Disadvantages, Potential and Idle Opportunities

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More and more real estate investors are exploring what the other side of the closing table might look like. I don’t mean to be a seller, but a lender. With interest rates rising, you can easily earn double-digit interest rates by funding or buying short-term notes.

Imagine investing in real estate where you don’t have to manage rehab, sign personal guarantees, or deal with tenants. And if things go wrong, someone other than you loses their money before you lose your dollars. Sounds great, doesn’t it?

So, what exactly do you think about becoming a lender? How can you lend money? How do people lose money lending? And finally, is there a way to become a passive lender so you can sit back and earn passive income from active real estate investors?

I’ve done over $500 million in lending over the past five years as a leader Aloha Capital, a nationwide lender focused on financing residential investment properties. At BPCON22 in San Diego, I had a lot of conversations with members of the BiggerPockets community, where they mentioned sitting on significant cash reserves that weren’t getting reinvested in their next deal – why? Because their ideal profit or cash flow from their fix and flip, BRRRR, or turnkey rental strategy was no longer attainable in the markets they were investing in. Not knowing when they would get their next deal, many were excited to find out how to keep up. their capital to act as a passive private lender.

Can you generate double digit returns as a lender? yes of course. Can You Lose Money as a Lender? You definitely can! In this article, we’ll unpack what it takes to become a lender, including:

• passive vs active lending
• how do lenders make money
• how lenders lose money

let’s get started.

passive vs active lending

I can tell you firsthand that private lending is far from passable if you’re doing it right.

You must locate qualified borrowers and acceptable deals that meet your criteria, offer competitive terms, then underwrite the borrower’s experience, liquidity and creditworthiness. Along with the detailed rehab budget, you will also need to underwrite the As-is Value (AIV) and After Repair Value (ARV) to ensure that the project has a reasonable profit margin to make money for the borrower or if it If the rental is out, the property will likely cash flow with a rate/term refinance.

It is just the beginning. Before you fund the loan, you need to ensure that the title insurance policy and property insurance minimize the risk to you as the lender and then produce loan documents that include the terms and conditions within state-specific compliance requirements. All commercial terms and lender protections are included.

Now that the loan is funded, you must ensure that the repossession timeline is being met and possibly send additional funds to the borrower to cover costs. Along the way, you have to keep track of the borrower and collect interest from him.

Alternatively, there are opportunities to lend passively by investing in real estate notes or in real estate loan funds managed by a professional investment property lending business. It gives you access to annualized returns, similar to what you would get through direct personal lending, while reaping passive investment benefits by tapping into the lender’s operational infrastructure, expertise and deal flow.

For example, Aloha Capital has 20+ full-time employees, all with backgrounds in real estate lending and investing, focused on loan finding, underwriting, origination and servicing. Aloha gives investors access to 8 to 14% returns from real estate notes Aloha Passive Note Platformwhere passive investors can select an already underwritten and originated note, purchase it, and relax while Aloha Capital services the loan.

In addition, investors can get access to a diversified portfolio of short-term loans through Aloha Limited Income Fund, which has an 8% annualized return target, no lockup period, and a 7-year track record. In addition, there are other opportunities to gain exposure to note investing, such as crowdfunding platforms where you can own a fraction of a note and private lender matchmakers that broker borrowers who need loans and are interested in private lending. People are private persons.

how do lenders make money

If you have the capital, lending is a great way to make high returns. Lenders that provide short-term loans on investment properties can earn loan origination fees of 0%-3% as well as interest of up to 8%-15% annually. In addition, if the loan exceeds maturity, you may be charged an extension fee, and if the loan goes into default, you may be charged a default interest of 20% or more annually (the actual maximum rate depends on the state). usury depends on the laws).

While this is a large range, in the current real estate climate, a double-digit annualized return in the first position with the borrower holding equity in the transaction is fairly standard.

For clarity, a first position or lien is secured by the underlying collateral in the case of real estate lending to the subject property. This means that if the borrower defaults on your loan, you, as the lender, can seize the collateral to recoup your capital and unpaid interest through foreclosure. If you are a junior lender, you are not able to foreclose, and the principal amount of your loan is only available once the lender in the first position has been paid in full. Although you may earn a slightly higher interest rate as a junior lender, you are substantially increasing your risk of loss of principal if the borrower ever defaults.

how lenders lose money

We’ve talked about making money as a lender. Now, let’s discuss how not to lose your money.

As the lender, ideally with a first position lien, you create a promissory note that is collateralized by an asset through a security instrument (usually a mortgage or deed of trust), and ideally, this The loan consists of a personal guarantee of payment from the guarantor(s).

So how do you lose money as a lender? Here are the top three ways:

1. Not being in the first place

Sometimes, borrowers are unable to execute their plans to rehab, sell or rent a property. Or situations arise where they are not able to cover the debt service, or their rehab budget is not high enough. In this case, the lender in the first instance will take action to ensure that they recover all or most of their capital through foreclosure, a deed in lieu of foreclosure, forbearance, or some other method.

If you are not the first lender in this scenario, you are the junior lender, and you have two options to choose from:

• Pay the first position lender in full, including principal, outstanding interest and default interest, to become the first position lender.
• Be prepared to lose some or all of your principal. Why? Because default interest, extension fees, and legal fees add up quickly, and the lender in the first place gets paid in full first!

2. Lending to borrowers with limited experience, low credit, or insufficient liquidity

I believe these are the three primary factors that increase the risk of loan delinquency and default. You should look for borrowers who meet your standards in two of these three categories. If they only qualify in one category, you will need an additional guarantor that meets your requirements or a pass on financing the deal!

3. Ignoring the Borrower’s Exit Strategy

Ideally, as a lender, you understand the dynamics of the market in which you are lending and the borrower’s exit strategy. If you are not adjusting your rate, fees and leverage based on the loan exit options available to the borrower, you may be setting yourself up to lose money. If the property needs to be rented out rather than sold, will the property cash flow with your loan or will the borrower be able to refinance into another loan? If you don’t know, don’t fund it!

conclusion

Finally, anyone can be a private lender if they have access to capital. But seeking returns from private borrowing without actively avoiding losses can lead to losses rather than gains.

Like most real estate strategies, you can be a passive or an active lender. I hope this provides some perspective on how passive lending with the right lending partner provides a great combination of income and risk mitigation. If you go it alone, I hope you consider three ways to avoid losing money before making your first trade.

Note by BiggerPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.