Private lending is a great way to add passive income from real estate to your retirement account without owning rental properties. In this guide, you’ll learn everything you need to know to help to get you started.
My Experience With Private Lending
I am a real estate investor first and foremost. But, I have also been both a Borrower and a Lender. I have bought and sold performing and non-performing mortgages. I have loaned and borrowed money to and from other investors. I have ‘fixed and flipped’ houses, and I currently operate a rental property portfolio of 70+ properties.
Personally, I have partnered with private lenders on 100’s of real estate investments. The vast majority of my current portfolio has been funded by private lenders. This funding model works really well for me, my lenders, and the buyers & renters who now live in the homes I develop.
What’s in This Guide?
This guide is not exhaustive. It’s not intended to be. I’ve been in the game for 10 years and I’m still learning every day. What you will get however are the need-to-know fundamentals for anyone looking to add private lending investments to their portfolio or retirement account.
We’ll also analyse a real live deal I did recently using a private lender, show you how and where to find credible borrowers, and cover some important lessons that will help you avoid losing money right off the bat.
- What is Private Lending?
- Who Can be a Private Money Lender?
- Why do Real Estate Investors Use Private Money Loans?
- How are Private Lending Deals Structured?
- Is Private Lending a Good investment?
- How & Where to Find Your own Deals to Fund
- What is the Difference Between Hard Money and Private Money?
- Some of the Big Risks of Private Money Lending
What is Private Lending?
Real estate investors borrow money to acquire and/or rehab properties. Whether they are aiming to ‘fix and flip’ the home or keep it as a rental, they will need cash for the purchase price, closing costs and any renovation (rehab) work.
Private lending is essentially when a private individual takes the place of the bank in the real estate investment cycle. Whereas a bank normally lends to a Borrower in the form of a mortgage, in this case a private investor makes the loan to a real estate investor, and the loan is secured against a property.
For the RE investor, using borrowed money (leverage) in this way is what makes real estate investing so potentially profitable. For example, If you make a $30,000 profit on a $150,000 fix and flip project, but you only put in $30,000 of your own money and borrowed the rest, you just made a 100% gross profit.
For the Lender, this is a great ‘hands-off’ way to use your cash or retirement account to generate dependable monthly income at a great rate of interest whilst using real estate as security for your investment.
Related Content: The Essential Private Lenders Checklist
Who Can Be A Private Money Lender?
Anyone holding spare cash, either as after-tax savings, or in a retirement account such as a self-directed IRA or 401(k), can be a private lender.
If you have a large disposable income, say for example as a Doctor, Lawyer, CEO, Professional or Business Owner, or you have a good size retirement account, you should most definitely consider whether private lending fits with your overall investment strategy.
Reasons to Consider Private Lending
In my experience, these are some of the main reasons people get into private lending:
- Having a large investable, disposable income from your employment or a business (or both)
- Actively building your retirement account
- Already having built a large retirement account – especially a self-directed IRA or 401(k)
- To diversify your investment portfolio
- Needing more passive income – for example a retiree
- To profit from real estate, but you do not want to to buy/rehab/manage/sell properties
- Concern about the growing volatility associated with traditional financial markets, and the next recession
- Inheritance of a lump sum
- Specifically needing monthly income from your investments
If any of these apply to you, you might want consider an investment in private lending. Especially if you want to build a well-diversified portfolio that is not over-exposed to the stock market, or you need dependable, passive monthly income.
Why Do Real Estate Investors Use Private Money Loans?
Let’s start with the big picture view. It’s important to understand why real estate investors might use private money rather than a bank loan. After all, surely if it’s a good lending opportunity the bank would be first in line, right? After all, the interest rate from a bank will be way lower than from a private lender.
Well, not necessarily. Private money can be a great alternative to traditional institutional lending for real estate investors. It is accessible, fast, and often more flexible on terms than a bank or hard money lender would be.
In real estate, getting the best deal often means being able to close quickly. To do that you need fast cash. That’s where private money loans are extremely useful.
There are other reasons too. Sometimes, it’s difficult to obtain bank financing due to the loan size (under $75,000), or the borrower might not meet the strict requirements from the bank for proof of income or debt to income ratio. It might also suit the deal better. If the investor intends to flip the house then a 30-year bank loan is not really appropriate.
Related Content: 5 Ways Real Estate Investors Use Notes
Introducing the Jefferson Deal
Around 9 months ago I acquired a property our of a short sale. The original lender had an outstanding note of $60,000. They agreed to a significant discount for me to take the house if I was able to come up with the funds to cash them out and close within a week. I used private money to fund this deal.
It would have taken me far too long to acquire a bank loan, and most of my free cash was tied up in other deals. So, in this case I partnered with a private lender who put up all the cash for the purchase, closing and rehab. We were able to close the deal quickly, and got the house at a significant discount to market value.
I paid $45,000 plus costs for the house. It was appraised immediately after a few minor deferred maintenance repairs at $91,000. This was a great deal, and I was only able to execute due to my relationship with a private lender. The bank would have taken way to long to approve the deal.
Using a professional hard money lender would also have been difficult. I would have had to put much more of my own cash into the deal, the rate would not have been as good, and there would have been up to $3,000 in upfront fees.
