I have been considering rolling my employer-sponsored 401K into a checkbook/self directed IRA for the purpose of providing hard money loans because I am DISGUSTED by the low ROR I get now. What advice do veteran lenders have to keep me out of trouble? What kind of vetting do you do with your borrowers? Due diligence process with properties?
Thanks in advance!
First, very few employer sponsored 401k program will let you do anything with the money until you're no longer an employee. Will your's even let you do this? Or, have you left this company?
I've been doing this for a number of years. I work with a local hard money lender who actually makes the loans. In the past I've done direct loans where I (and, I really mean my IRA) made a loan directly to the borrower. These days, the broker runs a pool and a bunch of us have money in that pool and he makes loans from it.
If you're doing it on you own, start with verifying the regulations governing what you're doing. You may be able to lend this money out, but you may still be subject to regulations. Or, you may have to work through a broker. This is a heavily regulated business and you will need to comply.
My advice is to get a full blown loan package - 1003 loan application, banks statements, etc. Just like you would have to produce if applying for a long. Hire an appraiser of your choice, at the borrowers expense. If you're unfamilar with construction, hire a general contractor to evaluate the proposed scope of work.
Loan an absolute max of 70% of the ARV of the property. And ONLY in first position. Forbid any additional encumbrances (i.e., start foreclosure if the borrower further encumbers the property, which, even being in first position weakens the collateral.)
You must work with an attorney to prepare the paperwork.
Do closings at a title company. Record everything that should be recorded.
Hold rehab money in escrow until work is completed and inspected by you. The way I used to do this was to have the title company issue checks made out to the borrower for the rehab money. One check for each "draw". Those were given to me at closing. As I did inspections, I handed these over.
If the borrower has money into the deal, their money goes in up front.
Borrower must absolutely not move into property. This should be a default condition in your promissory note.
Thanks for the feedback Jon. A majority of the funds I have are in an old 401k so that clears up some confusion I had about how I would use my currently funded plan. I also have access to private money-less restrictions. I appreciate the info on working through a broker and will investigate that in more detail. Since I am a new investor, the idea of growing my money through a seasoned investor/broker sounds tempting. Can you elaborate on how this works and the benefits of investing through a broker as opposed to direct funding? How do the pool participants get paid? Thanks!
Follow up question. What are some good questions to ask HM brokers when deciding which one to invest with ? Thanks
Originally posted by @Sherri Southwell :
Follow up question. What are some good questions to ask HM brokers when deciding which one to invest with ? Thanks
That's a dangerous question to ask in public forums.....LOL
I strongly suggest you go to a mortgage broker who is active in funding loans, doing hard money lending.
If you loan your money to the broker, you should do your due diligence on that broker. Any legal problems, are they properly licensed, are the subject to examinations and are they in compliance, do they have reserves, do they have the ability to pay you as agreed, what is their experience (in decades, LOL,) ?
I suggest you not take any assignment of collateral in any pool starting off, your collateral should be the entire note, or, the note should be only in your name.
I would never do a loan to a broker on a non-recourse basis, they are making money and that is a risk they need to assume to use and profit from your money.
Don't be impressed by membership to the BBB or any lending association, they are not finance regulators, usually join for marketing purposes, not legal reasons.
Payments are usually advanced to you from payments received, often simply to an account you hold. Any disbursement from your account should be by specific consent, brokers can get out of line, out of collateral if they have a free hand tapping your funds.
Do they service loans and are they in compliance, servicing is not simply origination. Who does the servicing?
Don't just get sold on a broker's program, get all the documents and terms in writing and then see your attorney, don't be penny wise and pound foolish.
Interview who you will be working with, you will be forming a personal and business relationship just as you would with your CPA or attorney.
No that all the brokers are ticked off at me, ask others you know who lend their money, not the brokers.
Forget about references given by a broker, you could be speaking to their uncle or beer buddy, or a girl friend, never know.
Have you mastered real estate? Can you value your collateral? Can you look at a rehab project to see that estimated costs are valid (if not, you're really banking on the broker's experience)? Construction lending is the riskiest lending with mortgages.
Interest earned is a function of risk assumed, the broker takes a risk with the borrower, you take a risk on the borrower and the broker!
