Real Estate Mailbox Money - Part 2

As I've said many times before: Real estate investing can be a great way to diversify your investment portfolio and earn passive-ish income.  That's passive-ish, not truly passive income.  Direct ownership of real estate still requires your attention and management.  But what about the investor who is a busy professional, who wants to have exposure to real estate but just doesn't have the time to find deals, rehab them and manage them?

This series we put together, called "Real Estate Mail Box Money", aims to provide different options for the busy person to make their money WORK FOR THEM in real estate.  The first installment that we posted a few weeks ago covers Triple Net Lease investing.  This week, we will cover the topic of real estate private lending; the pros and cons and what to look out for when making private mortgage loans.

What is real estate private lending?

Real estate investors of all types and sizes utilize private loans or mortgages from everyday people to fund their deals and grow their businesses.  Ever head, "you can buy real estate with none of your own money?"  They are usually referring to the fact that it is possible to borrow money from private individuals to fund buy and hold rentals or fix and flips for investment purposes.

Most people are under the impression that only banks make mortgages.  But did you know that YOU could in fact be the bank?  Active real estate investors like us borrow money from private individuals all the time and pay their lenders anywhere between 7% annual interest, all the way up to 16% in some cases!  We also make private real estate loans too!  There are a multitude of different reasons why investors decide to participate:

1. Higher interest than the bank.  The annual interest is often times far greater than what you would receive on standard certificates of deposit or short term bonds.  As of April 25th 2022, the average two year CD (certificate of deposit) is paying 1.6% interest.  What if you could earn 400% better than that?  Compounded over time, getting even slightly higher yield makes a huge difference in someone's wealth building strategy.
2. The investment is backed by a tangible asset.  CDs and Money Market Accounts are typically FDIC insured and are considered a risk free investment.  If you want greater yield than these types of products, you will usually have to go outside the government insured space and into Corporate or municipal bonds.  Even though bond investors are higher on the capital stack in order of security than stock holders, they are still pretty low.  Even though bond holders are higher up on the food chain than stock holders, the bond investors are typically some of the last in line to get paid if a company goes bankrupt.  There is usually senior debt and other obligations that would get paid out first before the bond investors get paid.  And when and IF they get paid is usually paid out pennies on the dollar from their original investment.  Private mortgage holders have an interest secured in the property they lend on as collateral.  So other than the local taxing authority and other super lien holders, they are first to get paid if a borrower defaults.  If the borrower bought the property right, there is usually substantial equity in the property that cushions and protects this security interest as well.
3. The collateral is owned by someone you know.  When we take on private lenders, we often hear this, "we are investing in you, not the property!"  They say this because our lenders know us.  They have probably lent money to us in the past and have gotten paid back several times.  We have a track record with them.  You could buy bonds from Apple, but do you actually KNOW the CEO Tim Cook?  When you lend money to a real estate investor, you actually have a a relationship with the CEO; the person who is responsible for taking care of your collateral and getting you paid back.  And to that end, if the borrower defaults, you not only have first right to taking back the property and recouping your money, but if the foreclosure sale doesn't allow you to recoup 100% of your money and any unpaid interest, you can have the personal guaranty of the borrower to go after... assuming they have assets to go after.
4. The terms are fully customizable to your goals.  Because a mortgage or private loan is a contract between two individuals, the terms are negotiable to whatever you and the borrower can agree to.  Have a need for your money back in order to make a large purchase or investment of some type in the near term?  You can make the loan term for as short as you like.  There are some lenders we know that only do six month terms on the loans they offer.  There are some lenders who prefer to have their loans "out on the street" longer, so they build in pre payment penalties if the loan is paid back in less than 3 years, lets say.  This incentivizes the borrower to use the money longer, therefore resulting in less time that the private lenders money sits on the side lines earning zero interest.

