I have an investing mentor who is based out of Cincinnati. She works with a lot of private lenders(people who make short term loans to rehabbers in real estate). It can be a great way to get a nice return on your investment, but it can also be a bad investment. Like anything, if it sounds to good to be true, then it prolly is… I work with private lenders, and have a pretty good reputation with them, but there are those people out there who are not good honest people. If you are considering private lending, then you should read the report below. If you want to speak with me about investing in Indianapolis Real Estate, then give me a call, and I can help explain the process and work with you, if you deem me and my deals worthy!
New Rules for Private Lending
As soon as a great new strategy is developed, it’s a pretty sure thing that some idiot is going to come along and ruin it for the rest of us.
Take for instance, private lending, the serious investor’s favorite way of financing rehab acquisitions over the short term. With the right lender, borrower, and deal, it’s a win-win for the investor who needs cash to close and renovate a property and the lender who wants a relatively high return (8%-10% to very experienced investors, depending on LTV and whether the loan is in first position or not). The investor gets money for repairs—almost impossible to come by in the conventional market today—and the lender gets high security and a passive income.
Unfortunately, I am increasingly hearing about private lenders who are losing part or all of their investments through borrower mistakes and outright fraud, and that means fewer opportunities for the rest of us—and, eventually, increased government regulations on these deals.
I have been teaching both lenders and borrowers how to protect themselves in these transactions for years, and I am of a mind to stop doing so, because it’s too easy for inexperienced (or financially unstable, or plain old crooked) investors to talk inexperienced lenders into deals that aren’t favorable for the lender.
Because ethical behavior always begins at home, it’s time to adopt new rules for dealing with private lenders (or with borrowers, if we are the lenders) in all of our businesses, and to understand where the pitfalls of this otherwise-awesome strategy lie.
First, it’s important to understand that only about 50% of the “safety” of a private loan lies in the property itself. We focus on the loan to value of the property as the primary “protection” that a lender has. The other half lies in the borrower’s ability and intent to repay the loan.
Unfortunately, I’ve seen a number of cases recently where lenders have found themselves in the unenviable position of either foreclosing on a property that they never intended to own, or, in the case of some lenders in 2nd position, actually losing money on a deal that was pitched as “secure”.
Here’s an example of how this can happen. Let’s say an investor/borrower purchases a property that really is worth $200,000 after repairs. If the repairs should cost, say, $40,000, and the borrower has it under contract for $100,000, a loan of $100,000 is, on the surface of it, very secure. In other words, if the borrower doesn’t make so much as the first payment, the lender can repossess the property and be reasonable sure of selling (or auctioning, in the case of an actual foreclosure) the property to recover his investment.
However, there are several things that can go wrong with this scenario. First, in some states, lenders are not permitted to recover the costs of foreclosure at the sale. They can get the principal, any unpaid interest, and sometimes reasonable penalties, but the cost of hiring the attorney or paying the trustee to file the paperwork and attend the auction is a cost that the lender eats.
Second, it IS possible for an inexperienced investor to DECREASE the value of the property through bad repairs or stupid decisions. If the lender repossesses—through foreclosure or “deed in lieu of foreclosure”—the property after it’s been gutted back to the studs, he may be taking back a property that now needs $50,000 in work rather than $40,000—and is thus worth $90,000 in a quick sale rather than $100,000.
And never mind the poor second mortgagee, who may well have loaned $40,000 to the same borrower for repairs, only to find that the property is worth less than the balance on the FIRST mortgage, much less the first and second, when the payments stop coming in.
Private lenders who are lending to relatively new investors need three things to make up for the lack of experience on the part of the borrower: first, a higher interest rate to cover the risk (why do you think hard money lenders GET 14-16% interest? It’s because there’s a high risk in lending money to every Tom, Dick, and Harriet who has a deal!). Second, a lender lending to such an investor needs some experience of his own to compensate for the borrower’s lack thereof; going over this borrower’s rehab plan to make sure both the repairs and the costs make sense is one way to avoid the “Oh my God, why did he gut perfectly good plaster walls?” syndrome later. And third, this lender needs to be willing and able to monitor repairs, and have some measure of control when and if the rehab gets out of hand.
Private lenders who don’t have these things would, in my opinion, be best served by lending money at the bottom end of the interest rate spectrum to very seasoned, very experienced investors with good reputations and solid businesses. An experienced investor whose property is destroyed by an uninsurable meteor strike will still be able to make his lender whole by taking the profit out of the next deal, or flipping some houses, or drawing from a business line of credit, or whatever. An inexperienced investor, faced with a loss of any sort, is much more likely to throw his hands up and let the lender deal with the mess.
