How Difficult (And Smart) To Start A HML Fund--Am I Nuts?

35 Replies

@John Thedford   don't give up your dream.. make some appointments at local commercial banks. and see if you can get 50 % leverage.. we got 4 to 1..

Its worth a try.

now again to be fair and balanced like fox news.. I had been with my banker at that point for 12 years and I had strong partners.. although as we got rolling I got another 12 million LOC with only my PG.

But they got me started.

you will also need to check on licensing NMLS and all of that.. When I got my mortgage bankers license I simply wrote into the state gave my qualifications and they sent me a license :)  and in CA you simply need a RE brokers license which of course I have had since 1975 .. then it comes down to contacts and networking.  when you have a lot of money to lend it gets quite a bit more competitive then when your a local lender making a few deals here and there.

Sounds like you're buying yourself a j.o.b., @John Thedford . You're just trading earning a lot of money from a few deals with a handful of borrowers to relatively small amounts from many deals. Obviously, at some point there is a crossover, but it will not be without a lot of work. Managing your fees and keeping the pipeline full is the name of the game in this business. Are you sure that's for you?

I suspect it's really the action you like. If so, you don't necessarily need a fund. You could sell your notes, keeping the points & fees, which I would do first, or you could hypothecate them. The latter involves a PPM but you don't necessarily have to raise money. It allows you to loan the money over an over as others loan to you, using your notes as security.

Credibility won't come from 3 month seasoning. It will come from the track record you've developed with reliable borrowers as well as wise underwriting and strong relationships. In the case of a hypothecation, you still retain ownership of your notes.

In this case, you might consider attending the American Association of Private Lenders conference in November. I'm an on again off again member. It's a legit organization with hundreds of members, including many fund managers and lending attorneys. The free advice you will get is almost worth the conference price. I know several fund managers who consult/teach burgeoning fund operators how to get started and they might be there. Unfortunately, personal business will take me elsewhere this year but I've attended and enjoyed this event in the past. I even wrote a review on it somewhere on this board.

@Jeff S.

J.O.B.....yes..after talking to a few people, reading the responses, etc that is exactly what it would be. I have to take into account other factors as well.  If I was 20 years younger I might love the challenge. I will stick with my current strategy which includes buying rentals as well as lending from my 401K. Thanks for the input.

Thanks @Jay Hinrichs

Thanks to many others as well. 

@Jeff S. great points as usual... with a HML company if your splitting your revenue.

you need scale to make any serious money.. and to me that means at least a million a year Net  for your time and effort and risk..

And depending on where your at in the country its very competitive for good deals. Bay Area for instance its easy to get 1 and 9 2 and 8 HML... so that does not leave you much spread if your cost of capital is say 6 or 7%... But were @John Thedford is the rates are 2 and 12 to 4 and 12. lets say the interest delta is eaten up in over head.. you have 5 mil out and that will generate about 200k in Net revenue.. maybe a little more.. now that's fine if its your personal money.. and you get to keep the 12% and you make larger loans so your not killing yourself finding deals. But you can see very quickly that to make any serious revenue in the HML business you need 10 to 20 million to lend minimum if your OPM.. 30 million and it gets pretty good then just gets better as things grow.

@Jeff S.   I have used hypothications at my commercial bank.. they work great if you have the banking relationships.. mine were not for my lending company it was back in my timber days.. and it was common that I would need to sell my residual land that was left after the logging operation on Contract... usually 1 to 3 years.. in Oregon it can take a year or more to get a building permit out in the country..  so I would then hypothecate those notes so I could go buy more Timber land  and rinse repeat.. very nice way to pretty safely get liquidity in what is normally a illiquid asset or if you went to sell it out right on the open market you would take a beating on the discount.

Now there are those that go in for buying or selling Partials.. in Oregon I am pretty sure that would be viewed as a security.. as Oregon does not allow fractional interest in Mortgage notes. And for that reason the local Oregon HML do use the PPM route and pre 08 most of us had LOC's with the 6 or 7 local banks that would do them. But as you state its all about your creds and experience to land one of those facilities. New comer would virtually have no chance unless they had as much cash in the bank as they wanted in a credit facility..

