Private Lending 101 | For Private Lenders

But, like any endeavor, the returns are better when investing in private money loans because it requires a little more knowledge, a little more effort, and a bit more patience, than just pushing a button to buy or sell a stock.  

Private Lending - 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  .  If you make a loan to a borrower for $100,000 at 8% interest, and require interest-only payments, you’ll likely earn $8,000 income each year.  And if the borrower does not default, the loan will pay off at or before maturity and the original principal will be returned.   

When researching how to be a private lender, you will discover a few things that make the private loan investment considerably more involved than a bond investment.

Liquidity – Do not consider becoming a private lender if you need the money before the maturity date.  Even though most loans payoff, many do not  pay off as expected.   You can sometimes sell loans using an online loan exchange such as LoanMLS, or brokered to another private investor via a hard money loan broker.  But even performing private money loans are typically sold at a discount.  If you want to sell notes, even if it is performing, be prepared to take a haircut. 

Collateral  Valuation – The underlying collateral for a hard money loan is very important to the overall security of 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 and get in your vehicle and drive to the subject property as well as each comparable and make the determination for yourself if you think the value is realistic.  Consider multiple sources of value.  In addition to an appraisal and driving the comps yourself, consider using an Automated Valuation Model or a Broker Price Opinion as well.   Some properties are easier to comp than others.

Advances – Sometimes loan investments require that investors 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 remodel a property if a foreclosure takes place.

Do not invest in hard money loans without leaving yourself a cash cushion.  Be conservative and leave yourself plenty of liquidity in your personal finances to handle unexpected circumstances.

Title – Make sure you obtain title insurance which insures your lien position as a lender and offers fraud protection against forgery.   Title insurance is not like homeowners insurance.  If you suffer a loss with your homeowner policy, you submit the claim and get a quick reimbursement.  Title insurance is an indemnity policy and as such you are reimbursed for a proven loss only and not the potential for a loss.   The result may be that even though you will eventually lose money due to a title issue, you may not receive reimbursement for months, or even years later.     

Borrower Credit – Carefully reviewing the borrower’s credit application and capacity to make monthly payments is the key to  a successful loan investment.    Private money loans are often made based on the collateral, but the best loans are those that give equal weight to the borrower’s past credit track record and capacity to make payments and repay the loan when a balloon payment is due, or when the loan matures.

Private Lender Insurance – You will need to make sure the property owner has appropriate fire and liability insurance in the amounts you desire as an investor.   The insurance company must also be notified to include the investor as an additional insured on the policy so in the event of loss, the check is sent to you first.

Documentation – Documenting the loan, creating the appropriate security documents and disclosures to the borrower is complicated and time consuming.   There are a myriad of 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.

Private Lending Loan Servicing

Once a loan has been originated, payments need to be collected from the borrower, and various tax, regulatory and informational statements need to be sent regularly to the borrower.

Hard Money and Foreclosure

If a borrower does not pay, investors must be prepared to foreclose on their collateral.  This will be an involved process which requires a significant amount of expertise and expense.

As you can see, investing in loans is not as easy as it may seem on the surface and certainly more involved than buying a publicly traded bond.    So, how to invest in private money loans?  How do you get started?  How do you take the plunge?  The answer is: very carefully.  Learning the private money lending business takes time.  But once you understand the nuances and study the business, it can provide returns substantially greater than the bond markets.

There are professionals in the business of helping investors make loan investments.  In the past, they have been referred to as hard money lenders, loan brokers, or mortgage loan originators.  The term “private money lender (PML) ” is becoming more popular and describes a professional business person who is highly skilled at originating private money loans.

The best part about using a PML to invest in loans is that the fees are typically paid by the borrower and therefore you get the expertise without paying for it.  Well, at least not paying for it directly.   You pay for it because of the additional fees you would likely collect if you originated the loan yourself.  For example, if the borrower was willing to pay 3 points up front for a $500,000 construction loan, you may earn the entire $15,000 fee up front  as the sole investor and originator.   If you use a PML, you may still get a piece of that commission; typically 1 point.  

If you’re just starting out, the services of a PML 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 a  business executive would maintain a relationship with an investment advisor.  When you work with a private money lender, you should know about  different ways you can invest in loans and the pros and cons associated with each.  

Originate New Hard Money Loans 

The new loan can be for  the purchase or construction of a new property  by the borrower or for the rehab or refinance of existing debt on a property the borrower already owns.  

Pro
A new loan to a new client offers the possibility of a continued lending relationship with current and future profits.  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, you will have no previous payment history on which to base a lending decision and will have to rely upon other credit performance or on the accuracy of conversations or reports from previous lenders.  

Buy Notes

The purchase of a loan that has already been originated.  When you buy loans from private money lenders they can be performing or non-performing and can be purchased at face value, at a discount, or sometimes, 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.  On non-performing loans, combinations of deep discounts at note purchase and good collateral values can provide excellent yields for an investor willing to go through the foreclosure process.  Some notes, while currently non-performing, may either perform in the future or payoff to avoid foreclosure. 

Con
You could adopt an existing liability if the note was not originated or serviced properly.  Non-performing loans may force you to foreclose to recoup your investment – a potentially lengthy and costly process.  Your due diligence reviews are always 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
A better discount will likely be given for buying in bulk.  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 in many different cities or states which means 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.

Invest in a Pool   These pools gather 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.

Your investment is diversified across a wide variety of loans.

Con
You can’t foreclose and liquidate just one loan.  You may be subject to the entire pool closing before you can get your funds liquid. 

Your success is directly tied to the pool’s success.  If the pool manager makes some poor decisions, it can jeopardize the stability and return of the entire fund. 

It is 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 private investor’s 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 into 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, the members all 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 set up in an entity such as a limited liability company (LLC).   In this way, the 10 members in the above example would be members of the LLC and someone (typically the note originator) will be the manager and responsible for decisions about the note.  More and more transactions are set up this way to avoid a conflict when decisions about advances or foreclosure have to be made.  If all members have equal interest in a note, all members must agree on every course of action.   With the LLC set up, 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 vs. all funds in one proverbial basket.

Con 
Everyone in the fractionalized group has to agree on foreclosure and advances (unless the transaction is set up as an LLC).  If one member does not agree, or cannot advance needed funds, it could create problems detrimental to the investment.

Junior Liens  You can earn higher returns by originating and/or buying seconds or other more 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 first lien position.

Pro 
Higher rate of return.

Less initial cash outlay.             

Con 
Much higher risk.   If a borrower defaults on the first mortgage, you may have no choice   but to bring the 1st mortgage current or payoff it off to protect your investment.  A declining market could put you upside down in the property unless you are able to “ride it out” until the market swings back and a bankruptcy filing by the borrower could easily wipe out your investment completely as other liens will take priority over you in the proceedings. 

There is no “right” way to invest in loans.  The only right thing to do is forge a relationship with private money lenders you have researched, feel comfortable with, and trust with your investment.  There is no substitute for your personal due diligence.   Rely on professionals for advice, but make the private lending underwriting decisions yourself after careful research and analysis.