I’ll use this deal as an example case study throughout this guide. We can use it to demonstrate how my own private lending deals are structured, and to assess profitability and risk for the Lender and the Borrower. From here on in let’s call it; The Jefferson Deal (because the house is located on Jefferson Street).
How are Private Lending Transactions Structured?
Much like any real estate loan agreement, private lending deals are structured with 2 parts; a promissory note and a lien.
The note is a contract between the lender and the borrower. It contains the terms of the loan, including the amount owed, term, maturity and interest rate. Also, the note should contain clauses defining rights and recourse for the lender in the event of late payments or a default and/or foreclosure.
The lien is recorded against the title of a property in the County records and acts as security for the loan.
The Jefferson Deal Structure
The terms of the Jefferson deal are as follows:
- Loan Amount: $50,000
- Property ARV: $91,000
- LTV: 55%
- Term: 60 months
- Interest Rate: 9%
- Points to Lender on Closing: 2
- Lien: 1st position
- Amortization: Interest Only
So for this particular deal, my private lender loaned me $50,000, which was enough to cover the purchase price of $45,000, closing costs of around $2,000, points of $750 and around $2,000 for some minor rehab to the property. I would be required to pick up the slack with my own money for anything else that came up during rehab .
The Lender has a 1st-position lien for $50,000 recorded against the property which has been independently appraised at $91,000.
This loan is interest only, so each monthly payment consists entirely of Interest. I make an interest payment on 15th of each month direct into my Lender’s self-directed IRA. We also included 2 points to the Lender on closing for this particular deal. That means the Lender received a further 2 percentage points of the loan amount upfront and paid out of closing.
After 60 months (or before) I am required to pay back the original loan amount ($50,000) in full. It’s a pretty simple transaction that works well for everyone provided we all play our part well. Again, I’ll cover some of the specific risks you should be aware of later.
Related Content: An Investors Guide to Lien Position and Priority
Is Private Lending a Good Investment?
As I mentioned right at the start of this 101, I have been both a Borrower and a Lender in private money loan agreements. As a Lender, I have had deals go bad. Despite the loans being recorded against property it IS very possible to lose money in private lending and note investing.
As a Borrower I have well over 100 transactions under my belt. I have never defaulted, or even been late with a payment. In my experience, provided deals are well structured private lending tends to work our pretty well for both parties.
Let’s take a closer look at the Jefferson deal as an example of the kind of return on investment both the Lender & Borrower might expect from this kind of deal.
How it Worked for me as the Borrower
For me, this deal has been great. I paid around $50,000 all-in to acquire a property now worth $91,000. I have already sold the property to my tenant on our rent-to-buy program.
I have already taking a significant deposit from the buyer, and by the time they get a mortgage and close I will end up with the full $91,000. My Lender will be paid back their $50,000 direct out of closing, so that’s a gross profit to me of about $41,000 (less closing costs and any interest I paid to the Lender).
On top of that, I also make a positive cash flow of about $175 per month from the buyers rent-to-buy payments. This is after paying loan interest, property taxes, insurance, management and a reserve for repairs and maintenance.
What a deal! ZERO of my own money in the deal, $175 per month in net cashflow, and $41,000 gross profit!
How it Worked for my Private Lender
From my Lender’s perspective, the deal has been running a while now. It’s 9 months in and they have collected a total of $4,125 in interest (including points).
As a comparison; during the same time period (August 2019 to May 2020), the Dow Jones fell from 25,579 to 24,221. A loss of 5.3% (or -$2,650 on a $50,000 investment).
If the Jefferson deal runs the full 60-month term (unlikely), here’s how it will break down for the Lender:
- Total Return: $73,250
- Net Profit: $23,250(tax free/deferred in this case)
- Total Net Return: 46.5%
- Simple Annualized Return: 9.3%
If the buyer closes before the 60 months is up, the Lender’s annualized ROI will actually be slightly higher. I would say that’s a pretty good investment.
The Lender also has some peace of mind. They hear from me every month with an update on our overall business and portfolio, and they know they can pick up the phone and speak to me at any time.
Where to Find Private Lending Deals?
Most private lenders know their Borrowers. It is not uncommon for family, friends or business associates to lend to someone to fund a real estate investment where they already know and trust that person. In fact, that’s where many private lenders (and real estate investors) start.
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. here are some starting points:
Real Estate Networking Groups
Most real estate investors would welcome relationships with new private lenders, and so networking at a local level can produce some good leads. That way, you get to meet your potential borrower face to face. Bad reputations tend to stick in those communities, so bad apples float to the surface pretty quickly.
You can find plenty of these groups using social media platforms such as Facebook, or just search online using a search engine like Google or Bing.
Third Party Advisers
There are a ton of investment companies that act as third parties, matching private lenders with real estate investors. This includes real estate investment companies, self-directed IRA and 401(k) investment advisers, CPAs, and financial advisers. I have used third party advisers to introduce me to private lenders before. It can work pretty well, but from the Borrower’s perspective there can be hefty introduction fees to pay.