Lending is not a profession you learn over night or in a month or a year, so get with a professional.
And again, visit your attorney and accountant. :)
Thanks Bill! Great information and questions. The only brokers who would be mad are the shady ones and i wouldn't want to deal with them anyway! I'm fortunate to have good mentors who are seasoned rehabbers and landlords so I have some good resources at my disposal. I appreciate you taking the time to respond.
When you're lending directly to the borrower, you typically have a security interest in the property. That gives you the right to foreclose if the borrower defaults. Been there, thought he borrower choose to hand over the property deed-in-lieu, rather than forcing a foreclosure. With a pool, it is the pool that would foreclose rather than you individually. A repossession, regardless of the details, typically generates some loss. At the very least, your returns are reduced from what you would have otherwise expected. With an individual loan, that "cost" is borne entirely by you. With a pool, the loss or loss of earnings is shared among all participants in the pool. Defaults do happen. Make enough of these loans, and it will happen to you.
With individual loans, you will end up with un-invested cash. Two reasons for this. Loans are for a certain amount. Its unlikely that amount needed will be exactly equal to your available cash. So, you will have some leftovers that sit in the bank after you've loaned out as much as you can. And then, when a loan pays off, it takes some time to get another one completed and the money back to work. So while 12% returns sound good, you will only get that on part of your money. The aggregate return for your entire bankroll for an entire year will be lower.
With a pool, that's less of an issue. The pool still has this downtime. But the percentage of the pool that's uninvested is less with a bigger bankroll than a smaller one.
With direct loans, the transaction is between you and the borrower, perhaps facilitated by a broker. With a pool, you're handing cash to the pool manager. So, you have the very real risk the pool manager runs away with your cash.
@Bill Gulley says:
Interest earned is a function of risk assumed, the broker takes a risk with the borrower, you take a risk on the borrower and the broker!
I have to disagree slightly. The potential interest earned is a function of risk. Risk, for investing, relates to the range of possible returns. It does not equate to a high return. Only the potential for a high return. In exchange for that possible high return, you take the chance of a low or negative return. A bank CD is a low risk investment because the exact return is defined up front. Hard money lending is high risk because while you might have high returns, you may well have much lower returns or losses.
@Sherri Southwell I believe the state of FL requires licensure to originate loans on 1 to 4 unit properties regardless of owner occ or not.. Just like the state of Oregon. And if you reside in FL and make loans say in a state were its not required to have Licensure.. since your domiciled in FL you may still need to have an NMLS rmlo license.. this is the case in our state of Oregon... does not matter were the property is its were your offices are.
Now we can go right across the border to WA and its commercial purpose and licensure not required.
I would follow Jon's line of thinking and hook up with a great mortgage broker in your area and let them do your first loans so you get a feel for it and the paper work... After that its repetition and making sure your Collateral is sufficient and the folks your loaning to are capable. Use the three C's when lending Character of borrower,,, Collateral, Capacity of borrower... if those three check out your usually in pretty good shape.
there are plenty of rehab loans that work very well.. there are also some that do not go well because of a myriad of reasons but usually the rehab cost more or the borrower just could not execute.
Also be for warned FLA foreclosures take much longer than most states so in a default scenario your going to be in the deal for a pretty long time. In a state like FLA I would be working hard for a deed in Lui.. And to Jon's point that's why you don't want any junior liens it mess up the water if and when you want to unwind a deal.
@Jon Holdman good explanation in plain English, there is no disagreement I see, my statement refers to several risks, market risk, credit risks, repayment, collateral and so on, the interest rate charged is based on the risks assumed, including the risk of loss from any aspect.
On the hard money lender side, they mostly set rates to the market, as much as they can charge and remain competitive, while they do some underwriting they seldom go through any risk analysis, one reason the loan pool is usually too small to bother with it.
When an HML knows a borrower, has done business before, they may well cut the interest for a good customer. That comes from more of a gut call than any formal risk assessment.
HMLs generally deal in a narrow loan classification, commercial, rehab, construction, transactional funding or bridge loans for investor borrowers. The law of large numbers is to low to make some assessments, the interest rate risk is minimal if not non-existent due to the short term nature of their loans. Credit is rarely an issue as they look to a low LTV. You may or may not have an appraisal with a HML.
