Private Lending: Question About Promissory Note Details

14 Replies

Context

First time investing with a PDX flipper (great at what he does) and happens to be a good friend. He is raising private capital and the deal seems bulletproof, but would love feedback to better understand if I'm asking the right questions.

Property Details

The property is a probate sale at a solid $160k w/ closing costs. I am contributing the purchase price and from there, there are a few options:

  1. Immediate Flip: 3-4 months; essentially wholesale the house to another developer w/ plans.
  2. Rehab and Sell: 10-12 months; complete teardown and rebuild (already has plans drawn).
  3. Light Rehab and Hold: time and return unknown.

Depending on the market, we're likely looking at options 1 and 2. 

Deal Details

I'm providing the capital for the entire purchase and he is grabbing another $320k for the teardown (should we move w/ option #2). Here are the details: 

  • 10% simple interest on the principle; full payment including principle plus interest due 12 months from loan dispersal or upon sale of the home. 
  • No pre-payment penalties.
  • If option #2, additional return of 1.25% paid off the final sale price of the home.
  • Late payment occurs 30 days of 12 month due date; 1.5%/month accruing per day from the original due date.
  • I will be on the Deed of Trust in first position.

Is there anything missing that I'm not seeing? Would you lend on this?

Sounds good BUT be sure the value of the property is really there. AND even though he is a friend run a credit check. If you feel comfortable with what you find go for it.

Make sure you have no subordination clause in your mtg.  He won't be getting bank financing for the build without them being in first position, and if he gets private money that will take a second, it will be expensive money.

Oregon law allows you to make up to 10 loans without being licensed.. and or that you do not hold yourself out as a lender. IE ad on craigslist offering loans or here on BP.. many lenders on BP are not licensed in Oregon even though they say they are nationwide.

This is very cheap money for your friend.. when your talking 100% financing.  So GREAT deal for him.

If you do the new build as @Wayne Brooks states your not going to get a loan of that size in second position. So it would be likely that the lender requires you to sign a subordination agreement putting you in Second position.

If it was me since your putting up 100% of the money I would want 100% control IE I would want to be the one on title then I would hire him to work for you.. Is he licensed.. Oregon requires Licenses to work on houses.. again if you do more than 3 a year or hold yourself out as a contractor developer.

You need a Developers license ( which is what I have) or a GC license.. Now you would qualify for the exemption if this is your only one.

Any title company can put this simple TD and Note together for you..

JLH

Genuine thanks for the feedback everyone. A few notes around those responses:

  1. This is my first real estate deal. For me, the return is better than what I would be receiving with current investment vehicles, but my primary takeaway is education. I want to use this deal to learn more about the process of redeveloping a property; the process of lending money; the process of asking questions here and learning from the community's feedback.
  2. @Wayne Brooks correct, I will be in 2nd position once a construction loan for the development is secured. Can you elaborate on a subordination clause - its the first time I've come across that term. Curious, what would you estimate the cost of money to be on a construction loan?
  3. @Jay Hinrichs a few notes. My friend is licensed and has done a number of flips; they look great and have sold at market rates. (serious question, no snark intended) Can you elaborate on why this is such a great deal for him (and note that he is the one who found the property, developed the plans and will be doing the construction - it seems like a win-win to me)? What would you estimate the cost of money would have been for him if he had gotten a loan (for the purchase) from a formal lender?
  4. Another general question: When doing a teardown and redevelopment, is it always necessary to get two separate loans (one for the purchase and one for the construction), or do banks allow you to roll everything into one loan at one rate?

Thanks again for the feedback -- I'm blown away by the quality of the content.

Happy to respond.

first off 100% LTC are pretty difficult to get and that's what your doing.. not saying it can't be done but the cost for those is usually about 2 to 4 points and 12% interest up to 14% .. so for him to get 10% with no points on 100% LTC  is a smoking deal for him

subordinating your position to a construction loan is about as dangerous a position you can find yourself in.. if it all goes OK then its moot..

Generally speaking as a lender YOU NEVER subordinate your position .. and especially if you don't have the 320k to pay the first off is something goes wrong.. Any experienced lender knows this straight away and I understand that's why your asking the question.

a fair deal here would be 10% interest and 30 to 50% of the profit.. this is more normal.. you should if your putting up all the equity get a piece of the profit..

You are putting up 100% of purchase price AND cost of improvement and your (current) friend is contributing locating the deal, experience and all the work. 

If everything goes as planned you stand to profit "X" and take a passive role. That's what most al lenders want: an easy role as capital provider and receive a predetermined profit in the form of interest of interest plus incentive Y.

Besides State and Federal compliance for lenders, the real test could come should things not go as planned. Especially if your borrower's project goes sideways and you, as lender, determine that you must seek liquidation of the collateral and foreclose. 

Hopefully, of course, everything goes as planner. Of course, you learn little when things go as planned. The real education and character testing occurs when they don't.

If you have money to lend you have money to see your attorney! Taking equity in lending can get you in trouble, be careful not to get into a security arrangement. A private loan/lender cannot charge points, only registered lenders as that is prepaid interest. Private loans, check your state usury laws concerning interest.

Never lend money to a friend you can't afford to lose! (Money or the friend) :) 

@Jay Hinrichs

> first off 100% LTC are pretty difficult to get and that's what your doing.. not saying it can't be done but the cost for those is usually about 2 to 4 points and 12% interest up to 14% .. so for him to get 10% with no points on 100% LTC is a smoking deal for him

Totally makes sense; thank you for the clarification!

