Should You Create a New Profit Center in Real Estate by Becoming a Lender?
As the CEO of a private mortgage investment fund, sometimes I get asked how I got started in the “lending” business—or even which bank or which servicer I started off working for.
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My answer: I’ve never worked a day as a banker. That can surprise people, especially if they’re coming from the world of institutional lending.
Thinking Like a Banker
The path that led me to found a mortgage note investing company was a roundabout one that entailed being a real estate agent, a rehabber/landlord, a private lender to other rehabbers, and finally to note investing, but it definitely taught me a lot about borrowing and lending with real estate.
Why learn to think like a lender?
Because eventually you’ll want to scale and scaling takes capital, and one day, you’ll run out of your own money. That’s when lenders become very important players on your team.
Plus, I’ll lay odds that once you “get” how real estate works for the lender, the “a-ha!” light will turn on, and it won’t be long before you switch seats at the closing table.
Here’s how that evolution in roles played out for me.
From Bank Borrower to Private Money Borrower to Private Lender
Back when I first started out in real estate investing, I didn’t know that borrowing or lending private money for rehab projects was even an option. Like many investors, I was focused on finding my next deal and trying to convince the bank to help me pay for it.
In my early days as an agent working with investor-buyers, though, I learned fast that if my investor clients didn't work out the financing side of the transactions I was brokering for them, I didn't get paid my commission. Nothing happens until the money changes hands, and "the bank" seemed in control of that part of things.
When I started networking with other real estate investors and attending local real estate club meetings, I learned about “being the bank” and other alternative investments—and ways to create multiple streams of income (see the article, “How to Create Multiple Streams of Income in Real Estate”).
Lending Opens Up a Whole New Profit Stream in Real Estate
My first encounter with non-bank lenders came when I was looking for capital as I grew my rental property portfolio. At real estate club meetings, I met several “professional” hard money lenders who did lending as a business, and I saw how much yield they were bringing in while taking on very little risk. But it just seemed so expensive to me (as a borrower).
The next thing I discovered was that hard money rates were typically higher than with private money, which tends to come from people who don’t lend as their primary business but do it more “on the side.” Borrowing private money was more appealing to me as a borrower, but I could see that the lender was also doing very well on his side of the transaction.
Related: 7 Truths About Private Money That Will Help You Raise Capital
And soon enough, after working with private lenders on my projects, I started tapping into the equity from my rental properties and doing some lending myself. Now, I run a fund that manages mortgage loans as investments (although to this day I still buy, borrow, broker, and lend on real estate).
So, that’s how I “became the bank.”
Whether you aspire to be a lender or you want to understand their side of things better, here’s a quick summary of how to think “like a bank” when dealing with real estate.
Think Like a Bank: Pros and Cons of Private Lending
1. Less Risk
As the lender, you can structure the deal in ways that protect you (i.e., short-term, points, etc.). Another good way to limit your exposure or risk is to release the capital on a draw schedule, meaning that you lend portions of the total amount as work is being completed.
2. More Passive
Lending private money is obviously more passive than being on the other side of the transaction, as the borrower. After all, you’re not the one rehabbing the property. However, it’s still wise to be involved. You’ll want to know things like the after repair value (ARV) of the property and the track record of the borrower before agreeing to fund the deal.
If you’re releasing the capital on a draw schedule, maybe you even want to go down to the work site and confirm that the agreed upon work is completed.
3. Short Term
The term of a private money loan could be anywhere from a few months to a few years. It's ultimately up to you, as the lender. Many lenders opt for a short-term loan, though, as this keeps their capital more liquid, allowing them to pursue other investments in a shorter period of time.
For example, if an investor lends on a deal at 15 percent for a six-month term and that deal is completed on time with the expected outcome, the lender could then “rinse and repeat” within that same tax year. He/she could redeploy the capital in a similar deal for another six months.
Another advantage of lending private money is that, in the event of default or breach of contract, you can take over ownership of the property pretty easily. Also, if the borrower is an entity, such as an LLC, the loan isn't subject to the lengthy foreclosure timelines that residential mortgages are by having the deed held in escrow. If the borrower were to default, you can just record the deed, and then you have control of the property.
That said, when you’re lending private money to rehabbers, there are also a few things to look out for.
1. Qualifying the Borrower
What’s the borrower’s track record look like? Who are their mentors? Do they have integrity? These are all very important questions. You have to make sure the borrower is going to honor his/her side of the bargain.
Personally, I’ve only lent private money to borrowers whom I knew, and I was always familiar with their work, whether that was through referrals or from working with them before.
Still, I’ve run into issues. For example, I once lent money to a rehabber who notified me that he was ready to receive the next draw of capital, but when I went to check out the property, the work he outlined in the contract was not completed.
Also, beware of investors who are working on multiple rehab projects at once. You want to make sure your money is really going toward this project and isn’t being used to buy supplies or pay vendors for another. This goes back to having a system of “trust but verify” when it comes to releasing money on a draw schedule.
2. Qualifying the Property
Prior to funding a deal, private money lenders typically want to know what the property is worth, how much work it really needs, how long that work will take, and how much it will sell for. You could even charge the borrower for the cost of an appraisal—this is a fairly common practice by hard money lenders.
Personally, when I walked through a property, I had a pretty good idea of what work needed doing and how much it would cost. But that knowledge comes from years of rehabbing properties as a contractor prior to getting into real estate investing.
If you’re not sure how to qualify the property, a possible work-around would be to hire a home inspector. This way, a third party professional can give you and the seller an unbiased opinion.
3. Unexpected Project Delays
Another potential con or threat to your deal would be if the project takes longer than anticipated or if it takes a while to sell.
This could tie up your money for a longer period of time. Or if home values decline in your area while the deal is being rehabbed, it might even impact the borrower’s ability to pay you back. This, however, is a much less likely scenario.
Personally, I think the pros far outweigh the cons, and I consider private money loans a valuable part of my investment portfolio. That said, lending private money isn’t for everyone.
Have you ever considered lending private money to fellow rehabbers? Given the pros and cons listed above, would you consider it in the future?
Let me know if you have any questions in the comment section below!