Sub-prime lending carries a higher interest rate due to risks assumed being greater than that with conventional borrowers, "interest is a function of risk" and legally justified.
Commercial lending or we might say non-consumer lending, carries less justifications of what might be charged since the borrowers are assumed to be in business for a profit. The same rate and loan expenses to a consumer would probably be predatory lending, charging someone who otherwise qualifies for an 8% loan when they were charged 14%.
Jon's comment to idle funds is a good one, you can't loan out all of your money, nor should you. You'll have a loss of interest by not having money active just sitting in reserves, this is an opportunity cost that should be considered with the earnings of the portfolio.
A landlord or any other borrower is not where you should be getting a lending education, they know what they did but they don't know what all a lender does.
Another issue with learning from potential borrowers, is that the borrower explains the deal to convince a private lender, they really won't get into explaining their risk exposure, that would be like talking the lender out of making the loan......ever hear a borrower tell an individual how long they may have to wait if the died, took bankruptcy or they can't finish the project because their tools got ripped off......or whatever the reason.
Investors that teach folks how to lend money to them are probably most most dangerous out there, their intentions can be very good, their knowledge is not from a lender's side and they won't be hammering all the nails in.
Learn from lenders, Jon has loaned money, HMLs and brokers that do a wide variety of lending are probably the best as their experience will be broader. If you can underwrite a loan at a combined loan to value of 90%, you'll be making more loans than staying at 70 or 65% and the difference in risk may not be all that far apart. :)
I agree with most of everything my colleagues have advised here. My only advice would be to move "talk to your Attorney and Tax Professional" to the top of the "To Do" list! Next, I would absolutely make certain that you are in 100% compliance with every aspect of the required compliance regulations in your intended state of investment, in your case, I presume this would be Florida. Please do this...even go so far as to contact the Florida Office of Financial Regulation - http://www.flofr.com/ and make certain you follow their guidance.
1. Understand the state usury laws as they still apply to retirement accounts.
2. Do secured loans and in first position.
@Jon Holdman and @Mark Nolan I'm curious why both of you guys are strongly recommending to only lend in first position. I've been lending in 2nd position to local rehabbers in my area that I trust and have a proven track record and it seems to be working out well, at least so far. I realize that lending in 2nd isn't as secure as lending in first but as long as the people you are lending to are reputable and competent is there some major drawback to it?
With any loan your FIRST consideration should be getting paid back if something goes wrong. Your statements, @Julian Buick , tell me you assume nothing will go wrong. When your assumption is correct you get your interest. Hopefully, its a nice, juicy rate. The firsts I've done are at 15% and I wouldn't touch a second at that same rate.
The problem is that if things go wrong its very, very likely your debt will become a total loss. If the first forecloses, in most states you will be wiped out completely unless YOU can make the first whole. The situations where I've see this being done are when the borrower hits up friends for $10-20K. Those friends don't have $100-200K to satisfy the first. So, a foreclosure by the first wipes them out completely.
If there is a problem, the rehab is almost certainly incomplete. That means the actual value is often significantly below ARV. Especially at the early stages where demo has been done and the new work is just starting.
A second lien on a property means deed-in-lieu is no longer an option for the first. A foreclosure is required to wipe out that second. They why we now make putting any additional encumbrances on the property a default condition. So, you just making the loan if the HML has this restriction will start the foreclosure process.
Recall I said in the first post that you want the rehabber's cash in up front. The rehabber getting the cash from someone else is just the reverse. Now, if they borrow it as a personal loan or against another property, no problem. But a second against MY security hurts me.
The loans you're making are effectively personal loans, not secured mortgages. Yes, you think you have a security interest in the property. Realistically the value of that security is very little. Remember, too, what I said earlier to @Sherri Southwell . Play this game long enough, and you WILL have a default. You MUST think about what's going to happen WHEN, not if, that happens. In first position, you have good protection to at least get back most of your money. The one default I had when doing direct loans involved about $150K plus another $20K to finish up the rehab after the deed-in-lieu. On the actual sale we took a significant loss. But we had received eight months of interest payments. So, on net, over the 15 months this deal took from start to finish, our loss netted out to about $2000. Had there been a second, its likely this would have taken an additional six months (due to foreclosure timelines in CO), our loss would have been $10-15K more (foreclosure costs) and the second would have been a complete loss.
