lend on properties that are in this amount of disrepair
3) The borrower may have been turned down by the traditional banks, for a number of reasons.
When it comes to trying to obtain a traditional mortgage, especially for a real estate investor, there is a tremendous amount of underwriting that goes on and approvals are very rare. The process can be long and drawn out and you may not know an answer until it is to late. The majority of the deals that real estate investors are taking on, the sellers are looking to close in a very timely manner, so funds need to be readily available. The speed, availability and also the risk the private money lender is willing to take on is the reason they can obtain such high returns.
As a real estate investor, working with private money lenders allows them to scale their operation and improve their overall business. This essentially allows them to do more deals, make more money for their lenders and their business and improve the consistency within their business. When the deals are structured properly and the deal is a good one, it is a win-win situation for all parties involved.
5) Why Is Private Money Lending A Better Investment Vehicle Than Other Mediums
So far we have discussed several of the benefits that you will get from choosing to invest your money as a private money lender. We want to further discuss these benefits as well as the security that you will receive when your money is out.
These are the 4 main reasons that an individual would want to choose to lend their money on a real estate backed security.
1) Secured Investment - The asset you are lending on is used as collateral. You will also be added as an additional insurer on the insurance policy.
2) Above Average Returns - The returns that you will achieve will be above average compared to the conventional mediums discussed
3) Consistent Returns - The returns that you will achieve will be the same every month, there will be no volatility.
4) Liquidity - You determine the length of the loan, thus the liquidity of the asset. You can have the loan mature in as little as 6 months or choose a longer term for a buy and hold investor.
It is very difficult to find a secured investment with little risk and such high returns. These are the benefits that becoming a private money lender can offer.
As we previously discussed, every investment does have a degree of risk. Private money lending is no different, however, you can reduce and mitigate this risk by choosing a great operator and structuring your loan agreement in a way that is beneficial to you.
Since your mortgage is secured by the property the monies are being used for, there are 2 ways the deal can play out.
1) The borrower pays as agreed upon and you receive a monthly return and a principal pay off at the end of the life of the loan (or an early payoff depending on performance)
2) The borrower defaults on the loan, the Private Money Lender, will foreclose on the property and gain ownership of the property at a deeply discounted rate.
6) Can You Explain The Process From Beginning to End?
If you have never went through this process before, you may be a bit overwhelmed by what we have discussed up this point. We want to let you know that the process is not very difficult once you have a good understanding of how it works. We will review a brief activity list of all of the tasks involved in a deal.
1) Find a real estate investor/borrower is has a successful track record
2) Analyze the deal and make sure the deal makes sense and you are under your LTV criteria
3) Get an appraisal or BPO from a licensed broker/agent to verify the ARV of the property.
4) Finalize underwriting process to make sure you are comfortable with the property and operator.
5) Work with a real estate attorney to prepare all necessary documents to legalize the transaction
6) Set up payment structure with operator. (wiring, check, online payment)
7) Sign term sheet
8) Sign loan commitment documents
9) Sign promissory note
10) Receive renovation schedule from investor if holding back funds for construction draws
11) Close on deal and record mortgage
12) Receive monthly interest payments
13) Investor closes deal, receive principal payment
The process is fairly simple and once you have completed your first deal and all of the paperwork is generated, the process gets much easier.
7) How Can I Mitigate The Risks Of Being A Private Money Lender?
As we previously stated, when it comes to any investment medium, you will be exposed to some sort of risk. In our opinion, naturally, this vehicle has a limited amount of risk compared to other traditional mediums, you may be used to.
1) Successful Operator - The best way to mitigate your risk and ensure that you will get your returns and money back efficiently is to work with a successful operator who has a good track record.
2) Due Diligence - Before you agree to lend money to an investor and on a property, you have to do your due diligence on that person and on the property. You want to ensure that the operator does have a successful track record. We recommend that you ask for the last 5 properties that he has invested in to get a visual of performance. You also want to be comfortable with the investor and ensure that he is an honesty/trustworthy individual.
3) Loan to Value - As the lender, you have to have a good understanding of what the property is worth and what percentage of the value of the property you are lending on to decrease your exposure if indeed you do need to foreclose on the property. As previously discussed, you can either get an appraisal or a BPO from a licensed agent/broker to determine value. Most investors want to be under the 65-70% LTV when lending on deals. This means that your total loan amount must be under 65-70% of the after repair value on the property.
4) BPO/Appraisal - As we just discussed it is very important to know the true value of the property once it is completely fixed up. You need to build a relationship with a competent real estate agent to have them produce this value for you.
5) Construction Documents - You will want to have a good idea as to what the operators plan is going into the project. The operator or investor should be able to provide you with some documents to give you comfort that he has a plan going into the project.
Scope of Work
6) Operators Income - Just as a bank would do, you should take a look at the operators current financial statement. You want to ensure that the operator has the ability to consistently make the loan payments throughout the life of the loan. You can do this by requesting bank statements, you want to ensure that he has atleast 2-3x the total amount of interest owed to you throughout the life of the loan.
7) Additional Insurer - Before you close on the property and lend the money to the borrower, you want to make sure that you are added as an additional insurer on the policy. In the case of a vandalism or fire to the property, you want to make sure that your money is protected as well.
8) Loan Servicing Plan - You have to make sure that you have a plan in place to make sure that you get your monthly interest paid to you every month. You should develop a simple system for the borrower to get you your interest payment every month. The simplest way is through online payment but you can also have him wire the money or send a check to your residence.
8) How Much Money Do I Need To Lend?
The amount that you need to lend on a deal is going to depend on the market that you are currently looking to lend. Ideally, you will want to have enough funds to lend on a deal where you are the only lender on the deal. Markets all across the country, vary when it comes to median sales prices.
For instance, if you are located in the Madison Wisconsin market, you can expect to lend around $100,000 - $200,000 per deal, however if you are in the Syracuse NY market, you will be able to get into a deal for as little as $15,000 and up to $150,000. So how much you will be required to lend on a deal will solely depend on the market that you are investing in and if you are lending on the repairs of the property, not just the purchase.
Wrapping Up | Private Money Lending
We hope that after you read this blog post that you have a pretty good understanding of the details behind private money lending. Private money lending offers several unique opportunities to the investor looking to earn above average returns. At this point you should have a clear idea of all of the benefits that this investment strategy has to offer. If you ever have any additional questions in regards to the concept of private money lending, you can always reach out to us and we would love to answer any questions that you may have.