IC Elesson: The Most Important Thing You’ll Ever Read About Being a Private Lender
Note: laws and regulations regarding the advertising, registering, and formalization of private loans vary enormously state-to-state. Generally, these rules apply to the borrower rather than the lender, but even lenders should be aware of what the laws in your state say about these transactions. Of course, this article is not intended as legal, accounting, or other professional advice. Always consult with your legal, accounting, or other professional before making any investment. Further, nothing in this article should be construed as an offering or solicitation of a security.
Private lending is a strategy in which even moderate income investors can easily get involved.
There are plenty of real estate entrepreneurs and rehabbers who want to borrow your money; if you let it be known you have as little as $20,000 to lend in most markets, someone will be right there ready to put that cash to work.
If all goes as it’s supposed to, it’s a truly hand-off investment; you just sit back and collect checks. And the return is oh-so-much-better than other fixed-rate investments; you can expect to average around 6-8% per year total (because higher rate loans are generally also shorter term; when you loan money to a rehabber at 12% but he only uses that money 9 months a year, that still works out to 8%).
But the big fallacy of private lending is that YOU, as the private lender, don’t need to know very much to assure that the deal goes well. After all, it’s up to your borrower to worry about the repair costs and tenants and resale, right?
Well, not quite.
After 25 years in the real estate business, I’ve seen many, many private lenders lose all or part of their investment to borrowers who were unscrupulous, inexperienced, or uneducated. Some real-life scenarios that I’ve been asked to help untangle over the past half-decade include:
- One student who loaned her entire retirement fund—upwards of $150,000—to an out of state company that she assumed was sound because, when they COLD CALLED her (yes, that should have been warning sign #1), they said she’d been recommended as a potential lender by her “mentor” (who was one of the usual suspect reality TV gurus). When the 18 month balloon date on the loan came and went without her money coming back, she become concerned; when I got involved and looked at the paperwork, it turned out that she hadn’t (as she believed) made private loans on properties in Massachusetts, but had in fact purchased unsecured notes backed only by the company’s promise to pay. They never did.
- Another student loaned over $100,000 to a former board member of a large REIA on 2 properties, believing that his was the first and only mortgage on both properties. When the balloon payment didn’t come as expected, the borrower ducked his calls for about 6 months, then told the lender that he (the borrower) was about to declare bankruptcy and that the lender should just foreclose. An examination of the properties showed that one was a worthless shell, gutted by the borrower but never rehabbed, and the other had two mortgages on it, neither one of which was students’. That one had never been recorded. Through a complex negotiation with the other lenders, he managed to get possession of the property, which was worth perhaps $40,000; his total investment in it including legal fees is probably $115,000. P.S. No, he didn’t ask me about this loan BEFORE he made it.
- One of my own lenders found herself in the position of being forced into a short sale when a (different!!) borrower defaulted and signed the property over to the first mortgagee—also a private lender—who then told my lender that she could either release her mortgage or the new owner would simply foreclose her out. This call was the first the lender heard of the borrower signing the property over; there had been no communication before that, despite repeated attempts to contact the borrower over the course of months. She did receive a few years’ interest payments before the borrower stopped paying, but lost all of her principal.
- And, in the crowning example of out and out malfeasance, one local investor basically stole over a million dollars from various private lenders in $15,000-$20,000 increments. He did this by offering high interest rates (12% plus points) for “repair seconds” on properties he was acquiring. When he defaulted on all of these loans, it quickly became clear that he was making his money borrowing money, not rehabbing houses. None of the properties he’d used as security had actually been renovated, and many had 3-4 mortgages totaling 2-3 times the after-repaired value of the property in question. The lenders to whom I spoke recovered NONE of their investments; when I asked why they’d done these deals in the first place, most answered with some version of, “He said he’d done over 200 deals, he seemed really trustworthy, and the interest rate was amazing”.
I don’t tell you these things to scare you off of private lending; I tell them to you to convince you that YOU have to know how to protect yourself in a private lending deal, because you can’t depend on your borrower to do so.
No, not even if he’s the president of your group.
No, not even if she’s really really nice and seems honest.
No, not even if it’s an out of state property that you’ve been assured is worth 3x your investment.
There is risk in EVERY investment. Neither I nor any other borrower can control the real estate market, or the availability of conventional financing for potential buyers of a property, or uninsurable losses. But every single one of the cases above could have been avoided through some basic due diligence and knowledge on the part of the lender.
The purpose of this article is to share exactly what those things are, so that you can make safe, secure passive investments when you decide to do that—and so that you can keep your lender’s money as safe as possible should you find yourself in the position of being the borrower.
- First, it’s important to understand that only part of “safety” of any investment in real estate lies in the property itself.
If you measure risk the way most lenders do (which is to say that you’re much more concerned about return OF your investment than you are about return ON your investment), then the thing that keeps you up at night is the idea of losing some or all of your principal.
