How to Invest in Private Money Real Estate Loans

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1 How to Invest in Private Money Real Estate Loans Investors seeking alternatives to the stock and bond markets will find refuge in the world of private money loan investing. If you are careful and diligent, you can earn solid returns while minimizing risk. The returns are better when investing in private money loans because it requires a little more knowledge, effort and patience, than just pushing a button to buy or sell a stock. 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 invest in private money real estate loans you will discover a few things that make the loan investment considerably more involved than a bond investment. Liquidity Do not consider buying private money loans if you need the money before the maturity date. Even though most loans payoff, many do not pay off as expected. Loans can be sold, using an online loan exchange such as LoanMLS.com, or brokered to another investor via a private money lender. But even performing loans are typically sold at a discount. If you want to get out of an existing note, be prepared to take a haircut. Collateral Valuation The underlying collateral for a 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 money 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 then drive to the subject property, as well as each comparable, and make the determination for yourself on value. In addition to an appraisal and driving the comps yourself, consider using an Automated Valuation Model or a Broker Price Opinion as well. You will find that 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

2 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. In addition it is also wise to make sure borrowers can repay the loan when a balloon payment is due, or when the loan matures. 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. 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. 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

3 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 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. 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. 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 Existing Loans The purchase of a loan that has already been originated. When you buy private money loans, they can be performing or non-

4 performing and can be purchased at face value, a discount, or if it s a great loan, possibly at a premium. There is a performance history that can be analyzed and evaluated. On nonperforming 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. You could adopt an existing liability if the note was not originated or serviced properly. Nonperforming 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. A better discount will likely be given for buying in bulk. There are established performance histories to evaluate. 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. 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.

5 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 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