Private Lending: An Option for the Passive Investor
By Christopher Levarek
“Real estate is an imperishable asset, ever increasing in value. It is the most solid security that human ingenuity has devised. It is the basis of all security and about the only indestructible security.”
- Russell Sage
Investing with knowledge is about understanding options and acting on those options. Expanding the tool belt of techniques and strategies to achieve investment goals should be a constant aim. One such option for investing is private lending. Private lending can be explained as the act of lending private capital or money to an organization or person with a specified rate of return in specified amount of time with or without collateral of some kind. Today we would like to explain the basics of private lending in real estate and how it might be a worthwhile method of investing for the new or even experienced investor
Why Private Lending
Every investor should have a defined set of goals or motivations behind their investments. These goals are the driving force behind the investment choices of the investor. Aligning investment options with the overall desired goals will achieve maximum results, see our recent blog post Investing with Why, What and How on defining goals.
Private lending closely aligns with the investor looking to play a more passive role in the investment project. By lending capital, the investor is guaranteed a specific rate of return with an exact timeline and acts as the cash provider with little action expected beyond capital funding.
This can be very appealing to those investors who have full-time jobs, additional ongoing business ventures or even for retired individuals looking to for additional streams of income to supplement retirement goals. The passive investor in a private lender arrangement gets a better rate of return then the stock market might offer with a well proven product, real estate. The security behind real estate as an asset class, makes investing as a private lender highly proven, reliable and effective.
Although there are many methods of lending money with a variety of terms, we will cover two basic or common ways to structure private loans, with or without collateral. In each case, it is up to the investor/project operator to determine which works best for the real estate investment project for both parties.
Private Lending with Collateral
Collateralized debt is when money is lent for a real estate venture or project which is backed by some sort of collateral. This is easily visible in everyday through car loans. In a car loan, the bank keeps the car title until the loan is paid off, so as to have a guarantee of being able to recover the owed loan amount if the borrower should default on the loan. This is lending with collateral.
This same structured loan applies with private lending on real estate. Two types of documents are usually present in a private lender loan on real estate with collateral, a promissory note and deed of trust. Both of these documents should be defined or established with the help of an attorney as a third party.
A promissory note is an agreement on paper between private lender and borrower expressing the details of the arrangement. Usually, this document will include the names of the lender, borrower, the amount borrowed, the rate or payment terms and timeline of the loan.
A deed of trust is a legal document with property description of the real estate property signed at closing, usually notarized, stating that there exists a lien on the property or private loan between borrower and private lender. This allows the private lender to have a position or ownership on the property, requiring the private loan to be paid according to promissory note terms, at sale or refinance of property.
The following is an example of how a private loan on real estate might be structured:
Joe the contractor is purchasing a property with the intent to rehab/renovate the property and resell in under 12 months. Mary the investor, recently received an inheritance of $150,000 and is looking to achieve a better return than the 1-2% of her savings account or traditional stock market returns. She also wants her investment to be something she can understand or see with her own eyes. Joe meets Mary at a local real estate meet-up and presents the following to her:
Joes Investment Project:
· Home Purchase Price of Example Property : $150,000
· Estimated Rehab costs $30,000
· Estimated After Repair Value(ARV) $245,000
Joes Investment Proposal:
· Private Loan of $150,000 at 9% annualized return over 12 months in a Promissory Note
· Deed of Trust with Property name and details – Notarized, signed and validated at closing.
In this example above, Mary is happy because she gets a good return and has a legal document providing collateral should the borrower, Joe, default on the loan. Mary can utilize the “Deed of Trust” and “Promissory Note” to claim ownership of the property and recover her capital if necessary. Joe is happy because he did not have to work with difficult bank terms/deadlines/requirements or hard money lender high interest rates/points.
Private Lending without Collateral
Uncollateralized debt is when money is lent without any backing piece of collateral guaranteeing the value of the lent amount. This is easily visible in everyday through credit card lending. Credit cards are a prime example of money lent or spent by individuals at defined rates without any collateral required by the credit card company.
With real estate, the private lender and borrower would again define a “promissory note” detailing the terms, payment plan and structure of the private loan. This time however, only the promissory note would be necessary and the transaction is much easier to complete as less paperwork is needed at closing. Uncollateralized debt in real estate is usually found between parties with existing trust and/or relationships, friends and family or close partners. In the same example as previously discussed, an uncollateralized proposal would look like:
Joes Investment Project:
· Home Purchase Price of Example Property : $150,000
· Estimated Rehab costs $30,000
· Estimated After Repair Value(ARV) $245,000
Joes Investment Proposal:
- Private Loan of $150,000 at 9% annualized return over 12 months in a Promissory Note
In both cases, the funds would usually be transferred to a escrow account held by the title company or closing attorney and then paid to seller of the property at closing. Upon repayment of the private loan through a sale or refinance of the property, the lender will simply provide a dated signature on the existing promissory note/deed of trust with a “Paid in Full” stated and provide to the borrower for record of repayment.
In Final
Private lending is a great option for adding an additional stream of income or investment asset to a portfolio. Whether investing with collateral or without collateral, we recommend working with organizations or people you trust first. Look for individuals or organizations with a clear purpose that aligns with your goals and do your research to ensure you understand the roles, terms and expectations. As always, Invest Smart!