This post was culled from LinkedIn but originally appeared on privatemoneylendingguide.
Private investors seeking alternatives to the stock and bond markets can find more opportunities in private lending (aka hard money lending). If you understand the basics and perform the adequate due diligence for each deal, you can earn solid returns while minimizing your risk as a private lender.
The returns can be sweeter in private money loans (compared to pushing a button to buy or sell a stock) because it requires a little more knowledge, a little more effort, and a bit more patience. And if you are willing focus and put in the time to learn how it works, you can hit home runs every time you bat. So let’s do exactly that – learn the game of lending.
PRIVATE LENDING - A QUICK EXAMPLE OF WHAT'S INVOLVED?
At its heart, investing in hard money loans is a lot like investing in a bond, which returns a fixed yield and pays off at maturity.
Example: If you make a loan to a borrower for $100,000 at 8.00% interest, and require interest-only payments, you will earn an income of $8,000 every year. And if the borrower does not default, the loan will pay off at, or before the maturity date, and the original invested principal will be returned.
Tip: If you make a loan to a real estate investor who is in the business of flipping property, you should offer to lend the total project cost (acquisition of property plus renovation cost) only if the investor comes to the table with 20% down. This way, the investor has “skin in the game” and also provides you with the appropriate due diligence -proving why the flip project has the highest chances to succeed.
When researching how to lend capital to others for a yearly return, you’ll discover a few important factors that make the private loan investment considerably more involved than a bond investment. If you can master these, then you can win.
Liquidity. If you think you’ll need the money that you expect to invest before the maturity date of the loan, absolutely do not consider becoming a private lender. Even though most loans payoff, there is a chance that it may not pay off as expected.
In the event that you do need your invested capital returned prior to the maturity date, you can try to sell your loan using an online loan exchange such as LoanMLS, or offer it to another private investor for sale through a hard money loan broker. However, keep this in mind: performing and non-performing private money loans are typically sold at a discount, so be prepared to take a haircut on the amount of capital returned to you.
Collateral Valuation. This is where you mitigate risk! The underlying collateral for a hard money loan is very important to your overall security and participation in the transaction. Carefully evaluate the value of the collateral and use several sources to make your valuation.
A common mantra 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. Take the appraisal, get in your vehicle, and drive to the subject property as well as each comparable to make the determination of value for yourself. You’ll may be surprised at what you find.
Also, use multiple sources to confirm valuation. In addition to an appraisal and driving the neighborhood and comparables, consider using an Automated Valuation Model or a Broker Price Opinion.
Advances. Some loan investments require that lenders 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 renovate and re-model a property if a foreclosure occurs.
The lesson here is do not invest in hard money loans without leaving yourself a cash cushion. Take a conservative approach and leave plenty of liquidity in your personal finances to handle unexpected circumstances. A good tip here is to always keep Murphy’s law in the front of your mind: "Anything that can go wrong, will go wrong."
Title. Make sure you obtain title insurance which insures your lien position as a lender and offers fraud protection against forgery.
Unlike homeowners insurance, where if you suffer a loss with your homeowner’s policy you submit the claim and get a quick reimbursement, Title insurance is an indemnity policy. Therefore, you are reimbursed only for a proven loss and not the potential for a loss.
Borrower Credit. Carefully reviewing the borrower’s capacity to make monthly payments is a very important key to a successful loan investment. Private money loans are often made based on the asset, or collateral, but the best loans also give equal weight to the borrower’s past credit track record and capacity to repay the loan when a balloon payment is due, or when the loan matures.
Private Lender Insurance. Make sure the property owner has the appropriate fire and liability insurance in the amounts you desire as a private lender. The insurance company must also be notified to include you as an additional insured on the policy. In the event of loss, you want the check sent to you first!
Documentation. Documenting the loan, by creating the appropriate security documents and disclosures to the borrower, is complicated and time consuming. There are a many 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. Ensure that you engage the appropriate counsel to guide you through the process!
SERVICING YOUR LOAN
Once a loan is originated, payments need to be collected from the borrower, along with various tax, regulatory and informational statements sent regularly to the borrower.
There are many loan servicing options to choose from and a quick Google search will help you identify a few options.
What Happens If A Borrower Doesn't Pay?
If a borrower does not pay, investors must be prepared to go through a foreclose process to claim the collateral. This will be an involved process which requires a significant amount of expertise and expense. Again, ensure that you engage the appropriate counsel to guide you through the process!
Befriend Another Lender
Private lending can provide returns substantially greater than those generally found anywhere else (i.e. stocks, bonds, mutual funds, etc). And now that you have discovered the business of private money lending, take your time to fully understand the nuances, ins and outs of the business, and most importantly, your investing personality. Only then take the next step of identifying and capitalizing on opportunities.
A great way to get started and to learn more is to seek the help of professionals who are already in the business of providing loans to investors. In the past, these individuals were referred to as hard money lenders, loan brokers, or also mortgage loan originators. The term “private money lender” describes a highly skilled business person originating private money loans.
