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:
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!
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