Should You Create a New Profit Center in Real Estate by Becoming a Lender?

by | BiggerPockets.com

As the CEO of a private mortgage investment fund, sometimes I get asked how I got started in the “lending” business—or even which bank or which servicer I started off working for.

My answer—that I’ve never worked a day as a banker—can surprise people, especially if they’re coming from the world of institutional lending.

Thinking Like a Banker

The path that led me to found a mortgage note investing company was a roundabout one entailed being a real estate agent, a rehabber/landlord, a private lender to other rehabbers, and finally to note investing, but it definitely taught me a lot about borrowing and lending with real estate.

So, are you wholesaler, rehabber, or landlord now? Then my advice to you is to understand the lending and finance side of the business as if you were a banker.

Why learn to think like a lender?

Because eventually you’ll want to scale, and scaling takes capital, and one day, you’ll run out of your own money. That’s when lenders become very important players on your team.

Plus, I’ll lay odds that once you “get” how real estate works for the lender, the “a-ha!” light will turn on, and it won’t be long before you switch seats at the closing table.

Here’s how that evolution in roles played out for me.

From Bank Borrower to Private Money Borrower to Private Lender

Back when I first started out in real estate investing, I didn’t know that borrowing or lending private money for rehab projects was even an option. Like many investors, I was focused on finding my next deal and trying to convince the bank to help me pay for it.

In my early days as an agent working with investor-buyers, though, I learned fast that if my investor clients didn’t work out the financing side of the transactions I was brokering for them, I didn’t get paid my commission. Nothing happens until the money changes hands, and “the bank” seemed in control of that part of things.

When I started networking with other real estate investors and attending local real estate club meetings, I learned about “being the bank” and other alternative investments—and ways to create multiple streams of income (see recent article, “How to Create Multiple Streams of Income in Real Estate”).

private-money-meeting

Lending Opens Up a Whole New Profit Stream in Real Estate

My first encounter with non-bank lenders came when I was looking for capital as I grew my rental property portfolio. At real estate club meetings, I met several “professional” hard money lenders who did lending as a business, and I saw how much yield they were bringing in while taking on very little risk. But it just seemed so expensive to me (as a borrower).

The next thing I discovered was that hard money rates were typically higher than with private money, which tends to come from people who don’t lend as their primary business but do it more “on the side.” Borrowing private money was more appealing to me as a borrower, but I could see that the lender was also doing very well on his side of the transaction.

Related: 7 Truths About Private Money That Will Help You Raise Capital

And soon enough, after working with private lenders on my projects, I started tapping into the equity from my rental properties and doing some lending myself.

And now, I run a fund that manages mortgage loans as investments (although to this day I still buy, borrow, broker, and lend on real estate).

So, that’s how I “became the bank.”

Whether you aspire to be a lender or you want to understand their side of things better, here’s a quick summary of how to think “like a bank” when dealing with real estate.

Think Like a Bank: Pros and Cons of Private Lending

Pros

1. Less Risk

As the lender, you can structure the deal in ways that protect you (i.e. short term, points, etc.). Another good way to limit your exposure or risk is to release the capital on a draw schedule, meaning that you lend portions of the total amount as work is being completed.

2. More Passive

Lending private money is obviously more passive than being on the other side of the transaction, as the borrower. After all, you’re not the one rehabbing the property. However, it’s still wise to be involved. You’ll want to know things like the after repair value (ARV) of the property and the track record of the borrower before agreeing to fund the deal.

If you’re releasing the capital on a draw schedule, maybe you even want to go down to the work site and confirm that the agreed upon work is completed.

3. Short Term

The term of a private money loan could be anywhere from a few months to a few years. It’s ultimately up to you, as the lender. Many lenders opt for a short-term loan, though, as this keeps their capital more liquid, allowing them to pursue other investments in a shorter period of time.

For example, if an investor lends on a deal at 15% for a 6-month term and that deal is completed on-time with the expected outcome, the lender could then “rinse and repeat” within that same tax year. He/she could redeploy the capital in a similar deal for another 6 months.

4. Collateral

Another advantage of lending private money is that, in the event of default or breach of contract, you can take over ownership of the property pretty easily. Also, if the borrower is an entity, such as an LLC, the loan isn’t subject to the lengthy foreclosure timelines that residential mortgages are by having the deed held in escrow. If the borrower were to default, you can just record the deed, and then you have control of the property.

That said, when you’re lending private money to rehabbers, there are also a few things to look out for.

Cons

1. Qualifying the Borrower

What’s the borrower’s track record look like? Who are their mentors? Do they have integrity? These are all very important questions. You have to make sure the borrower is going to honor his/her side of the bargain.

Personally, I’ve only lent private money to borrowers whom I knew, and I was always familiar with their work, whether that was through referrals or from working with them before.

Still, I’ve run into issues. For example, I once lent money to a rehabber who notified me that he was ready to receive the next draw of capital, but when I went to check out the property, the work he outlined in the contract was not completed.