If you’re just starting out, the services of a private money lender are invaluable and they will help walk you through the transaction. Most investors who are not real estate professionals maintain life-long relationships with their private money lenders just as business executives would maintain a relationship with their financial advisors. When you work with private money lenders, you should be aware of the various methods you can invest in loans and the pros and cons associated with each method.
New Loans. The new loan can be for either the purchase or construction of a new property or for the renovation/rehab or refinance of existing debt on a property.
Pro: In this scenario you are lending specifically to one party and have control over origination, documentation requirements, terms, servicing, etc. You will not have potential liability for a previous originator or servicer’s mistakes. If this is a new loan made to a previous client you have the previous performance history readily available.
Con: If this is a new client, there will be little to no prior payment history on which to base a lending decision. You will have to rely upon other credit performance or on the accuracy of conversations or reports from previous lenders.
Buy Notes. Private money lenders can also purchase loans that have already been originated. When you buy loans from private money lenders (either performing or non-performing), they can be purchased at face value, at a discount, or if it’s a great loan (high yield, low LTV, great borrower), at a premium.
Pro: There is a performance history that can be analyzed and evaluated. For non-performing loans, a combination of solid valuations for collateral and deep discounts at purchase can provide excellent yields for an investor who is willing to go through the foreclosure process. Some notes, while currently non-performing, may either payoff to avoid foreclosure or be “rehabbed” and restructured to become a performing note in the future.
Con: You can potentially buy an existing liability if the note was not originated or serviced properly. Non-performing loans may force you to foreclose to recoup your investment that this can be a lengthy and costly process. In addition, your due diligence process will always be at the mercy of the records available from the current lender.
Pools of Loans. The process of buying a group of loans in one transaction.
Pro: You will get a much better discount for buying loans in bulk. And for performing loans, there are established performance histories to evaluate.
Con: Files may not be readily available to conduct due diligence. Buyers are often rushed to make a bid when evaluating numerous loans across different cities and states. This only means one thing: it’s easier and more likely for mistakes to be made in the analysis. For the privilege of buying in bulk, you’ll get some good loans at a good price, but you’ll also likely get some duds.
Syndicated Capital. There are companies that offer opportunities to pool together funds from many investors and create a single entity to loan money.
Pro: You don’t have to make individual loan decisions as these are handled by a pool manager and your investment is diversified across a wide variety of loans.
Con: You can’t foreclose and liquidate just one loan and may be subject to the entire pool closing before you can get your funds liquid.
It’s also important to know that your success is directly tied to the success of the pool. If the pool manager makes poor decisions, it will jeopardize the stability and return of the entire fund.
It can be difficult to sell your position once you invest. The pool manager will only be able to accommodate your request if another party is interested in investing.
Fractionalized Loans. Similar to a pool, but in the case of a factionalized loan, private investor funds are gathered and vested on the security instrument. For example, if a borrower required a $1 million loan for a shopping center, the note may be fractionalized across 10 different investors, each investing $100,000. All 10 investors would be vested on the recorded security document.
Investing in a factionalized note is different from investing in a mortgage pool. In the factionalized note, all investors have an interest in a singular note. When the note liquidates, the investment liquidates. In a pool, members have an interest in the overall pool and not a particular note.
It is common for fractionalized transactions to be structured in an entity such as a limited liability company (LLC). This way, the 10 members from the example above would be members of the LLC and the manager (typically the note originator) is responsible for decisions about the note. It is commonplace to see transactions are structured in this manner because it can avoid a conflict when decisions about advances or foreclosure have to be made. If all investors have equal interest in a note, all members must agree on every course of action and with the LLC in place, the manager can make decisions in the best interest of the group as a whole.
Pro: Investors can diversify by investing in multiple fractional transactions instead of all funds in one bucket.
Con: Everyone in the fractionalized group must agree on foreclosure and advances, unless the transaction is set up as an LLC with a specific individual named as the manager. If any one member does not agree, or cannot advance needed funds, it could create problems detrimental to the investment.
Junior (2nd Position) Liens. You can earn higher returns by buying seconds or other junior liens, but the risks and complications of servicing escalate substantially. Junior lien investments are not for the faint of heart. You may be called upon to reinstate the 1st, payoff the 1st, or, if the market drops or a bankruptcy is filed, your likelihood of being wiped out entirely is much greater than a 1st lien position.
Pro: Higher rate of return and less initial cash outlay.
Con: Significantly higher risk. If a borrower defaults on the first mortgage, you may have no choice but to bring the 1st mortgage current or pay it off to protect your investment. A declining market could turn the property upside down unless you are able to “ride it out” until the market swings back. A bankruptcy filing by the borrower could also easily wipe out your investment completely as first liens will take priority over you in the proceedings.
Overall, there is no “right” way to invest in loans. The only thing you can control is a relationship with private money lenders you have researched, feel comfortable with, and trust with your investment. Remember, there is no substitute for your personal due diligence, whether it’s on the lender or on the property. Rely on proven professionals for advice, but make the private lending underwriting decisions yourself after careful due diligence.
To read the full article, visit: http://www.privatemoneylendingguide.com/investors/articles/hard-money-lending-overview