@John Thedford

You can expand from your personal investment/small business arena in stages, and see if and how much you'd be comfortable expanding

As a first step, you can take on passive investment partners on any loan you fund; usually the promoter (you) would get all the points, plus a small servicing fee, then each participant would get the remaining return pro rate with the capital invested.  The promoters incentive can be juiced by additional servicing fees, such as half of late fees, etc.  This model can be tweaked for more return (and increased risk) by obtaining a line of credit secured by the notes, assuming the interest cost is less than the interest earned.

The next step up is to syndicate larger loans (multi family, commercial ) of $250,000 to $2Million. anywhere from two to ten investors (or more) can provide the capital to fund the loan. A more formal structure would be needed; many use a limited partnership or multiple member LLC. A decision would have to be made as to whether the investors would own fractionalized interests in the note (each investor or his entity would appear on the mortgage or trust deed, and note as the lender with his percentage ownership reflecting his capital contribution. The other option is that the investors would own interests in the limited partnership or LLC, which would itself own the note and be listed as lender on documentation.

If the fractional interests method is chosen, an argument can be made (growing weaker every year) that the investment is not subject to securities laws because loans are excluded from Federal securities regulation in some regulations. If the LLC or Limited Partnership route is taken, then this would constitute a securities offering, and the determination would have to be made if (1) this is an intrastate offering exempt from Federal Securities Regulations but subject to state securities laws or (2) this is an interstate offering, subject to Federal Securities Laws. If (2) then assuming registration is too costly and time consuming, what exemption from regulation is available for the offering. The most commonly used exemption is the private offering; the decision then is to use the general private offering exemption or a Safe Harbor exemption, like Reg D Rule 506 (b) or (c).

Crowdfunding is merely a way of utilizing internet capabilities to raise funds bypassing the typical investment banking industry.  As a principal of the company making the offering, you do not have to be registered or pass any licensing exams to offer securities in your own company.

All this still assumes that the investors get to pick and choose which loans they participate in.  A blind pool offering is one in which the investors invest only knowing the parameters defining where and how their money will be invested.  They have no voice in deciding the particular loans that will be funded.

It has been my experience that once you get beyond investing your own money, in your favored asset class, in your own backyard, you move past the "low hanging fruit". Many who start with SFR, need to move to multi family, commercial etc. to have enough deal flow to maintain quality and meet the demand. Others, such as myself, move from our own state, to a region, and now nationwide in commercial hard money lending.

Good luck whatever you decide.

If you're not looking to spend a ton of time raising money, why start a fund. A fund is going to require a ton of time and energy to raise capital. 

It's not easy to get a credit facility/warehouse line. The investment bank will require a solid 3-4 track record. They will also want securitization. Two ways to do that include getting a bond from capital raised or securitizing the "chattel" from the loans going in and out.

You'll need a steady source of accredited investors. Whereas you could file a Reg D rule 506(b), but I have found it is easier to just work with accredited investors. I am not sure about other HML, but I built my relationships with accredited investors by coaching/mentoring real estate.

I think the hardest part is actually not raising the money. The hard part is building the underwriting system. In my opinion, raising capital is the easy part. Also, having a HML fund is very risky if your holding onto your notes. You can lose your warehouse line, have massive borrower default during a market crash, and lose your top investors. To mitigate the risk, you need to build an underwriting department that can underwrite for loans on the secondary market ie credit unions. You also need to build a FINRA licensed broker/dealer to sell the paper. If you are not selling the paper in 60-90 days, I believe HML is a risky business. You need a distribution channel to move the paper. In addition, the key to selling the paper is to underwrite better paper. So this is another challenge.

Here is the rule 506(b) from the SEC website.

Under Rule 506(b), a company can be assured it is within the Section 4(a)(2) exemption by satisfying the following standards:

  • The company cannot use general solicitation or advertising to market the securities;
  • The company may sell its securities to an unlimited number of "accredited investors" and up to 35 other purchases. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;
  • Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well;
  • The company must be available to answer questions by prospective purchasers; and
  • Financial statement requirements are the same as for Rule 505.
For my funds, I have opted to go the Reg D Rule 506(c) route. After the recently implemented JOBS act, you can know advertise in a rule 506(c) but it becomes your responsibility to verify that they are accredited. It is not worth messing with as one non-accredited investor can lose your exemption. Here is the rule 506(c) from the SEC website.

