Common Mistakes New Private Lenders Make & How to Avoid Them
I’ve been asked quite a few times over the last year to review “deals” new(ish) private money investors would like my input on as a seasoned private lender. Many have also come to me after the fact to evaluate options to problem solve after existing loans have gone sideways.
I thought I would recap some of the similar trappings found in each situation I reviewed to serve as a valuable lesson of what not to do when entertaining private loans in the future. Absolutely none of the investors who came to me were stupid or unaware. I think this is important to say given these people did what most decent humans do by trusting in the good intentions of others. Sadly, there are a lot of disappointing characters in real estate investing. Most aren’t crooks, per se, but many aren’t equipped to execute on their original plans. Excellent sales, poor execution.
At any rate, I hope this helps some of you and would appreciate anyone else weighing in on the subject so others can glean insights on their own journey to building passive wealth through private lending. The more we can share lessons learned with each other, the safer the journey.
Lesson 1: Relying too much on relationship and not enough on facts.
I see this WAY. TOO. MUCH. Just because you know someone “like a brother or a sister” (or even if they ARE family) doesn’t mean you know them in a professional setting. And thatdoesn’t mean they have magical powers to control market fluctuations or other variables outside their control. If you don’t have ‘punitive’ measures in your promissory notes, as I have seen with notes between parties who already know each other, there is absolutely zero incentive to pay off on time. No default interest, balloon payment penalties, or late fees, etc. can really hamper your ability to get your funds back.
Worst yet, lenders won’t secure the loan with the project property the borrower is requesting funds for. Unsecured notes are a huge issue with tougher processes to be repaid and I have seen too many borrowers take advantage of their lender’s kindness.
Lesson 2: Low to no equity buffer in the property securing a private loan.
This is singlehandedly the worst possible thing a new private lender can do, in my personal and professional opinion. There is absolutely no way to foreclose on a property with no equity left to pay the lender out. If you are trying to help “gap fund” a deal where you will provide the down payment and/or rehab costs and placing a junior lien behind the borrower’s first position loan, obtained either with a hard money or conventional lender, then you run the risk of losing your equity position and not being paid back your full interest owed or, worse yet, part or all of your principal loan amount. Funding a junior lien loan behind a hard money lender could seriously squeeze your equity buffer if the project takes a turn for the worse.
Lesson 3: ROI too good to be true. Hence, it IS too good to be true.
I can completely understand being enamored with promises of high rates of return - especially with short terms to get your funds back for reinvestment elsewhere. Almost every deal my friends have asked me to review lately had this same promise, er, I mean problem.
Why is this an issue? Because why would any savvy investor promise to give up so much of their equity or profit margin to you to get a short-term loan? We should first start by quantifying what would constitute an obscenely high margin that would make me suspicious. One deal I reviewed promised 30% ROI within 90 days. The note, however, was unsecured by real estate, and there were no major penalties requiring the principal to be returned quickly. Another deal was over 100% return within 18 months of the project being completed.
Still sounds great to you? Let me put it another way. If the project and its projected completed value was so strong, why wouldn’t a construction lender or rehab lender offer to lend more which would be a cheaper cost to the borrower? At a minimum, ask why the borrower hasn't sought out debt-financing as a first choice.
Lesson 4: Relying on other’s opinions and experience rather than underwriting the investment opportunity themselves.
I just love meeting people who are so optimistic and generous with their trust. In general, those can be the most genuine relationships around. However, when it comes to real estate investing and its derivative activities, this can be a recipe for disaster. Most newbies want to find someone to help them in their journey and to look up to for inspiration and aspiration. But we can’t lean so heavily on another’s “expert” opinion because of multiple reasons. Firstly, how do you know they are actually a proven expert? Secondly, how do you know their values, goals and resources are the same as yours, making it a good fit to follow their footsteps? And lastly, even if you can wholly answer my first two questions, why on earth would you want to recuse yourself of any responsibility in your decisions being made? What are you going to do afterwards when something bad happens, blame it on the guru or your work colleague who told you some "nuggets" of information?
Bottom line: Trust no one. Ok, this sounds a little harsher than I want it to but this is 100% your money, your responsibility and your decision. Take control of it and the consequences of your potential decisions.
Lesson 5: Lack of a proper legal review and a second, third, and fourth opinion.
Ok, ok. So I know I said not to trust anyone. But this isn’t blind trust, this is due diligence for making as well-rounded and aware decision as one can possibly make. I didn’t say to take their word as gospel but it’s helpful to try and thoroughly understand what you’re looking at from another lens, or three.
If you don’t know much about real estate investing at all, then it’s critical to ask those in your network who are experienced. How would you ever properly navigate this loan without any experience or knowledge of the local real estate market. I always asked my dad for a second opinion. He’s got decades experience rehabbing properties and he’s much more conservative than I am normally so I can expect a more conservative outlook from him which gives me more angles to consider. But just because I ask doesn't mean I take all his advice or opinions. But I sure do appreciate the honest gut check.
Speaking of network, if you don’t have one, build one. NOW! This is not the time to fly solo when putting your hard earned savings or retirement funds up for an investment opportunity.
Building your private lending virtual team
You will need plenty of resources including, but not limited to:
- A real estate attorney experienced at preparing and legally supporting secured note investments.
- A title and escrow company willing to help guide you through your first few title requests and reviews as well as to manage the closing of your loan.
- Experienced real estate investors or private lenders who can provide a second set of eyes on your deal and provide you with valuable feedback.
- A loan servicing company who can manage the payments and deposits between you and the borrower.
- A real estate agent, appraiser, or other resources to help you valuate subject properties with you - both as-is condition and the after repair value (ARV).
This is just a short list of the most critical. I would also add that we include an experienced insurance agent, hard money lender colleagues to broker my fallout loans to, other private money lenders in the same market as me, and other real estate investors who are experienced and give me second opinions on project economics.
While private lending can be a very lucrative, reasonably safe investment vehicle with short-term liquidity, there is a lot of work that goes into preparing for a loan before you can achieve the level of passivity you are looking for. Before getting started, examine your own needs, wants and desires out of private money lending. This is not an easy investment opportunity and there is plenty of risk if not done right. Make sure you understand your “why” before moving forward so you can keep your goals and values in mind before choosing to fund a deal. If lending out 6-figures to a complete stranger will keep you up at night, and create anxiety or tension between you and your spouse, then maybe you don’t pull the trigger yet. If you prefer lower risk to higher rates of return, maybe you create lending guidelines that only look at properties with extremely low loan-to-value ratios. Or if you don’t have a rainy day fund set aside and you think there’s a chance you could get laid off in the near future, maybe you wait until your finances are more stable.
Whatever your circumstances and the initial reasons for wanting to lend are it’s not an easy task putting up a significant amount of your own money and making sure it’s safe and secure while it’s literally out of your hands. Make sure you do as much homework as possible so that you aren’t winging it on hopes and prayers. Even if one deal is too soon for you to make a decision on or too hard to say yes to, there will always be a surplus of borrowers looking for private money lenders to fund their deals. So take your time!
Beth Johnson is a private money lender based in Washington state focused on direct placement, whole note investments. As a self-proclaimed private money matchmaker, she helps connect borrowers with private lenders seeking to invest in real estate backed, short term loans. Currently, her company, Flynn Family Lending, provides placement services to over 50 investors nationwide.