Our guest poster Elizabeth Martin introduces the concept of real estate private lending – an investment asset that has been yielding her 9-12% returns – and breaks down how it works and how one might get started.
I am continually impressed by the smart readers that have joined the Money Habit community. Today, I’m featuring a guest post from one such reader, Elizabeth Martin (pseudonym), who is a multi-millionaire retiree who has built a strong portfolio in real estate private lending to support her and her husband in retirement. This portfolio yields 9-12% returns and provides consistent cash flow, a critical feature in every retiree’s plan.
This is an idea I had heard about and was hoping to learn more about myself for our own portfolio. Elizabeth breaks down exactly how real estate private lending works, what it pays, and how to get started if you are interested. I’ll let her take it away.
My husband and I retired from techie jobs in San Francisco in October 2016 with a nest egg of just north of $6M. We accumulated that sum largely through real estate investments made over the previous 18 years, and now we travel around the country with our beloved dog staying in Airbnbs wherever the mood strikes us. We are not interested in living frugally, so my carefully crafted budget spreadsheet showed us needing approximately 5% return from our savings to be able to live off the income generated from our portfolio.
I spent the last quarter of 2016 and the first half of 2017 transitioning to income producing assets to achieve a steady income on which we could live stress free. Part of that process required crafting a well diversified asset portfolio that would weather any upcoming economic downturn. We invest in dividend producing stocks, bonds, single family and small multifamily real estate, as well as mortgage notes through private lending.
What Is Private Lending?
Most everyone is familiar with a typical mortgage relationship, wherein a bank lends cash to a homeowner for the purchase of or renovation of a property. In private lending, you are the lender rather than a bank. You put up the initial capital and earn interest and receive principal repayment on a schedule from the borrower just like the bank would. In secured private lending, your capital contribution is made safer by having a hard asset, like a piece of real estate, pledged as collateral against non-payment by the borrower. If the borrower stops paying you back, you can foreclose and receive the collateral in lieu of payment.
I discovered private lending by accident in 2015 after meeting a developer whose primary business was brokering the sale of long term (15 to 30 year) mortgage notes secured by owner-occupied single family homes in Texas. I purchased our first mortgage note in June 2016 for almost $95,000. The note earns 9.5% interest and is secured by a single family home in Dallas worth about $125,000. The borrowers are resident aliens who do not qualify for a “traditional” mortgage. The loan is serviced by a mortgage servicing company who collects payments from the borrower and automatically deposits the proceeds into our bank account every month, making it a totally hands off investment for us.
I quickly realized how easy, predictable and lucrative private lending could be, and over time expanded our portfolio so that about half of our current income comes from private lending. We lend to both long term owner occupied property borrowers and short term (less than 1 year) house flippers.
Parties Involved in Private Lending
While the two primary parties involved are straightforward – yourself as the lender and a homeowner or property developer as the borrower – you may find various other specialists involved in your transaction.
Broker: A broker is the intermediary between the borrower and the lender. In the case of long-term loans to consumers, often there is a mortgage company involved as well to deal with the extensive regulations. Because of these regulations, you do not want to get involved in making long-term loans to non-investor borrowers directly without a qualified mortgage company in the mix.
The broker will typically earn their fee from the borrower (in the case of newly originated loans) or the seller of the note (in the case of resales). I have not seen a situation where the lender pays any fees besides bank fees to wire money.
Attorneys: You should engage a real estate attorney to draft or review the contract. If you are working with a broker, they will have a standard set of documents for notes and deeds of trust (for newly originated loans) and for the bill of sale for the promissory note and first lien deed of trust (in the case of resales). If you are lending with partners via an LLC, the managing partner should provide an LLC operating agreement that details out the terms of the partnership. In all cases, you should have an attorney review the documents to ensure you are protected.
We use Anderson Business Advisors as our lawyers and have so far had a good experience. They handle all our LLCs, our management corporation, our land trusts, our living trusts, our retirement plan, and our taxes, so they do not charge us for occasional document review. It typically takes them about 10 days to review a document.
Loan Servicer: The loan servicer is the intermediary between the borrowers and you as the lender after the loan closes. They will collect borrower payments, ensure taxes and insurance are paid current, ACH payments to your account, typically perform the first 60 days of collections, and send out 1099s to both borrowers and lenders. They also serve as the conduit of information between the borrowers and you when there are payment concerns. Fees are typically paid by the borrower.
For long-term notes, we use August REI and have found them so far to be excellent. August REI is the loan servicer used by our long-term note broker and we have seen no reason to look elsewhere. For any long-term notes you purchase, the broker likely already has an existing loan servicer relationship you can leverage.
For short-term notes, loan servicing often is often performed by the broker with any fees paid by the borrower. As this arrangement is often more informal than using a mortgage servicing company, you will want to check that your broker is ensuring that property taxes and insurance are kept current and that there is a strong verification process that the construction is on track before releasing more of your money to the borrower.
Any Other Parties Involved To Make Private Lending Successful: For short-term loans where there is no broker involved because you are making a loan directly to an investor, you may employ additional people to ensure that construction milestones are achieved before you release additional funds. We currently have two such loans and pay our niece $100 to visit the construction site and take pictures before we will release funds for a construction draw. We have also found friends of friends who have been willing to go out to meet inspectors when we purchased properties out of state and could not attend. In absence of a personal connection in the future I might try Task Rabbit or a similar service.
Research and Best Practices
Before expanding our private lending holdings, I focused intently on risk mitigation, asking questions such as: What happens if the borrower stops paying? What is the worst case scenario? Will I be happy if we have to foreclose and take the asset?