Things to know
The Difference between a mortgage and a promissory note.  When you lend your money to a real estate investor, you can secure the loan a couple of different ways.  The most tried and true way to secure the loan is through a first position mortgage.  This means that the mortgage is the most senior lien on the property.  The way first position is verified is through the title search process done by the attorneys before the loan closes and proceeds are distributed.  If there are any clouds on the title that would challenge the lenders lien position, they would need to be resolved before closing.  That being said, ALWAYS make sure attorneys are involved if your objective is to be top of the heap as a lien holder!  If your borrower insists on saving costs by not getting an attorney involved, run the other way!
Besides a mortgage, the other way to secure your loan is via a promissory note that is secured by membership interest in the LLC that owns the property.  The membership interest in the LLC that owns the property becomes the collateral in this case.  If the borrower defaults, the lender can serve notice of default and sweep the membership interest to themselves and essentially take over possession of the property.  This may be a tactic used when a borrower is borrowing the money for a down payment on an investment property when they are using bank financing where the bank's loan is in first position.  The risk under this scenario is that the buyer can cloud the title with another mortgage for instance and render the promissory note less secure.  For example, let's say I take out a promissory note to purchase a $100k investment property.  Since the loan isn't secured to the title, I could go to my bank and put a mortgage on the property without the promissory note lender even knowing about it and thus making that lenders collateral position virtually disappear!
How To Find GOOD Real Estate Investors To Lend To
So if you want to get into the money lending game, where do you start in finding high quality investors who have high quality real estate opportunities?  The first place I would recommend going is to your network!  Do you know any active real estate investors?  Reach out to them!  If they aren't actively looking for funding right now, perhaps they know someone who is.  Investors don't operate in silos, investors know investors.  I, myself am good friends with dozens of other investors.  If this approach doesn't get you anywhere, consider reaching out to a local real estate attorney you know.  A real estate attorney probably has relationships with several investors, and they would probably not have a vested interest in introducing you to an investor who has gotten into money trouble before.  Do you know any realtors?  Everyone knows at least 5 realtors.  There's bound to be one who has a relationship with a rock star investor who needs occasional funding!  When you've found an investor, there are several ways to vet them to make sure they are a good risk.  First there is vetting the individual investor and then vetting the collateral.
How to vet the investor
First, what's their reputation and values?  Do they have a reputation of always doing the right thing?  Do they operate by the golden rule?  "Do unto others?" or do they operate by something else "Do it to them before they do it to you?"  Second, how strong are they financially?  Before I lend to an investor, I look at their balance sheet.  How much cash or cash equivalents do they have?  Do they have a cash position that will allow them to weather the storm if things get tough?  What do their liabilities look like?  Do they have a lot of personal debt and a lot of short term debt, that could come due at any point in time?  How many other short term mortgages (like the one you are considering giving them) are coming due soon?  How much real estate do they own?  If they own and control a lot of assets, they generally have a lot to lose if they default on their loans.  Generally, I operate by the banks principal philosophy.  Only lend money to people that don't really need money.  Ever notice that when you don't need money, the banks are pounding on your door?  And the moment you actually NEED money, they are no where to be found?  This is because banks are risk adverse and only want to make good bets on borrowers.
How to vet the collateral
Just because an investor passes the first test doesn't mean every deal is going to be the right one for you to lend on.  First, I evaluate the location of the asset.  Is it in a good location?  An area where people actually want to live or work?  Is it in an active high velocity market?  High velocity means that there are a lot of transactions that take place frequently in that market and in that asset class.  A low velocity market would be one that is typically very rural or economically depressed.  A way to evaluate this test would be finding out what that average days on market are for properties in that area.  Do properties generally sell in days when they hit the market or do they take months?  A low velocity asset type can be one that is generally outside the realm of what's considered normal.  As an extreme example, if the investor wants you to fund a purchase of an amusement park, that could be problematic.  How many people are looking to buy amusement parks?  Any niche asset type should be avoided unless the borrower has a rock solid plan to exit or add value in a way that would allow them to execute an exit strategy.  Other niche asset types could be schools, churches, a nursing home, or any property that you would walk through and ask yourself "what the hell would I do with this thing?"