> Generally speaking as a lender YOU NEVER subordinate your position

Is it possible to retain first position if you are the minority lender (as in this case)?

@Bill Gulley

> ...be careful not to get into a security arrangement.

What is a security arrangement? Why is it bad? What would the language for that look like?

Thanks again everyone - this is really incredible helpful information.

@Sean Coonce This is a totally different world than "having a first position trust deed". You are now the "gap funder" ie.  the now common term for "I have no money in the deal, and you are lending everything that the guy in the safe 1st position won't lend, in order for him to be safe".  Your risks of loss just went up by a multiple of ten.....and at 10% rates.

The other lender is providing the first 67%, you are providing the remaining 33%.  If there is a 10% overall project hicky, you lose 1/3 of your capital.   33% overall hicky, you get wiped out.  In either situation, the 1st position lender collects 100%, plus interest.....and His rates are probably 10% or better.

@Wayne Brooks   our rates for this deal in our market would be 2 to 4  and 12 to 14%

Originally posted by @Sean Coonce :

@Jay Hinrichs

> first off 100% LTC are pretty difficult to get and that's what your doing.. not saying it can't be done but the cost for those is usually about 2 to 4 points and 12% interest up to 14% .. so for him to get 10% with no points on 100% LTC is a smoking deal for him

Totally makes sense; thank you for the clarification!

> Generally speaking as a lender YOU NEVER subordinate your position

Is it possible to retain first position if you are the minority lender (as in this case)?

@Bill Gulley

> ...be careful not to get into a security arrangement.

What is a security arrangement? Why is it bad? What would the language for that look like?

Thanks again everyone - this is really incredible helpful information.

Sean, since this is your first loan & first deal, & this isn't a DYI thing and you certainly don't want a borrower to furnish the note, see an attorney!

While there are different folks on here that talk about financing, this is really not the place to be advised.We can't underwrite your loan in a forum.

Making a mortgage and taking an equity position can turn into a security, an unregistered security, an illegal security, so how such arrangements should be made needs to be by your attorney, not how it's done in MO. or TX. or ID.......

If you mess up the note and your friend gets hit by a bus, and your note is not enforceable you lose! If your attorney screws it up you have recourse, if someone off a forum screws it up, you just lose. :(

Good luck :)    

@Bill Gulley   our local title companies prepare notes and Deeds of trust all the time.. it would be VERY rare that anyone went to an attorney for this type of small one off loan.

But there are plenty of attornies here in town that could do that for this gentlemen.

I think the bigger issue is he does not understand his risks of being in second position and providing 100% of the capital only to receive what is a very low rate for the risk.. but if its with a friend he knows and trusts.. that's one thing.. but like you said  friendships can end in deals like these..

Originally posted by @Jay Hinrichs :

@Bill Gulley  our local title companies prepare notes and Deeds of trust all the time.. it would be VERY rare that anyone went to an attorney for this type of small one off loan.

But there are plenty of attornies here in town that could do that for this gentlemen.

I think the bigger issue is he does not understand his risks of being in second position and providing 100% of the capital only to receive what is a very low rate for the risk.. but if its with a friend he knows and trusts.. that's one thing.. but like you said  friendships can end in deals like these..

 Title companies usually have an attorney, that attorney provides the notes since title companies aren't law offices nor a lender.

You're right, he doesn't understand nor will he learn in a forum. 

Looks like he's in San Francisco, I'll bet there is an attorney there that can explain and assist him. 

And, since it's almost a full time job just keeping current with financial laws (I spend a lot of time doing so) let's let him put his deal together with a local attorney who deals in financial matters. Friend or not, this structured deal is on a thin line, even municipalities have predatory lending/dealing ordinances, I have no idea what they do in San Fran. 

Last June I went to a closing with a title company note, it wasn't compliant, I pointed it out and they changed it. Just because a title company has blank notes in the storage closet they have been using for years doesn't mean they are current, after all, they aren't in the lending business. 

Just another "note" allowing a subordination can be the smartest thing to do, it can keep you from having to foreclose on an unfinished project, just so long as the collateral value is still there, so I wouldn't say "never do it". 

Just saying, it's best that he sees an attorney, and no, he won't understand all the risks involved, that simply takes years of experience in the trenches to see what can and does happen.  :) 

    

I'm currently looking to get into contact with all lenders for knowledge, insight and advice on how to close on financing properties

I am fairly new to the business, but I do own a couple properties in the downtown Albany NY area free and clear. My goal is to GET THESE PROJECTS REHABBED! 

From my experience I have been in contact with two hard money lender companies, both of which I did not close on. Reason, they were offering way more than I needed and asking for too much to bring at closing. Prior to this, I was clear on my second go with a company that I could not bring a lot to close and is it possible to get funding on a project without coming out of pocket? I was told yes! For these companies they make you come out of pocket for appraisal and broker fee ($1,000 plus), which I understand and I'm not against investing in my company but to lose that amount and not get a deal hurts, especially when it happens twice. But throughout the 7 months of disappointment with these companies and them not being straight forward, I have learned a lot and I do thank them for that. 

This may come off to some of you as venting. But, honestly I'm in my last semester in college beginning my career in the real world and I'm looking for positive guidance and look forward to seeing the vision having my personal professional portfolio of investments. 

Looking forward to hearing from all of you! Thank you in advance!

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