How to come in 2nd (position) and still win every time.
A lot of people are surprised to hear close to 50% of my annual loan volume is in 2nd position loans. They are even more surprised to hear that despite funding nearly $100M in loans in the last six years - mostly through direct placement of whole note (also known as trust deed) investments for our private lender investors - our company has not had a single principal loss and sub 2% default rate.
While there can be some increased risk involved in these types of junior lien loans, the same could be said for all private or hard money loans, regardless of position. And when done properly, junior liens can provide higher interest rates than funding a loan in 1st position.
Why is this true? Let’s break down some of the major myths and little-known facts around junior lien position loans.
MYTH - 2nd position loans are much riskier than 1st position loans
The risk involved in a private loan is not exclusively about loan position. For example, if you funded a fix and flip project at 85% LTV (loan-to-value) in 1st position, is it any safer than a 2nd lien position loan with a combined loan-to-value (CLTV) of only 45%? It could be if the 1st position is with a hard money lender who had extremely punitive default penalties. But if done behind a 30-year bank loan, then the potential loss of equity is a lot less at 45%, even in 2nd position.
MYTH - If hard money lenders will not do it, then it must not be safe because they are much more risk tolerant than I am
Have you ever asked a loan officer why their company will not do 2nd position loans? Probably not, but as a lender who does about 50% of our volume in junior liens with our private lending investors, let me say that its more about loan economics than risk. Simply put, loan officers are typically commissioned roles and hard money businesses make their money on origination fees and monthly interest. The lower the loan amount, the lower the overall loan costs and monthly interest payment.
Many hard money lenders also rely on selling their loans on the secondary market to free up capital in their pooled mortgage fund. Some may leverage a warehouse line of credit with a bank to fund loans. In both cases, the institutional capital dependency makes it difficult to do 2nd position loans because the hard money lender will not be able to fund the loan using their line of credit due to restrictions of use and they can’t sell the loan on the secondary markets either.
FACT - Junior liens behind conventional loans can come with a few perks
First, the bank mortgage typically impounds for property taxes and insurance making it difficult for the borrower to default on either of these while your short-term loan is out. Second, the bank loan is long term, typically 30 years, so it won’t mature before your loan comes due making it less likely to have a default situation occur in front of your loan. And even if it did, a bank’s “punitive” default penalties and interest are far less aggressive than a hard money lender would be, which is often double the regular interest rate. So a bank loan will likely not squeeze the equity buffer protecting your loan, even in junior lien position.
MYTH - There is no legal recourse if a junior lien loan goes into default
It is a misconception that a junior lien holder can’t foreclose on a property. So long as you are the first to file your legal proceedings, at least in the state of Washington where I operate, you will have the ability to start with a notice of default and then proceed on to a foreclosure (also known as a Trustee Sale in my home state) after the requisite cure period has passed. Check with your local state regulations on what this process would look like and what your rights are as a junior lien holder as this may vary state to state.
FACT - 2nd position loans is a great lead generation tool for those private lenders looking to scale
Like us, many private lenders start to invest with their own savings or retirement plans and then catch the private lending bug because of the relatively low level of risk, passivity and CD-like liquidity. And finding people who need these types of short-term loans is like shooting fish in a barrel; the supply and demand always being in favor of private lenders.
But how do you differentiate yourselves from the hard money lenders with lots of marketing spend and a greater presence in your market? By doing what they cannot do. Flexibility and creativity are hallmarks of private lending and offering to do loans they cannot fund will help set you apart. In fact, many hard money lenders in my market do not even view us as competition because we’re too small and inconsequential compared to the bigger players in our industry who fund 9-figures annually. Hence, they end up sending their loan fallout our way since we can likely assist when they cannot.
The Do’s and Don’ts of Funding Loans in 2nd Position
In a nutshell, if done with care - this means taking an educated approach to loan processing and underwriting - being a junior lien holder can be a financially rewarding position to be in (I could not resist myself with the pun). Here are a few extra tips and tricks to making sure you are always a winner when coming in 2nd!
- - Do keep your combined LTVs (CLTVs) conservative to account for any additional default penalties, interest owed, late fees and potential legal costs incurred. We like to aim at a maximum 65%-70% CLTV or lower. If you are new to private lending or do not know a lot about real estate investing, I would suggest lowering the CLTV even more.
- - Do not gap fund loans. Period. Gap funding is when a borrower goes and gets a loan at 85% LTV and is looking for a private lender to fund the 15% down payment balance and possibly rehab funds as well. Not only is there zero equity buffer right out of the gate but why would you risk more of your own money when the borrower is putting absolutely nothing into the project? It makes it way too easy to walk away when the borrower has no skin in the game.
- - Do get a personal guaranty regardless of who you are working with. If the property vesting and the loan is going to be in the name of a business entity, as it often is, then be sure to have the borrower personal guarantee the loan.
- - Do verify the first mortgage/loan is current. You can do this by requesting a copy of a current bank statement or the actual promissory note if the loan is seller financing or with a hard money lender.
- - Do make sure the first mortgage/loan allows subordinate loans. Many hard money lenders will have a clause disallowing junior liens as required by their warehouse line of credit or institutional capital partners. If you are choosing to go behind a HML, make sure to know if this is allowed or not. By not checking, you could be immediately putting your loan and the borrower’s mortgage in jeopardy of being called due early.
As with all investment opportunities, you need to determine your own risk tolerance and deal preferences before proceeding. Doing your homework and consulting with professionals experienced in the junior loan arena can prevent some serious issues I have seen other independent private lenders get themselves into. But if done properly, investing in second position loans can be a solid way to earn double-digit returns (typically 2-4%+ more than you would typically earn in a first position loan) and be a great way to scale your private lending practice beyond your own funds.
And always consult with your own legal counsel. All my opinions are just that, personal opinions from a seasoned private money matchmaker who’s been around the block a few times. But I am not an attorney, tax accountant, or business advisor, so please do your own due diligence on the subject matter.
I’d love to hear your thoughts on if you fund 2nd or junior lien positions and what your experience has been. If you do not fund 2nd position loans, comment below on why you won’t do them and your rationale. I would love to hear other opinions - both for and against the ideas expressed here!
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.