Structuring a deal with both private and hard money?

8 Replies

I'm looking to do a deal with both a hard money loan and a private investor and I'm not sure how to structure it. By structure it I mean how to protect everyone's interest in the property. Both myself and the private investor will split the down payment and then the rest of the funds will come from hard money. I will be doing all the work of finding and executing the deal and the private investor will just be passive and paid an agreed interest rate of say 12%. So for example if purchase price is $1M we will each put up $100k for the down payment (totaling $200k) and then get hard money for the remaining $800k plus rehab funds. 

Should myself and private money partner create an LLC and partnership agreement spelling everything out and purchase the property through the LLC?

Or

Can I purchase the property with my own LLC and have hard money lender as 1st position lender and private money lender as 2nd position lender?

Or

Is there a better way to structure this?

This deal will be done in California. 

- Steve

Yes to the second- I would say to put the hard money lender as 1st position (I'm sure they require that anyway), but make sure they are ok with a second position lien being on there too, then put the private lender with you in 2nd position. 

There is no right or wrong answer, @Steve Buchanan , but here are a few thoughts to consider.

Most hard money lenders will only loan in 1st position. As a lender, your investor will almost certainly have a second position loan. Also, some HMLs don’t like anyone in second position. Some don’t care. Obviously, you should ask.

If you agree to borrow from your investor, he or she would not be a member of the LLC or share any ownership interest in the property (any more than your hard money lender would be). You would agree on terms such as interest rate, deferred or monthly payments, etc.

If this is a CA property and the interest rate exceeds 10% you would have to use a licensed CA real estate broker to originate the loan for you. I would approach a local hard money lender, who will either be a broker or have one on staff. (Not a solicitation, we don't do this.). A broker/HML will have a vetted loan doc package, work with title and escrow, understand the process, read the title report, specify liability/fire insurance requirements, etc. A good HML will also help you evaluate your deal with a second set of eyes.

The benefit to lending is that your investor will be completely passive with no liability in the deal. That's the reason not to include them in the LLC. A drawback to them is their return is fixed. Yours is unlimited. Note that if this is a CA brokered loan, your investor will not be allowed to invest more than 10% of his/her net worth into any one loan. Also, make sure he or she understands that if your HML has to foreclose, their lien would likely be wiped out and their loan would become unsecured. That is, they would likely be wiped out.

If you partner, there will be no loan. Here you could have an LLC in your name alone and a partnership agreement with your investor or both you and your investor would be members with a specific percent ownership.

You're both investing the same amount of money and will share liability so it seems you should both be on the LLC as co-owners. This means your friend will almost certainly have to sign the hard money loan as a co-borrower. You are doing all the work, however. How much extra is that worth? How much extra should you be paid? Use that to determine your percent ownership. Or, both of you can own 50% each and you get a preferred dollar amount off the top when you sell to pay for your extra services. More to think about and discuss to keep it fair.

The drawback for your investor is that as a partner he or she will have unlimited financial and legal liability. The benefit is a potentially unlimited return.

As I wrote above, there is no right or wrong answer, but I hope this helps clarify your discussions. Best of luck to the two of you, Steve.

@Jeff S. First off a big thank you for writing such a detailed response. You've nailed the gist of what I was trying to get at with my post. 

Just a few questions for clarification...For an interest rate above 10%, you mentioned I would need a licensed broker. Did you mean a CA licensed mortgage broker or just a real estate broker? 

Why exactly does the 2nd position get wiped out if the 1st position were to foreclose? Is this due to the cost of a foreclosure and there not being enough in proceeds to cover the 2nd position? Does the private investor having a 2nd position offer him/her any protections if he/she gets wiped out in the event of a foreclosure?

If I wanted to offer the private investor some blend of debt and equity, say 6% interest plus 10% of profits is it possible to structure that? Could we do it with a 2nd position loan plus an agreement spelling out terms? Would we need a licensed broker to do this?

-Steve

“Did you mean a CA licensed mortgage broker or just a real estate broker?”

In California, there is only one broker license through the DRE, @Steve Buchanan . A licensed broker can call themselves a real estate broker or a mortgage broker. There is no difference. It’s just a name.

For the reasons I suggested above, plus others, I strongly suggest you have a broker originate your investor’s loan no matter the interest rate. You really want someone licensed and with private lending experience. That's why I suggested using an HML. You could be talking about life changing amounts of money here, Steve, and neither of you have ever done this.

To be uncomfortably blunt, your investor might have to go after the property or your assets at some point. He or she will want a set of legally vetted, bulletproof loan documents. Don’t read the oft repeated nonsense here that a proper loan consists of only a note and a deed-of-trust.

If you go the loan route, your investor now becomes a lender in the eyes of the law. I also suggest you have your investor speak to a lending lawyer to understand the law at a top level, and what he or she is getting into along with all the risks. You should sit in too. First position loans at a low enough LTV can be relatively safe. Second positions loans can be the polar opposite. A lending lawyer is not the same as a real estate lawyer. Ask a local HML who they use and recommend.

“Why exactly does the 2nd position get wiped out if the 1st position were to foreclose? Is this due to the cost of a foreclosure and there not being enough in proceeds to cover the 2nd position?”

Yes, exactly. If a property sells at auction the proceeds first go to pay of the 1st position loan. If there are any funds left these pay the 2nd position loan, then the 3rd, etc. The property owner gets any remainder. If there is nothing left after the 1st get paid, everyone else gets nothing. Understand then that their notes become unsecured but you still owe them money. And for completeness, if the opening bid is not high enough to even pay the 1st, they get the property (at a loss).

“Does the private investor having a 2nd position offer him/her any protections if he/she gets wiped out in the event of a foreclosure?”

If I understand your question, you could cross collateralize the loan. That is, add perhaps a free and clear property you own to the deed of trust. Or, offer something else of value.

“If I wanted to offer the private investor some blend of debt and equity, say 6% interest plus 10% of profits is it possible to structure that?”

Of course. This might be easier as a partnership of some sort. For example, if the investment was for $100k, the agreement might say your investor would receive $6000k per year prorated, plus 10% of the profit upon sale. This is something you would take to a lawyer to write for you. The possibilities are endless and can easily become convoluted. Don’t over-complicate it.

Some more good information. Thanks @Jeff S. ! Out of curiosity, would you lend to an investor who buys a small multifamily, say 3 or 4 units, renovates the building and sells to multiple buyers as tenants in common?

Shout out to @Jeff S. for a wealth of detailed information. One thing for @Steve Buchanan the "second getting wiped out" is just bluntly stating part of what would happen to their investment if they were a partner. 2nd actually gives them more protection than a partner as they aren't liable for losses in addition to their investment which a partner could be.