In theory, and in the pitches most lenders get when they’re asked to put money into a deal, the property itself is the primary guarantee that you won’t lose money.
The come-on sounds like this: “It’s a $200,000 property fixed up, and I only need $140,000 to buy and fix it, so if I default, you just auction off the property and get paid back!”
Unfortunately, even if the facts as stated above are true (and would you KNOW?), it’s still entirely possible for a lender to lose money on such a deal—and I’ve seen it happen. How? Here are a few scenarios:
- The borrower pockets the $40,000 cash you gave him for repairs, defaults on the loan, and disappears, forcing you to foreclose. If the property is in a state where lenders are not permitted to recover the costs of foreclosure at the sale (and don’t you think this is something you should KNOW if you’re making a loan in that state?), you’d recover your principal balance, unpaid interest, and back payments LESS the cost of hiring the attorney or paying the trustee to file the paperwork and attend the auction. You could, depending on those costs, find yourself able to recover less at the auction than you had in the property to start with.
- A more common scenario: an inexperienced rehabber runs through the $40,000 in repair money making bad repairs or the wrong updates, and then defaults when he runs out of funds to finish the job. The property is in WORSE condition when you repossess it than it was to start with. Perhaps it now needs $50,000 in work rather than $40,000—and is thus worth $90,000 in a quick sale rather than $100,000—despite having absorbed $40k of your cash already.
If you’re going to lend to new investors, you really need to have some experience of your own to compensate for the borrower’s lack of it; going over this borrower’s rehab plan to make sure both the repairs and the costs make sense is one way to avoid the “Oh my God, why did he tear out perfectly good plaster walls???” syndrome later. You also need to be willing and able to be a little more hands on—monitoring the work and having some measure of control when and if the rehab gets out of hand—than the typical private lender is willing to be
If you don’t really know how to evaluate someone else’s rehab plan, you would, in my opinion, be best served by lending money to very seasoned, very experienced investors with good reputations, solid businesses, and, most importantly, the intention and ability to make you whole, out of pocket if necessary, should the deal go bad. An experienced investor whose property is destroyed by an uninsurable meteor strike will still be able to make his lender whole by taking the profit out of the next deal, or flipping some houses, or drawing from a business line of credit, or whatever. An inexperienced investor, faced with a loss of any sort, is much more likely to throw his hands up and let the lender deal with the mess.
To be honest, that’s a small handful of borrowers, and they typically don’t pay the super-high rates of interest that you might have heard about. Still, most lenders would agree that 6%-8% interest with a 99% certainty of repayment is better than 10% with a 70% chance of repayment.
- Control the cash in the deal.
Most private lending deals include a cash component, because most great real estate buys are on properties that need work. I have no problem with you loaning money for purchase and repairs for a newly-acquired property. What I have a problem with is you handing over 6-figure sums of cash to a near stranger, with no real controls on what happens to that cash.
Case-in-point: in one of the most innocence-shattering cases I’ve ever seen of a borrower really messing over a lender, I worked with a guy a few years ago who presented me with an almost unbelievable scenario.
His borrower was a guy I knew, an experienced and successful rehabber with deep ties in the local REIA, and an all-around nice (and, I would have told you then, ethical) dude.
The borrower arranged a loan with this lender under these terms:
- $15,000 for the purchase of a property with a $90,000 ARV
- Another $40,000 for the repair of said property
- 8% simple interest, due at the end of each year or when the property sold, whichever came first
All relatively standard (except for the annual payments; I kind of hate it when borrowers set that up, because the payment, though put off, is big when it does come, and often hard to meet).
The problem was, when the year was up and the lender went looking for his payment, the borrower informed him that he’d just have to take the house back, because the borrower’s entire business had crashed and burned and he had no way of paying.
And what was much, much worse was that most of the $40,000 the lender had handed over for repairs to HIS SECURITY had in fact gone into other houses and into paying personal bills for the borrower.
The property in question was gutted beyond anything I’d ever seen (nothing left but exterior walls and a foundation) and not worth more than $1,000. I recommended, in fact, that the lender not even take a deed in lieu of foreclosure, because the liability of owning the property (did I mention there were no windows?) far outweighed any money he was likely to see from it.
When you think about it, handing any borrower a wad of cash and hoping it will be used for the intended purposes is just foolish.
The correct way to handle cash outside of that needed to purchase a property is the way banks do—to put it into an escrow account to be released to PAY for repairs as they’re completed.
This, clearly, creates a layer of complexity that many private lenders and borrowers are not used to. First, a checking account must be set up especially for the money, and the signatures of both the borrower AND the lender (or his representative) should be required for withdrawals (thus keeping either party from draining the account).
Second, a reasonable system has to be set up to release the funds in a timely fashion. I’ve seen this done as a schedule (the borrower gets an initial “get started” draw of $5,000, then gets 25% of what’s left when the furnace and roof are installed, another 25% when the kitchen is done, another 25% when the bath and carpet are completed etc). I’ve also been involved in a deal where the out of town lender appointed an experienced local to check the property (and the invoices) prior to each draw.
