Part 5 of a series
First, let's define a real estate investor, for purposes of this series of posts. Buying real estate to hold for income, or buying real estate to resell - both of these are called real estate investors. Also, wholesalers, who get properties under contract and then assign the contract. We're not going to get into the debate about whether these people qualify to be called "investors", I'm simply defining the word for my purposes. For my purposes, a financial investor or lender is the person putting up the money. So I'm differentiating between a real estate investor, who may or may not have money, and a financial investor, who is putting up the money.
Ok, you've decided you want to consider lending as part of a real estate investing strategy. Here are some points to consider as you work through the process.
How do you find these good deals to lend on?
- This can be a challenging process. If you belong to your local Real Estate Investor Association (REIA), you know dozens of real estate investors. At the REIA's, you'll find dozens of people who have deals and are looking for funding. They don't want to pay hard money rates, so they seek private money lenders or partners. Also check your local Property Owners Association. Ask your friends and family - they may know real estate investors that you don't even know about.
- Find a local hard money company. Most of them use OPM to lend - either they have warehouse lines from institutions, or they lend pension fund money, or they have pools of financial investors, or a combination of these and other sources. You would be one of these financial investors. But be careful! Get references, and be sure you have transparency from the lender. In New Hampshire, a well known private lender was recently sentenced for fraud in a large Ponzi scheme. I know people who invested with him and lost hundreds of thousands before he was shut down by the FBI. So ask around, and get lots of references from people you know and trust.
- Some companies, (like mine!) lend out other people's money on individual deals. The financial investor (you) gets to choose which deals they are comfortable with on a case by case basis. The source of those funds is frequently your self-directed IRA, or perhaps capital that you've earmarked for real estate investing. Instead of buying a property and rehabbing it, the financial investor lends money on a deal screened by the hard money company.
How do you choose the deal you will lend on?
Are all of these people that invest in real estate good candidates to lend to? NO!
- First, disqualify first time investors. If you are a first-time lender, and they are a first-time rehabber, for example, there is greater potential for disaster. Everyone needs to get started, but let the experienced lenders lend to them for their first time out of the gate.
- Trust your instincts. If you don't feel right about the investor or the project, let it go. It might be totally legit, and the person might have the greatest integrity, but if the deal makes you uncomfortable, move on to the next one. Your instincts will evolve as you learn more, anyway. And that includes deals you might look at that I present.
- Consider the worst case. If you have to foreclose, heaven forbid, and take back the property, consider what you will do to get your money back. Can you finish the rehab if it's not done? Can you find a buyer? Will you keep it and rent it out because you liked the neighborhood and property anyway? Will you sell it "as-is" through the large network of real estate investors looking for deals? Can you pay the taxes that the real estate investor didn't pay? Can you afford to pay the attorney and auctioneer and media for the foreclosure process? (Hint: if you can't, you shouldn't be doing the deal.)
- Decide on a return that works for you. You may be getting only 1/2 a percent on your money market fund, but if the borrower is offering only 6-8%, that may not be anywhere near high enough to compensate for the increased risk. Your money market fund is much less volatile.
- Don't put all your eggs in one basket. Yes, you've heard it a million times before, and it sounds corny. But the reason you've heard it so many times is that it's true. If you have $300,000 to lend, don't put it all in one deal. Consider several smaller deals to diversify. And while we're at it, don't take your entire savings or capital and put it into lending until you are more experienced. If you are an experienced real estate investor, then my recommendation would be different, because you know what you are doing. Experienced real estate investors can make money in up or down markets, and the rich don't get rich by diversifying into money market accounts. They get rich by concentrating on a niche.
Should you ever lend in second position?
- No. I've seen so many second position mortgages get wiped out, that after lending on one, where I got out by the skin of my teeth, I thanked my lucky stars and never did another. The more you know about investing, the more you realize just how risky a second position is in this market. If the borrow runs out of time, money or know-how, the liens ahead of a second position can grow quickly. Taxes, utilities, interest and penalties on the first position, foreclosure expenses on the first position, etc.
- Maybe. The reason for the maybe is this: If you are determined to be an equity partner in a deal, then at least take a second position to protect your capital. Remember, the mortgage gets paid before the equity investor. Next post we'll continue on the rest of the questions. If you are reading this and want to see the earlier posts in the series, the rest are on my Active Rain blog and my website blog starting with Lending, Borrowing or Buying.
•What about business loans instead of real estate loans?
•How do you protect yourself from fraud or incompetence?
•How much of my portfolio should I allocate to lending?
•What happens if the borrower stops paying?
•Should I form an entity to lend?
•Should I lend outside of my geographic area?
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