My research led me to a 2006 whitepaper from the Mortgage Bankers Association that shows a detailed historical analysis of residential mortgages. I determined that the loans we were making were roughly analogous to sub-prime loans which, according to the whitepaper, have a historical default rate of about 6%. I would have preferred a more current analysis, but that was the best I could find, and it gave me a baseline. After additional research and conversations with experts, I came up with the following principles to guide our private lending practice. We lend by the following rules, and my hope is that by these principles I can further reduce the risk of a negative outcome:
- Only Lend In The First Position: When you have a first position loan, any subsequent loans made against the same collateral don’t collect anything until your interests are satisfied.
- Only Lend in States That Are “Lender Friendly”: Different states have different rules about when and how you can foreclose on a property. California is one of the worst, and I would never lend in that state. Texas is among the best allowing for foreclosure without going to court in certain cases.
- Don’t Loan More Than 80% of the Value of the Collateral Asset: Often we’ll lend far less than 80%. For some of our short term loans, we’ll lend a maximum of 65% of the after repaired value (ARV) of the property. For long term loans, the amount we’ll agree to lend depends on the quality of the borrowers.
- Only Loan On Assets We’d Be Happy to Own If It Came Down To It: I always, always research the property that serves as collateral to ensure that the value is accurately stated and that we could rent the property easily and for an amount that would be acceptable if we did need to foreclose.
- Lend Only to People We Feel Positive About: As the lender, we get to see the entire underwriting package that the loan originator receives from the borrowers, including bank statements, tax returns, pay stubs, etc. You know all that stuff you have to turn over to your mortgage broker when you apply for a home loan? As the lender, we have access to all of that. I will research the borrower’s employer, double check the validity of social security numbers, pore over bank statements to see how they spend their money, and look for social media accounts.
None of these long term loan borrowers are perfect – if they were perfect, they’d be getting a traditional mortgage at less than 5% interest – but I like to ensure that they are above board and telling the truth on their application. For short term loans I typically demand less financial information if I feel our contact has sufficient rigor in their vetting processes; however, I will still review criminal history and social media accounts as well as any other loan history I have access to.
- Employ At Least One Other Risk Mitigation Feature Because private lending is a private agreement, there can be all sorts of arrangements. For example, through one of our contacts, I’ll only make loans if the contact holds a second loan on the same property, so our contact is motivated to provide great quality loans because they also have an interest at stake. With another contact, short term loans are made through an LLC where we are co-invested with both the contact and his mother. Additionally, the contact resides near the properties and goes to check on them personally. I consider these loans among the safest in our portfolio.
- Have Our Lawyers Review Contracts When Working With New Contacts: Since each of our contacts does things a little differently, the first time we work with a new contact, we have our lawyers review the contracts in advance to ensure we are protected.
Short-Term vs Long-Term Loans
We currently have an equal mix of long term loans and short term loans. Long term loans are great for a self directed IRA or to provide steady, hassle free cashflow. I love that our long term loans are fully amortized which means that at the end of the loan term, the entire loan has been paid off. The best thing about fully amortized loans is that the earlier payments are mostly interest with just a little bit of principal. You may have noticed this on your own mortgage payments that you make to your bank. If our borrowers pay off their loans early – as most people do – our yield is actually larger than the interest rate on the note because the earlier payments are mostly interest.
I like short term loans for two main reasons. First, they are a great way to keep cash you need semi-liquid while still earning good money. For example, we need a lot of cash every December to pay property taxes on our portfolio of rental real estate. Rather than having the money sitting in a bank account, I prefer to have it in a series of short term loans that are due to be paid back between September and November. Second, we get the opportunity to make loans to the same people over and over again. My confidence is higher in a borrower who has already paid back a loan on time, and it requires less due diligence on my part to make another loan to that person.
How To Find Private Lending Opportunities
We currently work with three contacts and provide funds through them to the borrowers. Two of the contacts are developers or flippers from whom we’ve purchased property to own as rentals. I met our third contact at an investor retreat. Other ways to find people who place private capital include attending local real estate meetups, looking through the forums of Bigger Pockets, talking with turn key real estate providers, and talking to small independent mortgage servicers such as August REI to see if they have any notes that their clients are selling.
Most loans require a cash investment of at least $60,000 – remember, you are providing funds that the borrower will use to purchase and/or rehab a property.
Depending on your contacts, you might be able to purchase a fractional note (partial ownership) or co-invest with other investors to fund one loan. For example, one of our contacts offers fractional notes with a minimum investment of $20,000, and with another contact we co-invest with him and others to fund a loan with a minimum buy-in of $10,000.
If you are interested in getting your feet wet with a much smaller cash investment, you might consider a group like American Homeowner Preservation which maintains a fund that purchases non-performing home loans at a steep discount and works with the borrowers to restructure their loans to get back on track with payments. Strong disclaimer – this is not an endorsement of the company, as we just recently made a small exploratory investment in the AHP fund. Do your own due diligence before investing in anything!
Sample Loan Terms
For even more detail, I’ll share some specifics of a few of the loans we currently have in our portfolio so you can get a feel for the dollar amounts, yields, terms and variety of options. All returns are taxed at ordinary income rates.
Private lending may seem complicated at first glance, but it has many benefits that make the initial effort worthwhile. It has a great rate of return, requires little ongoing effort after funding a loan, and provides cash flow flexibility through mixing short and long term loans. It is an integral part of our retirement plan, providing regular, hassle-free income with high yield and security. I encourage you to review your portfolio and see how private lending might fit.
What are your thoughts on real estate private lending? Is it something you’ve considered before?
Optimize Your Portfolio
Could your portfolio benefit from more high-income investment ideas like Elizabeth’s? To figure out what your current allocation looks like and how an income-generating asset like real estate private loans could change your retirement trajectory or budget during retirement, I highly recommend signing up for Personal Capital’s free net worth and investment tracker.