@Jon Holdman so it's a numbers game. I agree with everything that you said and thanks for the response. I currently have 6 deals in work, 2 of them are joint ventures and 4 are 2nd position loans. If one goes south, hopefully the other 5 will make up for it or at least offset it. I'm not assuming nothing will go wrong but I am assuming that nothing will go that badly wrong that the rehabbers will walk away from their business that they have been building for many years and leave me with nothing. I may be naive but I think that they would pull out all the stops to pay me back so as not to tarnish their reputation. I know there are a lot of shady characters out there but I did a pretty thorough background search on all the people I am working with. So, do you think I should be getting a personal guarantee for these loans? If so, how do you do that?
There's a difference between walking away from a business and walking away from one property. Bad things sometimes happen and sometimes the best choice is to walk away from one deal. And rest assured that when the bubble burst lots of folks just walked away from various businesses.
If you don't have a personal guarantee then your only recourse is the property. Being in second position means you really have almost zero security. A personal guarantee would be something you would incorporate into your loan agreement. Ask your attorney how to add that. If you don't have an attorney preparing your documentation, well... get one. Absolutely do not use documents provided by the borrower unless they have been thoroughly reviewed and revised by YOUR attorney.
Sorry, but I think you're being incredibly naive to say "I think that they would pull out all the stops to pay me back so as not to tarnish their reputation". Businesses fail. Deals fall apart. I have a different deal with the same person I work with on hard money and it has gone completely bust. A significant amount of cash lost by me and others. Do I expect him to come up with the cash to make us all whole? No. I went into to it eyes wide open knowing it was a risky deal. Risk for investments means there are a wide range of possible returns, including some high ones. But also including low and negative possibilities.
Never, ever, ever put more than 10% of your nest egg into one deal, person, or company. If you have six loans out with six different borrowers and one defaults and you make 20% on all the others, you're at least break even. If these are all with the same person and things go sideways, they're all going to fail.
Do you have social security numbers, a full 1003 credit application and a full credit report on these borrowers?
Thanks for the advice @Jon Holdman I will take it into serious consideration. I'm just starting out investing so I know I have a lot to learn. I do not have credit reports, social security numbers or 1003 credit applications on the people I have invested with. I know who they are, I know where they live, I know their friends and associates, I know how to find them. Could they skip town, never to be seen again, of course. But if they ever want to get involved in real estate in this area again the word will get around. I guess I need to keep my fingers crossed that these first few deals work out and then get an attorney to create my own trust deeds and promissory notes with personal guarantees included. I like your suggestion of not putting more than 10% of my nest egg with any one person. With only 6 deals that's hard to do but going forward I will try to split it up that way.
The OP is about becoming a hard money lender, which I suppose is almost always in first position so I understand where the recommendation to always lend in 1st position comes from. I'm just a private lender and it seems there are lots of people willing to lend in 2nd position. They would all be subject the same concerns that you laid out earlier. Your comment "with any loan your FIRST consideration should be getting paid back if something goes wrong", would that be accomplished by getting a personal guarantee? If not, how would a 2nd position lender consider getting paid back? Or is it like I said, a numbers game?
Originally posted by @Jon Holdman :
Never, ever, ever put more than 10% of your nest egg into one deal, person, or company.
Interestingly, that is the law in California. A loan broker cannot put a trust deed investor in any one loan that is more than 10% of their net worth.
Just a few comments, not an essay, LOL
Restraining a property owner from obtaining equity, such as doing a first and not allowing a second behind them can be illegal, (State laws vary) and is predatory, even in commercial. If your contractor takes bankruptcy and his attorney sees equity that could have been used, but could not due to your lending constraints, guess whose tail can be flapping in the wind.....go ahead....guess!
The only reason not to allow a second is that the first HML/Private lender has the intention of taking the property, not just getting their money back, another predator matter.
Taking a deed-in-lieu-of-foreclosure is not like it use to be, now any lender should be able to show that the borrower request that a deed be accepted, which also means any pre-arranged deed is off the table, you can go down the road of an illegal foreclosure. A loan is not an old contract for deed arrangement which is also an issue today.
