As more and more real estate investors find their favorite markets becoming too hot to handle thanks to fierce competition for suburban and even rural single-family residential properties, an increasing number are turning to a tried-and-true alternative: private lending. Long the realm of the self-directed investors and heirs to moderately sized fortunes in capital, today private lending is an option for almost anyone with a few thousand dollars in liquidity and a basic understanding of how to take out (or make) a loan. However, there is a lot more to private lending than just agreeing in writing that you will loan your capital and, in the end, you expect to get it back.
Most real estate investors have a far better acquaintance with the idea of private lending than other individuals, including most other investors. In fact, if you have ever done a fix-and-flip deal, the odds are good that you considered borrowing private money yourself. The important thing investors must remember is that a basic understanding – even a really solid understanding – of real estate does not necessarily mean that a private loan will go well or that gaining control of the property in the event of a default will go swiftly or smoothly. Getting that smooth experience from beginning to end is best achieved by reducing risk in private lending up front.
What Exactly is Private Lending?
The best way to gain the knowledge you need to reduce risk in private lending is to first confirm your knowledge of the process is comprehensive. For example, while you may think of private lenders as existing solely in the real estate space, the reality is that there are private lenders everywhere. Furthermore, they are not all private individuals. Some private lenders are fully corporate operations.
“A private lender could be an individual or it could be an entire company,” points out Adam McCann, a financial writer for WalletHub. He noted the most common types of private loans are real estate loans and personal loans. For a real estate investor hoping to successfully leverage investment capital in private lending until the markets loosen up, personal loans are likely something to avoid. A personal loan often does not have collateral and can be difficult to collect in the event that the borrower fails to pay on time (or at all).
In real estate, private lending may take the form of a personal loan in the event that the borrower wishes to avoid putting up collateral on the loan. However, this is a risky move that most private lenders would do well to avoid. Instead, look for borrowers willing to put up a property as collateral and remember: If you would not do the deal, then you should not expect it to go well for someone else. You should anticipate that there may be issues and structure the terms of the loan accordingly.
In a nutshell, private lending involves making loans to others in order to earn money through the interest that the borrowers pay on the loans. If you keep this simple definition in mind, the many complicated aspects of private lending actually get a little easier to understand. For example, when you borrow money from a bank in order to buy a house, the bank requires you to put up collateral on that loan. The bank may elect to give you flexible payment terms, such as permitting a balloon payment or a certain number of months “interest-free” or paying a lower rate. All of these things are possible in private lending as well as long as you stick to legal terms and you have the note structured legally and in a binding manner.
Reducing Risk Up Front is Easier than Recouping Losses on the Back End
The most successful private lenders are not the lenders who only lend money to people with perfect credit. They are not the ones who are so big that they can “eat” their losses when a loan goes bad. They are not the ones who have the foreclosure process down to a science (because, let’s face it, anything can happen during a foreclosure). They are the ones who look objectively at every loan, figure out where the potential problem spots are, and then create private loans that optimize the chances of the lender coming out ahead – preferably with the borrower also succeeding and borrowing again another day.
Here are a few ways to do this successfully:
Evaluate each potential loan as if the deal were your own.
This means you should look at the comps, verify that the appraised value and projected after-repair value (ARV) are accurate and realistic, and identify how long you can afford to wait on a payment and on your returns if the project takes longer than expected. Think about the terms the borrower is offering to meet. If you would not offer those terms on that deal, then be wary of offering the loan on the deal. There is likely a flaw somewhere.
Don’t trust it if it’s too good to be true.
At one time when private money was difficult to obtain, “experts” and “gurus” would tell their students to offer to pay outrageous interest rates in order to get lenders’ attention. The rationale was that the deal would be done quickly (since it was so amazing) and then the cost of the high interest rate would be relatively negligible. This is horrible advice. It cost many new real estate investors their working capital and many private lenders who had found the high rates irresistible a great deal of time and often money dealing with the defaults. This also applies when it comes to overleveraging loans. If a deal is incredible and the payoff is going to be astounding (in theory), often investors will ask private lenders to front 80 percent or more of the ARV. Real estate investors who are moving into private lending are often very sympathetic to this “ask” since they have been on the other side of the equation in the past. However, if you elect to do this you should be prepared to also do the amazing project personally in a year when the borrower decides to walk away because loaning to someone with no “skin” in the deal is the best way to get stuck with said deal!
Factor in the cost of foreclosure every time, no matter what.
The fact of the matter is that nothing ever goes completely according to plan. This is especially true in real estate! When a private loan does not go according to plan, you end up facing foreclosure. While it’s always better to be facing the prospect of foreclosing on an asset than being foreclosed on, it still costs time and money to foreclose when a loan goes back. Consider how long it will take to fully complete the foreclosure process, whether you will be able to handle the carrying costs of the property once it is yours, and how you will exit the deal once the foreclosure is complete.
Legal Advice is a Necessity
The last facet of reducing risk in private lending is budgeting for an attorney to give you good legal advice and to help you write the terms of your note. Anyone who remembers the robo-signer fiasco in the wake of the housing crash in the mid-2000s knows how important it is to have your legal documents reviewed and declared enforceable. Otherwise, you might end up with a loan document that you cannot use to collect payments or foreclose. Furthermore, the fine print of lending changes regularly. You must be sure you are adhering to all requirements when it comes to treating your borrowers fairly, giving them plenty of notice, and providing all information about the loan and options to default and foreclosure in a timely manner.
Private Lending is a Great Way to Generate Wealth in 2021
Handled correctly, private lending is a great way to generate wealth in 2021.