Private lending can yield better returns than stock and bond markets. If you understand the fundamentals and know how to conduct proper due diligence for each transaction, you can earn solid returns while minimizing your risk.

A little more knowledge and effort can give you better returns in private money loans. Electronic transactions that require pushing a button to buy or sell stock are fast. But if you focus your time and attention on learning the ins and outs of private money lending, you can win lucrative deals. Read these tips and learn the lending game.

PRIVATE LENDING 101
Investing in private money loans is similar to investing in a bond. They both have a fixed yield and pay off at maturity.

Example: If you make a loan to a borrower for $100,000 at 8 percent interest and require interest-only payments, you will earn an income of $8,000 annually. If the loan is paid, it will pay off at or before the maturity date. You will also get the original vested principal.

Tip: Look for a real estate investor who flips property. Offer to lend the total project cost that includes the acquisition of property plus renovation cost. He should make a down payment of 20 percent. The down payment will demonstrate his “vested” interest and proves the appropriate due diligence. These factors will contribute to a higher chance of success.

Research how to lend capital to others for an annual return. Discover the pivotal factors that make the private loan investment considerably more involved than a bond investment.

Study these rules so you can master the process and invest with confidence.

1. Liquidity
Do not become a private lender if you think you will need the money that you want to invest before the maturity date of the loan. Most loans pay off, but some do not.

If you do need cash before the maturity date, it may be possible to sell your loan. You can utilize an online loan exchange like Loan MLS. Consider offering it to another private investor for sale through a hard money loan broker. If you do need to sell a note that is not paying, keep in mind that non-performing private money loans are typically sold at a discount.

2. Collateral Assessment
Reduce your risk. Collateral for a hard money loan is important. “Drive the comps yourself” is the philosophy for lenders. Get in your car and drive to the house that you will be appraising. Take photos. Use an Automated Valuation Model or Broker Price Opinion to determine market value.

3. Loan Advances
Some transactions require advances because of delinquent property taxes, attorney fees or foreclosures. Lesson No. 1: Leave yourself a cash cushion. Provide for enough liquidity in your finances so you can fund for any unexpected expenses.

4. Fraud Protection
Make sure your title company insures your lien position as a lender. Get fraud protection to address possible forgery. Title insurance is indemnity insurance. To be reimbursed, you must be able to prove a loss.

5. Credit History
Analyze the borrower’s credit report carefully. Private money loans are based on hard assets and collateral. Make your assessment of a borrower’s creditworthiness on the person’s ability to repay the loan when a balloon payment occurs, or when the loan reaches maturity.

6. Fire & Liability Insurance
Make sure the property owner has the correct type and adequate amount of fire and liability insurance. The insurance company must notify you (the private lender) as an additional insured on the policy. In a case of loss, have the reimbursement check sent to you first.

7. Written Agreements
You must document the loan. Create security documents and disclosures for the borrower. There are numerous state and federal regulations that must be followed and should not be ignored. A violation could render the loan invalid.

8. Loan Servicing
Conduct a quick Google search to get the proper tax and regulatory statements. Many private lenders hire a servicing company to manage this part of the process for them.

If a borrower defaults, investors must go through the foreclosure process to claim the collateral. The complex foreclosure process varies from state to state and requires expertise and understanding of the law, so get the proper guidance. Seek advice from other seasoned professionals or attorneys who specialize in real estate law.

The role of a private money lender is a specially trained person who originates private or “hard” money loans. If you are new to the private money lending arena, it’s best to let experienced professionals help guide you through the pros and cons associated with each transaction. Here is a list of the types of private money opportunities and the positives and negatives to consider for each.

1. New Loans. The purchase or construction of a new property requires renovation or refinance of existing debt on a property.

Pro: Because you are lending to one party, you have control regarding origination, documents, terms, etc. You will not have potential liability for a previous originator’s errors. If this involves a former client, you have access to his performance history.

Con: New borrowers do not have a prior payment history that you can evaluate for a lending decision. Use reports from previous lenders.

2. Note Purchases. As a private money lender, you can purchase loans that have already been originated. When you buy performing or non-performing loans, they can be purchased at face value, at a lower rate.

Pro: There is a performance history that can be analyzed. For non-performing loans, a combination of solid valuations for collateral and deep discounts can give excellent yields if an investor is willing to risk foreclosure. Some non-performing notes may pay off to avoid foreclosure or be restructured in the future.

Con: If the note wasn’t originated properly, you could be purchasing a liability. Non-performing loans may result in foreclosure. Your due diligence is limited to records from the current lender.

3. Loan Pool. The process of buying several loans in one transaction.

Pro: Bulk loan purchases typically come with a discount. Performing loans have histories available for evaluation.

Con: Files may not be accessible. Buyers are often rushed to make a bid, resulting in potentially costly mistakes. You’ll get a mix of good and bad loans.

4. Mortgage Funds. There are companies that collect funds from multiple investors and create a single entity to loan money. A Limited Liability Company (LLC) is the structure for most mortgage funds. The investors would hold a membership interest in the LLC. The fund manager makes decisions regarding the note. This arrangement typically avoids conflict with respect to the disposition of loans by the fund.

Pro: Pool managers handle the transaction, and your investment is diversified across a wide variety of loans.

Con: Since you are an owner of the LLC, foreclosure is not an option to recover your investment. You may be subject to the entire pool closing before you can get your funds returned to liquidity.

Your success is dependent on the success of the pool. If the pool manager makes poor decisions, the entire fund is affected.

It can be difficult to sell your position, as there are often restrictions regarding to whom you can transfer your interest.

5. Fractionalized Loans. In the case of a fractionalized loan, private investor funds are collected. Each investor is vested on the security instrument. For example, if a borrower required a $1 million loan for a shopping center, the note may be fractionalized across 10 different investors, each investing $100,000. All 10 investors would be vested as beneficiaries on the recorded security document.

Investing in a fractionalized note is different from investing in a mortgage pool. In the fractionalized note, all investors have an interest in one particular note. When the note liquidates, the investment liquidates. In a pool, members have an interest in the entire investment.

Pro: Multiple fractional transactions allow investors to diversify their investment portfolio.

Con: Everyone in the fractionalized group must agree on foreclosure and advances.

6. Junior (Second Position) Liens. Buying a second or junior lien brings higher returns. However, risks associated with the junior position and complications with servicing escalate substantially.

Pro: Less initial cash up front and a higher rate of return.

Con: Significantly higher risk. If a borrower defaults on the first mortgage, you may have no choice but to bring the first mortgage current or pay it off to protect your investment. Junior lien investments are not for the faint of heart. If the market drops or bankruptcy is filed, you could lose everything.

Nurture your relationships with other private money lenders. Practice due diligence and weigh your options carefully.

Comparably, private lending can be lucrative. It can offer greater returns than stocks, bonds and mutual funds. Strive to understand all aspects of the industry, especially your personal investing.

 


This article originally appeared in Private Lender magazine, May/June 2016.