Private lending is a great way to invest in real estate for passive income. This essential checklist will help you get started.
You might be looking for a reliable means to build dependable monthly income in your retirement account or investment portfolio. Or, you might be hunting the big financial wins from non-performing real estate notes. Whatever your reasons for becoming a lender, there are four fundamental elements to every investment: the borrower, the real estate, the note, and the lien.
What’s in This Checklist?
- Know Your Borrower
- Understanding the Real Estate
- Understanding your Promissory Note
- Lien Position and Priority
Part 1: Know Your Borrower
I’m putting this first because – in my opinion and experience – it’s the most important element of private lending. If you’re going to lose money in this game, then it will most likely be because your borrower screws up. The instances in which I have seen people (myself included) lose money as a private lender, has been as a result of either incompetence, dishonesty or plain bad luck on the part of the borrower.
You might think; credit score, background check or job history might be among the most important things to check out first? Well, those things are important but, here’s my top 3 things to look out for in a potential Borrower.
Working Relationship & Communication
Many people make their first loan to someone they already know. For example; a family member, friend or business colleague. But to find the best deals and the best Borrowers to work with, you will most likely have to look outside of your existing circle of contacts.
If they are serious real estate investor, chances are that your investment with your Borrower won’t be a ‘one-off”. They will want to maximize the potential of your relationship as much as you do. With this in mind, it is important to have a good working relationship and an open line of communication. This becomes especially important if things don’t go to plan!
You need to know that your Borrower is prepared to pick up the phone and communicate the good, the bad and the ugly as the project progresses. There is nothing worse than receiving bad news out of the blue!
Real Estate Investing Experience
There really is no substitute for experience. Establishing the operational credibility of your Borrower is extremely important for both parties. After all, they’re doing the dirty work, whilst you are just the bank. A real estate investment that looks great on paper can run into all sorts of problems along the way. That could seriously impact your Borrower’s ability to repay, or sink the project entirely.
By way of example, I currently own 70+ rental properties, and not one rehab went exactly to plan. Some ran way over budget. Others needed expensive permits or unexpected title work. I even had a tree fall through a house mid-rehab. But, I have also had some unexpected big wins. Some projects came in way under budget. Some houses sold or rented for far more than we anticipated. We even found an entire 2nd house (in good condition) on the parcel of an abandoned home we bought.
At the end of the day, you want your Borrower to be experienced and agile enough to adapt to – and overcome – the practical problems one encounters.
Financial and General Stability
As a responsible Lender, you want to get a handle on the general and financial stability of your Borrower. Whilst asset-based lending of this nature relies heavily on the value and/or income of the underlying real estate as security, you also want to be sure that your Borrower treats credit with respect, keeps to their commitments, isn’t overrun with debt, and isn’t harbouring any other issues that might impact your investment.
A Credit Score is a good place to start. You will also want to do a background check where possible. If someone has a litany of DUI’s, anti-social behaviour offences, theft or fraud on their record, chances are they have issues that might well turn up to impact your investment!
How to do It
There are many ways to get to know your Borrower. In my business for example we regularly have prospective Lenders come visit us personally on ‘inspection tours’. They get to meet the team face to face, including management, contractors and sometimes even tenants and home-buyers. They also get to see some of the houses other private lenders have funded, including pre, current and post-rehab sites.
I have found that this kind of ‘hands-on approach’ to relationship building provides a great opportunity to establish a good working relationship, and to demonstrate our experience and capabilities first hand. Your Borrower should be prepared to do the same for you before you provide any funding.
Be comfortable with the kind of working relationship you can establish. You want responsive and honest borrowers.
Look for experienced real estate investors, ask to see their previous work, and/or speak to their other private lenders.
Run at least the basic credit and background checks to highlight any unseen issues.
Part 2: Understanding The Real Estate
As a private lender, the real estate acts as sole security for your investment. You are relying on the value of the asset to repay the debt, regardless of whether it is to be sold or refinanced. In the case of you having to foreclose the loan, there are few things you need to know.
This includes; purchase price, closing costs and incidentals, and includes any liens being settled as part of the purchase such as mechanics liens or tax liens. A copy of the HUD or Alta tells you everything you need to know, so make sure you get a copy before closing.
The last thing you need as a Lender is to end up entangled in title issues. Make sure there is appropriate title insurance in place at the point of acquisition to protect your investment. Also check that the property is conveyed properly with clean title through an appropriate closing company or attorney.