The cost to the Borrower of going through a third party adviser ranges from 3% to 10% of the loan amount. Now I’m certainly not saying that is unjustified. In many cases, advisers have a high cost base. It costs a lot of marketing dollars to generate relationships with potential Lenders. But, taking that kind of money out of the transaction comes out of my bottom line, and it can turn some deals upside down – especially on lower value properties.
Direct to Borrower
There are opportunities to connect with borrowers directly. In my experience, having a direct relationship between Borrower and Lender is the best way to go about the private lending business. You’ll find that is what really counts if and when things don’t go to plan.
In many cases, I have seen third party advisers disappear into the mist when a Borrower they have introduced defaults, or a deal goes bad. If you have no line of communication with your Borrower, it’s going to be an uphill struggle from day one to get things sorted
What is the Difference Between Private Money and Hard Money?
The difference between hard money and private money is that hard money lenders are professional lenders. Private money lenders tend to be private individuals making personal investments.
Hard Money is Professional but Expensive
Hard money is so-called because it is the kind of funding that is traditionally hard to access. It’s quick cash, readily available to fund real estate deals, much like private money.
Hard money lenders tend to be businesses with the sole purpose of making short term loans to real estate investors. With that in mind, hard money tends to be be more expensive than private money. This is largely down to the fact that the hard money man has his own investors to pay, overheads to cover, and profits to make. He must also factor in losses for any deals that might go bad.
I have paid up to 15% interest on hard money loans, plus upfront fees of up to $3,000 per loan. Now, when you’re dealing with sub $100k houses like I do, the funding requirement can be as low as $30,000, so those kinds of fees make a serious dent and can wipe out the profit from a deal before you’ve even started. Hard money loans are also always short term. 3 to 12 months is typical.
Private Money is Cheaper and More Flexible
I pay between 8% and 10% on my private money loans direct to my Lenders, with no upfront fees apart from the occasional points here or there (such as with the Jefferson deal). That’s a way better deal for me than hard money.
I can also negotiate terms with private lenders that are specific to the deal. This might include points, term, interest rate, and equity share. Due to my existing relationships I can also access private money just as fast (if not faster) than hard money. I can pick up the phone and find someone to fund a deal same day if needed.
What are the Risks of Private Lending?
You are totally forgiven if you feel that this guide promotes private lending as a good investment. You’re right, I certainly do promote it as such. It has worked well for me despite some losses along the way. Note investing gave me my first exposure to the real estate market, and our private lending model has allowed me to build a portfolio of over 70 rental properties.
All that said, there is certainly risk involved in private lending. As I have alluded to, I have lost money, and seen other investors suffer the same fate. I’ll use this last section to tell you a real life horror story, and lay out some ground rules that will give you a good head start in avoiding some of the mistakes I (and others) have made in the past.
Related Content: A Guide to Credit Risk for Private Lenders
The $10 Million Dollar Ponzi Scheme
The first time I saw private lenders burn their fingers was back in 2016. A real estate investor based out of Portland, Oregon owned some 300 rental properties. Most of them were C-Class single family homes in tough neighborhoods. The vast majority were located in Jackson, MS, the State capital of the poorest State in the Union.
This guy had used private lenders to fund all of his properties. So, if you imagine an average loan amount of about $35,000 – he would have had approximately $10 million in private debt.
Now, admittedly these kinds of low grade properties can be difficult to manage. Often they are in poor condition, and the are not that many good tenants in these kinds of neighborhoods. That said, they can also be very profitable if you put the work in and manage them well.
Well, this guy didn’t do that. Despite starting out well enough, eventually he got greedy and failed to do any rehab. Property taxes were never paid, and the houses were never rented. He just used funds from the next Lender to fund interest payments on existing loans.
This ended up being nothing short of a ponzi scheme. Eventually it collapsed as money from new Lenders dried up. Most of the properties were lost in tax sales, and the Lender’s lost everything.
I know all this because, not only was I one of the Lenders, but I also referred many of my own investors to this guy. It was a nightmare, but it taught me some very valuable lessons that I carry to this day.
10 Ways to Lose Money
Here are ten real life reasons I have seen private lending deals fall apart and the Lender lose some – or all – of their investment. You will note that the majority are due to incompetence, bad luck or willful fraud on the part of the Borrower:
- Failing to pay property taxes
- Not rehabbing to a good standard – or at all!
- Houses with severe underlying mechanical issues such as foundation work
- Failing to properly record liens
- Not ensuring clean title, or no title insurance
- Being unable to sell/refinance
- Borrower going AWOL or collapsing financially
- Rehabs running hugely over budget
- Not being named Loss Payee on insurance
- Market conditions suppressing resales
Related Content: How I Lost 80 Per cent of my Money on a Private Lending Investment
All things considered, I think private lending is a great way to invest in real estate. Especially if you want more passive income, and you’d rather not involve yourself in the day-to-day stress, time and costs of actual real estate ownership and/or construction.
Remember, it is not a ticket to instant riches. In fact, private lending will not make you rich. But a few well-placed investments with a quality Borrower(s) will earn you a solid and dependable passive monthly income, as well as add valuable diversification to your portfolio or retirement account.
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