Under Rule 506(c), a company can broadly solicit and generally advertise the offering, but still be deemed to be undertaking a private offering within Section 4(a)(2) if:

  • The investors in the offering are all accredited investors; and
  • The company has taken reasonable steps to verify that its investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.

Purchasers of securities offered pursuant to Rule 506 receive "restricted" securities, meaning that the securities cannot be sold for at least a year without registering them.

Companies relying on the Rule 506 exemption do not have to register their offering of securities with the SEC, but they must file what is known as a "Form D" electronically with the SEC after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s promoters, executive officers and directors, and some details about the offering, but contains little other information about the company. If you are thinking about investing in a Regulation D offering, you should obtain a copy of the company’s Form D available from the EDGAR database.

All this requires a ton of time and energy. Maybe it would be better to keep doing what you are doing. It might take 3-4 years to get a warehouse line. Fundraising is a full time job. It is expensive to set-up the rule 506 exemption filings. On the other hand, the benefits are getting a 2-to-1 warehouse line at 3.25% based on libor and if you get your investor money at 8%, then your blended cost of capital is 4.83%. If you turn your paper every 60-90 days, it is possible to 40% to 50% IRR. Getting capital at 4.83% and getting returns 40% is a nice arbitrage. But I can tell you from experience that all this is a ton of work. There are many moving parts building the waterfall.

Thanks @Ryland Taniguchi

After reading this thread I realize it is a LOT easier to just do my own loans. Not a lot of red tape. Nobody to answer to. If a loan goes bad, no unhappy investor..only me handling the situation. You guys scared me off:) and truthfully..I thank you for that. My life is relatively uncomplicated at this point. I am going to keep it that way.

Originally posted by @John Thedford :

Thanks @Ryland Taniguchi

After reading this thread I realize it is a LOT easier to just do my own loans. Not a lot of red tape. Nobody to answer to. If a loan goes bad, no unhappy investor..only me handling the situation. You guys scared me off:) and truthfully..I thank you for that. My life is relatively uncomplicated at this point. I am going to keep it that way.

 I totally agree with the keep it simple idea.  Along the lines of keeping it simple, I have a couple investors that I use to fund loans. If the loan goes bad I offer to buy the loan back with my own money, no guarantee of course, there's some kind of legalities surrounding guarantees that I don't want get into.  Haven't had to buy one back yet, been doing this for over 5 years, works great, investors keep saying give me more, I'm very conservative, keep ltv's low and place them with borrowers that have a good track record.  That way I keep it simple, very little risk to the investors, I can make a little extra money and, maybe most importantly, I don't have to say I ran out of money so often when a borrower comes to me for a loan, keeps the borrowers happy and coming back.  This is considered brokering and requires a license in my state, probably similar rules in other states, you should talk to the right people before trying at home.

I'm also liking Jay's idea of getting a LOC from a local bank, no investors involved while allowing one to expand. Hard for me to see how a bank would lend me $100k's unsecured however. I'll have to look into that. Sounds like a simple enough way to expand without dealing with investors.

Originally posted by @John Thedford :

@Darren Eady

I am doing short terms right now. Just curious if I am missing something as far as selling the notes and then lending it again. I don't think this works for me because most pay off quickly. I do want to grow my PL business and that is why I posted the original question as to starting a PL fund. If it is a LOT of work and time consuming it probably isn't for me. I like my freedom too much..

Hi John, great thread here. Another reason for not holding onto the note, you have less risk in the deal if there was another rough downturn again. For example, lets say you lend at 70% LTV. If your market were to crash and decline 40-50% your borrowers would probably hand over the keys to you and now as the lender you are underwater as your collateral is less than the balance of your loan. However, if you sold the note you collected the points and removed the risk off your balance sheet. That said, if you know your borrowers, they have good character and you are not looking to grow much more in your lending, your risk is mitigated lending off your own balance sheet and money from others.

It's your choice if you want to be a service business by lining up the money for borrowers and lenders, collecting the points and shedding the risk or by being the bank by lending your own and other peoples money and holding onto the risk. Just my two cents.