Second, we need to stop tempting our borrowers (and ourselves) with large sums of cash. I refer here to lenders who loan money for purchase and repairs, whether it be as part of an all-inclusive first mortgage or a repair second. The temptation to dip into such a fund for personal expenses, other deals, emergencies and so on is huge even for the most ethical, well-intentioned borrower—and, unfortunately, not all borrowers are ethical or well-intentioned.
A few years back, there was a case here in Cincinnati wherein a local investor—we’ll call him Gary—was cutting a giant swath through the private lenders in town, offering them high interest rates (12% plus points) for “repair seconds” on properties he was acquiring.
The high rate should have been a tip-off, given that Gary claimed to have renovated over 200 houses in the past 5 years, but he managed to borrow something in the range of $1 million from dozens of small lenders, $10,000-$40,000 at a time. Eighteen months later, I started getting calls from some of those lenders asking what to do about the fact that Gary was months behind in his payments. As the story unfolded, it turned out the he was behind to everyone—banks, first mortgagees, credit cards, even the lender on his own home. The proceeds from the repair seconds had not been used to repair the properties at all; it had been spent on repaying the last lender, whose money was spent on keeping Gary in the lifestyle to which he had become accustomed. The lenders to whom I spoke recovered NONE of their investments—the properties that secured them were not worth, unrepaired, the balance on the first mortgages, much less the seconds. Gary evaporated into the night, leaving a bunch of burned, broke lenders in his wake who will probably never be rehabilitated.
Now, don’t get me wrong—I think that repair seconds can be a safe and profitable investment for the lender. But handing any borrower a wad of cash and hoping it will be used for the intended purposes is just foolish. The correct way to handle cash outside of that needed to purchase a property is the way banks do—to put it into an escrow account to be released to PAY for repairs as they’re completed.
This, clearly, creates a layer of complexity that many private lenders and borrowers are not used to. First, a checking account must be set up especially for the money, and the signatures of both the borrower AND the lender (or his representative) should be required for withdrawals (thus keeping either party from draining the account).
Second, a reasonable system has to be set up to release the funds in a timely fashion. I’ve seen this done as a schedule (the borrower gets an initial “get started” draw of $5,000, then gets 25% of what’s left when the furnace and roof are installed, another 25% when the kitchen is done, another 25% when the bath and carpet are completed etc). I’ve also been involved in a deal where the out of town lender appointed an experienced local to check the property (and the invoices) prior to each draw.
Overcomplicating this system, or making it difficult for the borrower to proceed with the work in a timely fashion, helps no one—but creating a plan that works easily for everyone and, most importantly, leaves the unspent repair funds in liquid form in case the renovations are never completed, is an important safety measure for both the lender and the borrower.
One note: this, of course, applies to second mortgages that are intended for repair of properties, of course. If the second is for the purpose of pulling equity out of a fully repaired and operational property, there’s no reason to escrow the money—just to make sure that the value of the property supports and protects the value of all mortgages against it.
Third, it’s important to trust, but verify. Even when working with an experienced investor/borrower, it’s important not to get complacent about the basics of safe private lending. Even when lending to (or borrowing from) someone with whom one has worked before, it’s crucial that all the paperwork be in place, all the numbers be right, and all the safety measures be solid.
The bare essentials for protection of the lender include: a title search showing that the lender will be in the expected position as a lienholder; a lender’s policy of title insurance, generally paid for by the borrower; a proper hazard insurance policy showing the lender or lenders as loss payees; a recorded mortgage that correctly outlines the terms of the mortgage; and, if the lender is not experienced enough to determine value, a professional appraisal.
In my opinion, several other things should be added to this list for the protection of the lender, including: a personal signature by the borrower(s) on the mortgage note (as well as his signature as owner of his entity); and an escrow agreement or modified land trust that allows the lender to take possession of the property without foreclosure in case of the borrower’s non-payment. In addition, when working with a new borrower, I think it’s a good idea for the lender to do a records search to make sure he hasn’t ripped off others in the past.
It is so important to make sure that all of the I’s are dotted and the T’s are crossed with risking your money (or someone else’s). Things change in people’s lives, and the most important thing I can say to you is, make sure that everyone in the deal is fully protected from loss.
And one last piece of advice for private lenders: if there are facts that you can’t verify, or something seems “wrong”, or “too good to be true”, or if there are parts of the deal or his business that your borrower wants to keep you away from, trust your gut. When an “experienced” investor suddenly wants to borrow your money at 12% interest when 8% is the going rate, and wants you money in cash for “repairs”, and seems to be borrowing an awful lot of cash from an awful lot of people, don’t let the fact that it’s not standard operating procedure to pull a copy of her credit report keep you from doing so anyway. Don’t let the fact that he’s a trustee with your association and seems incredible confident stop you from doing ALL of your due diligence. Don’t hand over the cash until you know you’re as protected as you can be.
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