Overcomplicating this system, or making it difficult for the borrower to proceed with the work in a timely fashion, helps no one—but creating a plan that works easily for everyone and, most importantly, leaves the unspent repair funds in liquid form in case the renovations are never completed, is an important safety measure for both the lender and the borrower.
One note: this, of course, applies to second mortgages that are intended for repair of properties, of course. If the second is for the purpose of pulling equity out of a fully repaired and operational property, there’s no reason to escrow the money—just to make sure that the value of the property supports and protects the value of all mortgages against it.
- Trust, but verify.
Even when working with an experienced investor/borrower, it’s important not to get complacent about the basics of safe private lending. Even when lending to (or borrowing from) someone with whom one has worked before, it’s crucial that all the paperwork be in place, all the numbers be right, and all the safety measures be solid.
The bare essentials for protection of the lender include:
- a title search showing that the lender will be in the expected position as a lienholder;
- a lender’s policy of title insurance, generally paid for by the borrower;
- a proper hazard insurance policy showing the lender or lenders as loss payees;
- a recorded mortgage that correctly outlines the terms of the mortgage;
- and, if the lender is not experienced enough to determine value, a professional appraisal.
And here’s something that shocks me all the time; lenders will sign over tens or hundreds of thousands of dollars to a borrower without even doing a basic public records search to find out if there’s been trouble that the borrower hasn’t disclosed.
Look, scam artists don’t look or sound like scam artists. If they did, no one would give them the time of day, much less their whole IRAs. Most are pretty good at drawing people in, using the “Law of reciprocity” to make you feel like you should help them because they helped you (by mentoring you, or keeping you out of a bad deal, or letting you into their secret meeting, or taking you out on their yacht, which guess how they bought…). I rarely talked to a ripped-off borrower who says, “Yeah, I knew he was a scumbag, but the RATES OF RETURN…”.
In fact, most ripped off lenders say, “I don’t get it, there were a half dozen other people in REIA that he referred me to, and they all seemed positive about lending to him…and I met his wife and we went to dinner…”
Unfortunately, even the baddest of the bad guys don’t always leave a legal footprint behind (often, oddly, because they intimidate people into NOT suing them) but why would you not do a quick search of your local court records to make sure he doesn’t have a bunch of foreclosures and judgements he hasn’t told you about? Check the property records and make sure he doesn’t have tens of thousands in tax liens he hasn’t paid? Check the state and make sure his company really exists? You know, basic stuff like that?
- Finally, make sure that you’re in a good place to be a lender.
An experienced borrower knows that there are some lenders from whom we should NOT borrow because they lender doesn’t understand the investment, or can’t tolerate the risks of the investment, or is almost sure to need their investment back before the deal runs its course, and so on.
That’s why a good borrower won’t take your money without doing 2 things: QUALIFYING you as to your ability to understand and accept the risks of making the loan or investment (see www.InvestWithVena.com for what an investor qualification form looks like) and DISCLOSING in writing, what those risks might be.
If you’re approached for money by someone who doesn’t qualify you and makes no disclosures, double down on your own due diligence. It’s possible that the deal is still OK, but it’s a sure thing that the borrower isn’t terribly sophisticated.
If you’re given the disclosures and you realize that you will never, ever be able to sleep at night knowing that it’s vaguely possible that the property could have an unforeseen and uninsurable environmental problem (like a leaking underground storage tank) that makes it unmarketable or that the banking systems could crash and the property might not sell before the balloon date, or that the value of the property could drop, or whatever, don’t make that loan (or any other, because that’s a possibility with ALL of them)
If you literally can’t afford to lose any of your money, don’t make the loan (or any other investment, for that matter).
If there’s a good chance you’ll need your investment back prior to the time it’s due back to you, don’t make it.
And finally, remember that the responsibility for making good investments ultimately falls on you. Therefore, if a borrower—no matter how friendly, popular, or apparently successful—doesn’t seem to want you digging too deeply, or, worse yet, tries to intimidate you by using a takeaway close (“Look, if this great investment is too scary for you, I’ll just give it to someone else!”), be wary.
If there are facts that you can’t verify, or something seems “wrong”, or “too good to be true”, or if there are parts of the deal or his business that your borrower wants to keep you away from, trust your gut.
When a “successful” investor suddenly wants to borrow your money at 12% interest when 8% is the going rate, and wants lots cash for “repairs” or “operating expenses, and seems to be borrowing an awful lot of money from an awful lot of people, don’t let the fact that it’s not standard operating procedure to pull a copy of her credit report keep you from doing so anyway. Don’t let the fact that he’s a trustee with your association and seems incredible confident stop you from doing ALL of your due diligence. Don’t hand over the cash until you know you’re as protected as you can be.