Current As Is Value
Whether it’s a fix and flip, long term rental or whatever, you need to know the current disposal value of the property BEFORE any value-add work takes place. If for some reason the project does not get off the ground and you have to foreclose early on (or midway through construction), then you might well be relying on the proceeds of a sale of the property in its current condition to recoup your money. A brokers price opinion (BPO) or appraisal will tell you what you need to know. Do NOT rely on online listing platforms such as Zillow or Trulia!
After Repair Value & Rents
This is crucial. You need to know what the property will be worth once the rehab (if any) is complete. This is a key metric is ascertaining risk. It tells you your loan-to-value and investment-to-value once the Borrower has completed any physical rehab work. You also want to know what market rent is for the property, ensuring that the asset is capable of generating sufficient income to service interest payments on your loan. This is called a debt service coverage ratio.
Detailed Scope of Work
This will tell you exactly what will be done to the property to force up its value to meet its after-repair value. Ideally, your Borrower will provide an itemized and fully costed contractors quote. This is another key piece of information you can use in assessing the overall risk of providing a private money loan.
It’s important to know that your Borrower has a plan. Will this be a fix and flip, a long term rental or something else?How and when does the Borrower plan to exit the investment and pay you out? This could be via a sale of the home on the retail market, or a refinance of your loan with a traditional mortgage. Either way, you want to know and you need to feel confident that it is realistic for the Borrower to repay the loan in full at maturity by one means or another.
Loss Payee Cover
Make sure you are named as Loss Payee on the Borrower’s buildings insurance policy. That means you are paid out first in the case of a total loss of the property. I have seen this in action before, and it has saved the proverbial bacon of private lenders countless times in a total loss scenario.
Understand the basic fundamentals of the deal at the point of purchase.
Make sure there is appropriate title insurance in place, and the property is conveyed properly.
Obtain a scope of work – ideally itemized and costed.
Understand the exit strategy for you and your Borrower. How and when will they repay your loan.
Part 3: The Promissory Note
Now into the technical part of your private lending investment, and the first thing to look at is the note itself. The note is the contract between you and your Borrower. There are a ton of templates online, but you really should speak to a real estate attorney and have specific terms drawn up that suit you.
Here’s what every note should contain as a bare minimum:
- Details of the Borrower and Lender
- Loan Amount
- Interest Rate
- Payment Terms
- Dollar amount of monthly payments
- Term in months
- Maturity Date
- Late Charges
- Details of the Associated Mortgage or Deed of Trust
- Reference to the Security/Collateral
- What Happens if the Borrower Defaults
- Governing Law (e.g. Ohio)
Obviously this list is not exhaustive. But, for the most part your note should be clear, concise, and contain the relevant legal language that will lay out the terms of the loan and the responsibilities & liabilities of both Borrower and Lender.
Part 4: The Lien (Position and Priority)
The last piece in our private lending puzzle – for the purposes of this checklist at least – is your lien. There are a number of things to consider here. All liens are not created equal, and as this instrument acts as the entire security for your investment you need to make sure you understand it.
You will have either a mortgage deed, or deed of trust depending on which State the property is located in. For example, private lenders for my houses in Mississippi have a deed of trust, whilst those located in Pennsylvania have a mortgage deed.
There are broadly two things to consider; the position, and the priority of your lien. These might sound like they are the same thing, but they are not. You may have a 1st position lien, but there are other liens that can be recorded before or after making your loan that take priority over you in the case of a sale or foreclosure. I have seen this type of thing sink more than one real estate project, taking down the private lender with it!
You will have either 1st position or 2nd position lien recorded against the title of the property in the County records. A first position lien will usually take priority over all other liens in the case of a foreclosure. As a private lender you ALWAYS want to be in 1st position as 2nd position liens carry much more risk.
This can be tricky. There are certain types of lien; such as a property tax lien, or some types of contractor’s (mechanic’s) liens, that would take priority over your first position lien in a foreclosure, even if they were recorded after your lien.
Again, working with an experienced and competent Borrower is key. if they don’t keep up their property taxes for example, that could end up coming out of your pocket.
Ensure you have a 1st position lien recorded properly in the County records.
Be positive that the property is conveyed with clean title, and that you have title insurance in place.
Deal with Borrowers that are experienced and competent, with a demonstrable track record.
As I mentioned right at the start of this post, private lending can be a great way to invest in real estate. But, there is a lot to consider, and I have seen plenty of people lose money because they skipped some of the fundamental basics that I have included here.
If you want add passive monthly income to your portfolio, make sure that – over and above anything else – you buy into the Borrower. Whilst the real estate certainly matters, you are reliant upon the Borrower to execute their game plan, choose the right property, carry out the rehab, and market the property for sale or rent, or obtain a refinance loan to get you paid out in full and on time.