What someone might do in one state and in one county shouldn't be a model for private lenders. Usury laws may apply, and usually do to private lending more than to institutional lending. Interest rates are not an arbitrary matter to what ever you can get out of someone, that too is predatory lending.
Last comment, it's not so much as a borrower agreeing to something, it's if things ever blow up, and they do, other eyes will be looking over what went on. Believe it or not, there is lender liability. :)
As long as you aren't lending to owner occupants it isn't too difficult to get through the paperwork. Though, i don't believe it is a good idea in most cases. Seen so many get stuck with really bad loans because the broker didn't know or care. Foreclosures take about a year in Fl now a days without them fighting it too hard. I still see 2009 cases coming through the sale.
10-12% is about the going rate for small HMLs. I've seen larger companies offering 6-8%. You might want to consider using crowd funding sites for real estate, i rarely see deals I'd do myself though.
So much material in this thread. Ironically, Bill's second post I almost complete agree with, but the third I almost totally disagree with.
Bearing in mind, @Bill Gulley , that most hard money loans (at least ALL of mine) are made to companies for a business transaction, the reason for prohibiting a second position loan is NOT to take the property. (We don't WANT to take the property, we want to get our interest, lather, rinse, repeat.) It is because at the end of the day, it prolongs the foreclosure thereby adding significantly to the cost, prevents a deed in lieu which is less costly, and opens up the possibility of the 2nd position lien holder petitioning the courts to force the borrower into bankruptcy, which significantly increases costs. And, it frequently means that the borrower does not have skin in the game, which increases the likelihood that the borrower would abandon the deal, leaving a half completed rehab.
@Julian Buick while lending to rehabbers you know does help insure you get paid back, and I understand your reasoning regarding their reputation, it "ain't always so". I once had a borrower where we had completed about 12 deals successfully lending only to his company. We loosened our requirements a little for the next two deals with the downpayment. I bet you can guess where we are going with this. He fell off the planet in the middle of the last one, and we had to foreclose because he stopped working on the project.
As for seconds, you said "your comment "with any loan your FIRST consideration should be getting paid back if something goes wrong", would that be accomplished by getting a personal guarantee? If not, how would a 2nd position lender consider getting paid back?" You have to always take into consideration the worst case scenario when you are a small lender doing one-off loans that are not part of a pool. A personal guarantee will allow you to go after the other assets of the guarantors. However, if these are small seconds, like 10-20K, you may find the cost of doing so, relative to the likelihood of collecting, is prohibitive. It helps, for sure, so that the guarantor knows he is liable no matter what, but it doesn't actually guarantee a result. A second position lender has to consider what will happen if it all goes down the tubes. It is very likely to happen, and in fact, I have executed a first position foreclosure that wiped out a second position, unfortunately. It was over 100K. It was a seller 2nd and wiped out all their profit in selling the property in the first place. Once that happened, I became acutely aware of the problems with 2nd position loans and never did another. One bad deal can wipe out the profits of a bunch of good ones.
There is a huge gap in all facets of real estate investing between what is supposed to happen and what the paperwork says will happen, and what actually happens. And the way that you find out the limits of that gap is by encountering it. As in divorce, the only one making money in those difficult circumstances is the attorney helping you fight for your money.
Thank you to all for your responses. The invaluable feedback received will help me make better and wiser choices when lending out my hard earned money.
Without drilling to the center of the earth of financing, let me put it this way ;
This thread is about an individual wanting to get into hard money lending, I assume just as most individuals approach lending in a commercial manner to investors, not consumers.
Sates have different laws on private and hard money lending by individuals or said a better way, who are not registered, not really in the business of lending, who may make occasional loans but are not considered in the business of lending to the public.
You will also find predatory dealing and lending ordinances at the municipality level, 3 that come to mind are in Texas, San Antonio, Huston and Austin, I'd bet Dallas is included and other larger cities in other states as well, California also has equity protection laws.
There are lending aspects that apply to individuals that do not apply to institutional or registered lenders in the business of lending. The reason is is because registered lenders are subject to examination, they have regulations that vary but may get into areas of reserve requirements, net worth requirements, insurance, bonding and they are under regulator controls, many must submit a "call-report" that outlines the lender's financial position, number and types of loans and other lending business aspects.
