Real Estate Investment Options (Part 2 of 3): Private Lending

In last week’s post, we discussed direct ownership real estate investment options. Today we’ll discuss private lending.
 
With private lending, the investor loans money to an individual or business for a fixed rate of return through interest. For the passive investor – perhaps someone with a busy and successful career in something other than real estate – private lending can be an attractive investment option.

​Advantages of Private Lending

• Fixed Rate of Return: If you’re looking for a predictable fixed rate of return, then private lending is a great option. For example, an investor who makes a $100,000 loan at 6% interest would receive $6,000 per year on his investment.  

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• Collateralized Loan: Private loans are collateralized by the property for which they are being used. The loan is recorded against the title to the property, making it public record that the private lender has a loan against the property. In a worst case scenario where the borrower defaults, the investor has the right to take back the property through foreclosure and then decide whether to sell it or keep it. Not an ideal situation, but it is a nice benefit that helps mitigate risk. Further, even though the value of the collateral (i.e. real estate) can fluctuate, real estate always retains at least some value. Other investment vehicles, like stocks, can lose their value altogether, and are not collateralized by a hard asset.

 

• Real Estate can be Insured: In a total loss situation, private lenders are protected by property insurance. Insurance covers damage to the property and the lender is paid off through insurance proceeds.  

 

• Passive: Compared to direct ownership of real estate, private lending is a much more passive investment option. The hard work comes at the outset—a smart investor will do some due diligence on the borrower and the collateral. But once the loan is in place, the investor sits back and receives payments while the borrower manages the day-to-day operations. 

While we’re on the topic, let’s talk about what to look for when you’re doing your due diligence for a private loan.
 
First, look at the track record. Does the business have experience with the type of projects it is requesting money for?
 
Second, try to understand the company’s financial position. Ask for credit reports and personal financial statements, but keep in mind some (but not all) borrowers are seeking private funding because they can’t qualify for a conventional loan. This is not necessarily a red flag, but as a lender you can increase the interest rate to mitigate the risk. In some cases, borrowers are very well qualified but can’t secure a loan because traditional lenders don’t like non-cash flowing properties in need of significant renovation. Vacant or mismanaged properties may need a lot of work and may not cash flow, but they can represent excellent opportunities for private lenders.

Finally, understand how the principal is to be repaid. Private loans typically run anywhere from a few months to 10 years. At the end, the property can be sold and the loan paid off, or the borrower can improve management, add value, and put in place a long term conventional loan. The new loan proceeds are used to pay off the private lender. The latter is how Mayfair Real Estate usually operates. 
 
Now that you know the benefits of private lending and the right questions to ask the borrower, you should also be aware of some of the disadvantages of private lending. 

"For the passive investor – perhaps someone with a busy and successful career in something other than real estate – private lending can be an attractive investment option."

Disadvantages of Private Lending
 

• The Flip Side of a Fixed Rate of Return. A fixed rate of return is great, but unfortunately private lenders don’t get to enjoy the upside of direct ownership. If the borrower does a stellar job on the project, typically the private lender sees none of the profit above and beyond the fixed rate, though in some unique circumstances a profit share structure can be used. If you lend to a house flipper for instance, you might be able to work in a bonus based on the profit in exchange for lower interest during the renovation period.

 

• Not Highly Liquid. When you make a private loan, your principal is tied up for the duration of the project. You could sell your loan to a note investor, but you probably wouldn’t get your full principal back that way. So, you certainly don’t want to commit your emergency savings to a private loan.

 

• Borrower Default. Even though your loan is collateralized, finding yourself in a situation where your borrower has defaulted can be aggravating. No one wants to go through the hassle of foreclosure to gain control of a property. The best defense against this outcome is good due diligence.   

A Final Word on Private Lending
 
Private loans come in all different shapes and sizes, so be sure you know exactly what you’re committing to. Some lenders will offer simple fixed rate returns paid monthly over the duration of the loan; others may offer a single balloon payment for principal and accrued interest at the end of the loan; and still others may prefer a fully amortizing loan.
 
As always, we’re here to answer all your real estate investment questions. Don’t hesitate to contact us, and if we’re not connected already, please find us on LinkedIn and Facebook.