Article written by: Josh Manier with NuWire Investor
If you want attractive yields utilizing a self-directed retirement account, but have little time to find alternative investments, then investing in loans backed by real estate could be a reasonable choice.
One of the simplest and most straight forward alternative investments that exists today is funding a private mortgage loan. Loans typically are made at no more than 60%-70% of the market value of the property, so risk is extremely low.
For interested investors, often the main reason for not pursuing this type of alternative investments is the experience of underwriting or assessing the risk associated with a private mortgage loan. Without firsthand knowledge of how to underwrite this type of alternative investment, most investors are left to rely on trusted professionals to guide them through the necessary steps, or learning by trial and error.
Loans made to real estate owners are typically 1 to 5 year terms, allowing the borrower an opportunity to increase the income generated from the property and then qualify for a lower cost traditional mortgage.
Some of the advantages of private mortgage loans are:
– They provide security by being backed by a hard asset such as real estate – This helps to minimize the risk if the borrower defaults on the loan
– They carry shorter terms on the investment noteswhile private real estate loans provide a higher rate of return than traditional investing, there are also some risks associated with them. They may include:
Not properly vetting the investment such as:
– Verifying the lien position – Choosing anything other than first position on the title increases the risk that you will not be able to collect should the borrower default.
– Not completing a recent title search – not knowing if the property has a clean title may have a negative impact on your return if the borrower defaults on the note.
– Not having a current appraisal report of the property. When all is said and done, the goal of the private mortgage investor should be to confirm they have more than sufficient equity within the collateral to justify the loan. This is one of the more crucial aspects of due diligence for this type of investment.
– Not requiring homeowners insurance for the property, which creates unnecessary risk in the event of destructive weather, fire, or vandalism on the property.
– Not having an experienced attorney reviewing the loan closing documents and agreements – which could leave the investor exposed to otherwise avoidable risks.
Choosing properties that have a limited resale market.
By lending against properties that have very high values relative to the rest of the market, the pool of potential buyers is often smaller. For example, if you provided a $400,000 loan on a $1 Million dollar investment property — unless the property is located in an area where a high resale price is common — you may not be able to sell the property very quickly for the appraised price.
There are many private loan opportunities that are present in today’s lending market. An ever increasing number of real estate investors and business owners need access to capital but are unable to obtain funding through conventional banks for a variety of reasons. Below are some examples properties types that can serve as collateral:
– Income producing commercial properties
– Multi-family homes
– 1-4 family investment properties
– New construction
– Renovation projects
One of the most prudent things you can do to reduce risks related to private mortgage investing is to choose an expert service provider that can assist you in evaluating these opportunities — preferably one with an established network of resources to assist you.
Because this investment vehicle is new to many investors, I’m often asked about what potential returns are. The following is an example of what a private mortage investment might look like:
– Loan at 8% Interest Rate
– Based on a commercial building with $128,000 annual revenue
– Loan Amount: $350,000
– Loan Term: 24 months
– Appraised Value of Property: $800,000
– Loan-to-Value: 44%
– Security: 1st lien position on property with total assignment of rents
Financial results of the investment:
– Annual Interest Earned: $28,000
– Total Interest Earned: $56,000
– Total Return: 16% over a 2 year period
So as you explore this emerging alternative asset class of private mortgage loans, keep in mind these three things: (i) make sure to obtain and verify all the facts on the property or asset you are lending against, and/or information regarding the company managing these investments on your behalf (ii) understand your exit strategy, and (iii) confirm the loan-to-collateral value falls within what you deem as a reasonable risk threshold. Lastly, once completed, enjoy collecting passive income though this unique alternative investment.