Registered lenders will generally follow prudent lending guidelines applicable to their type of lending activities, they will or should be consistent in their policies, they should have written policies applicable to their loan products.
Unregistered lenders, private lenders are unregulated, these folks will or could have different usury rates applied, be subject to predatory dealing and lending falling under completely different rules. I call these lenders "hip pocket lenders", they have their own money and they will make some loans with it. There are also triggers for these folks in what they do that can require the to be registered, won't go into all that, but most try to fly under the radar to avoid registration that can mean more compliance, and that's even if they area aware of registration requirements too. Anyone is free to loan money, so long as they are in compliance with applicable law, part of free enterprise.
So, what we have in reality is two different lending platforms, institutional lenders and the hip pocket lenders. Different rules, different conduct allowed, different requirements.
Institutional lenders for example, are required to dispose of collateral obtained and sell it to apply funds toward the debt. Through their loan products, underwriting, standardized policies in dealing with the public they assign interest rates that reflect the market, their earnings and the risk associated with the loan.
Hip pocket lenders do not have these lending aspects in common, some may set policies, rates, loan requirements, but that doesn't make them an institutionalized lender. In other words, some may take a more sophisticated approach on their own, but they may not be required to as a private individual.
Now, much of the lending issues do "bleed over" to both sides, Dodd-Frank for example, predatory practices of taking excessive collateral, providing loans to those who aren't close to having the ability to repay, or making loan terms that constrain a borrower's ability to carry on their business.
More to the topic mentioned, institutional lenders may restrict other liens and encumbrances, it's not about any of the justifications you mentioned Ann, although those are a plus for you. The reason is to ensure that the borrower does not take on more debt in a project placing their ability to pay as they originally presented or qualified for. A borrower who loads up more debt than originally agreed to is a much higher risk.
Institutional lenders may require life insurance on a borrower, another example of differences, they may require annual audits and accelerate a loan in the event of any significant change in financial position, another example, if a borrower went out and racked up debt in another project they can call the loan due.
These types of lending overlays are allowed due to the fact that the lender is under regulatory lending authorities. Hip pocket lenders, regardless of how sophisticated they may be are not considered sophisticated lenders, therefore they are not allowed to do the same things that sophisticated lenders may do.
I have seen law suits against individuals and banks where the lender tied the hands of the borrower with restrictions that kept them from obtaining future equity and the lenders lost! Lenders have to be very careful about not sticking their nose in the business of a borrower, influencing a borrower to act or not to act in some manner. If a lender can be seen as controlling the outcome, that is predatory lending, especially if the lender has a quit claim deed with wet ink ready to sign.
You won't see institutional lenders taking a quick claim deed and moving into the property (only if that property ends up as another branch office or property held in connection with their lending activities). Yet, this has been and still is the goal of many hip pocket lenders and again, that is predatory dealing as they do not allow the borrower or owner to obtain any excess equity over the amount borrowed. There is also a difference in lien states and title states, but we had a recent thread on that.
Often, a hip pocket lender will set an interest rate as high as they think they can get, there is no legal justification or financial risk justification, it's simply based on their gut feeling of what they may get or can get. Barring any usury law issues, when these lenders go too far, they are again acting in a predatory manner, unless they can show measurable risk, their idea of what is fair can be irrelevant. Such loans are a favorite in bankruptcy for cram downs.
Many of the justifications mentioned, like making my foreclosure easy, isn't a justification, lenders must be willing to accept usual and customary risks or they should not be lending to that borrower at all. You don't add lending restrictions to ease efforts generally required of a lender, restrictions and covenants should have a risk management basis or element, not necessarily a profit motive, interest is to cover profits over these usual and customary risks, not high rates and then more restrictions. Again, if that is necessary to manage risk, that loan should never be made.
Now, for the fun of it, let's see if @Dion DePaoli can have a longer post, LOL :)
Nope. You win this one Bill. I had to take a lunch break half way through that.
Yeah, I still haven't finished reading it. And I think I'd rather go look at a deal than argue. It's not productive.
my advice, be lazy. There is no need to reinvent the wheel here. Contact 5 + HM lenders, and ask them from the borrowers perspective what their due dilligence process entails. Then take all of those lists and combine them. Between 5 HM lenders it is likely that you will miss any important details.