Also, beware of investors who are working on multiple rehab projects at once. You want to make sure your money is really going towards this project and isn’t being used to buy supplies or pay vendors for another. This goes back to having a system of “trust but verify” when it comes to releasing money on a draw schedule.

1031-exchange

Related: How I Find Private Money Lenders to 100% Fund My Deals (& How You Can, Too)

2. Qualifying the Property

Prior to funding a deal, private money lenders typically want to know what the property is worth, how much work it really needs, how long that work will take, and how much it will sell for. You could even charge the borrower for the cost of an appraisal – this is a fairly common practice by hard money lenders.

Personally, when I walked through a property, I had a pretty good idea of what work needed doing and how much it would cost. But that knowledge comes from years of rehabbing properties as a contractor prior to getting into real estate investing.

If you’re not sure how to qualify the property, a possible work-around would be to hire a home inspector. This way, a third party professional can give you and the seller an unbiased opinion.

3. Unexpected Project Delays

Another potential con or threat to your deal would be if the project takes longer than anticipated or if it takes a while to sell.

This could tie up your money for a longer period of time. Or if home values decline in your area while they deal is being rehabbed, it might even impact the borrower’s ability to pay you back. This, however, is a much less likely scenario.

Personally, I think the pros far outweigh the cons, and I consider private money loans a valuable part of my investment portfolio. That said, lending private money isn’t for everyone.

And even if you’re focused on fix-and-flips or building a rental portfolio now, have you ever considered lending private money to fellow rehabbers? Given the pros and cons listed above, would you consider it in the future?

I hope this dive into the “brain of a banker” was helpful. Let me know if you have any questions.

About Author

Dave Van Horn

Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for over 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

15 Comments

  1. Louis Presley

    As a HML here in Texas (DFW) note makers can borrow in the name of their LLC or as individual(s). I only know of two options, deed in lieu or foreclose, I’ve done both, not sure what you mean by… “having the deed held in escrow” and “you can just record the deed, and then you have control of the property” used in the following:

    “Also, if the borrower is an entity, such as an LLC, the loan isn’t subject to the lengthy foreclosure timelines that residential mortgages are by having the deed held in escrow. If the borrower were to default, you can just record the deed, and then you have control of the property.”

    Other than that, I enjoy your writing.

    Louis Presley

    • Dave Van Horn

      Hi Louis,

      Good question. Let me elaborate:

      In my state of PA for example, a deed-in-lieu of foreclosure circumvents the normal Foreclosure process. And in my state (which is a judicial state), uncontested foreclosure can take at least a year. But with a commercial loan, to a non-owner occupied entity, I can have the deed in lieu (already signed, notarized, just not recorded) held in escrow and if the person misses two months payments (or they are at least 60 days delinquent), I can record the deed and acquire the property without having to go through a lengthy/expensive foreclosure process.

      Hope this helps!

      Thanks for reading.

      Best,
      Dave

  2. Vincent Joseph

    Hi Dave,

    Nice article. I am also interested in this part of the business however I am wondering about the tax impact of the profits: is it taxed as part of your regular income or is there some tax protection that I am not aware of? I am not looking for a detail tax analysis but just understand the big picture.

    Thanks,

    Vincent.

    • Dave Van Horn

      Hi Vincent,

      Although I’m not an accountant, I believe that unless you end up taking a house back (which is a long term or short term capital gain/loss), it’s usually just considered interest income. You’re charging points and interest. Points themselves are just pre-paid interest.

      Best,
      Dave

    • Dave Van Horn

      Thanks!

      And to answer your question: if I have investment vehicles that are paying a higher return than the debt, then I wouldn’t put the money into equity. I think there are safer (more liquid) places to put capital than equity.

      Best,
      Dave

        • Dave Van Horn

          Hi Thomas,

          I would have to agree to disagree with you on this. I think it would really all depend on both the loan and the equity investment I’m comparing, along with experience level.

          For example, I’ve lent a $25,000 first mortgage on a property that’s worth $100,000. In that scenario, my risk was severely limited. In fact, if they defaulted on the loan I wouldn’t even mind! I also think there’s things to do to limit the risk in a lending situation, like implementing draw schedules, requiring escrow or cross collateralization.

          And on the flip side of that, I’ve also put money towards equity and have had said property significantly fall in value.

          So all in all, in my opinion, I really think it’s a case by case basis.

          Best,
          Dave

  3. Mark Gibbs

    Dave-

    You write great articles and this is a topic that I’ve thought of more and more.

    Take a flip though, are you lending to a borrower for aquisition and rehab? How do you preserve a first position lien right? If a borrower comes in looking for funds to rehab a house they already own, with an underlying mortgage, would you put yourself in second position and make sure their is equity?

  4. Scott M.

    Great article but got a question: If you want to start lending, what’s the best way to find potential “customers/rehabbers?” If there’s not an active local REIA, can you recommend where to find these more credible borrowers?

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