Secondly, what is the property worth in it's current state and what is the after repair value (ARV)?  Many lenders will ask their borrowers to supply comparable sales to establish this.  I wouldn't rely on this information alone.  I would do your own research.  I receive information on projected valuations from other investors offering to sell me their properties or lend on their properties quite often.  Sometimes the valuations are accurate, other times it draws data that is cherry picked by the investor to support a high valuation.  If you don't know the area or property type and valuations, you might want to get a second opinion.  Appraisers or Realtors can give you this type of information but there is a cost to it.  This cost CAN be borne by the borrower.  Although most hard money or private money lenders know enough about the general values themselves so to not need this additional opinion.  Warren Buffet is often quoted as "I only invest in what I understand."  You should follow the same mantra and if you don't know the market, either focus on lending on what collateral you understand or seek a second non-biased third party opinion.
Other things to watch out for in commercial properties more specifically is environmental issues.  For a buyer to get regular bank financing on any commercial property, their lender is going to require some sort of environmental due diligence.  So if the collateral has any type of commercial use, whatsoever, your borrower needs to provide at least a Phase One environmental assessment on whatever you are lending on.  AND from a local reputable environmental consultant.  A Phase One is basically a research report on the history of the property and all of its historic uses.  If there is any historical use or historical use of adjacent properties that could have created negative environmental impacts (think ground water contamination due to industrial or commercial uses), the environmental consultant will usually call for a Phase Two which would then take soil samplings and/or air quality samplings at the property to see if there are any existing environmental impacts that would need to be mitigated before a bank would be comfortable putting permanent financing on it.  The reason why environmental due diligence is important is because you could get stuck with a property that you or your borrower wouldn't be able to sell or refinance to pay you back.  As an added measure, make sure you share the results of any environmental due diligence and/or recommendations to a local lender to get their take on it to see if they would be comfortable offering financing on it.  Some times a report will come back squeaky clean with no environmental concerns at all.  Some times a report will come back with some type of nuanced concerns based upon the intended use.  A lot of times the report isn't simply PASS or FAIL.  This will be important information to know whether your borrower is planning on flipping and selling it or refinancing it and taking your loan out.
Ways to fund loans if you don't have a ton of cash sitting around
What if you meet an investor who needs $100k in funding but you only have $80k in cash?  There are many professional full time money lenders who don't even fund mortgages using their own cash!  They use lines of credit from their bank or investment management firm and borrow against other assets they own.
Did you know that you can borrow against stocks and mutual funds as a line of credit?  Many brokerage firms have low interest rate loans that allow you to borrow up to a certain percentage of the account value at a decently low interest rate.  I actually do this myself when I'm funding other investors.  I borrow it at 3% and lend it out at 10-16% (depending upon the risk of the deal) and make my money on the spread between the two rates.  Sound familiar?  This is what your bank does to your cash!  They borrow it from you at 0.2% interest and lend it out at much higher rates!  Another thing that some banks do is they will actually lend to you and use your private mortgages as collateral, sometimes up to 80% of the principal value of the loan!  So you can fund a mortgage of $100k and get $80k back when you fund the loan, at which you can lend out again!  As long as the spread is good and the loan is low risk, this can be a fantastic option to grow your loan portfolio!
How to price your loans
What interest rate should I charge?  If investors are paying anywhere between 7% and 16%, shouldn't I only do loans at 16%?  Your pricing should be based upon risk.  For instance, a seasoned investor with a successful track record usually is not going to be accepting of private loans at 16% interest.  If the only loans they could find were at 16%, they wouldn't borrow the money.  Generally if the opportunity is solid and the borrower is solid, the going rate is usually going to be at the lower end of the spectrum.  However if the collateral is junk, in a junk location, with a junk borrower then the borrower would expect to pay more.  But then again, would that really be an opportunity that would be safe for your money?  Warren Buffet also said, "Rule number one of investing is DON'T LOSE MONEY.  Rule number two of investing: DON'T FORGOT RULE NUMBER ONE."

I hope this helps you in your investing journey and we look forward to releasing Part 3 of Real Estate Mail Box Money in the coming weeks.  If you are interested in participating as a lender or investor in one of our upcoming opportunities, please consider subscribing to the OakGrove Capital investor mailing list!  If you're interested in learning more about how to scale your own real estate portfolio, don't forget to buy tickets to Go Big Or Go Bigger! bootcamp this coming July 30th in Rochester, NY!