Most real estate investments come in the form of debt or equity. In this article we will discuss investing in real estate debt by becoming a private lender, and weather it is the right investment strategy for you.
Purchasing Real Estate
When real estate is purchased, the transaction is usually financed through a mixture of debt or equity.
A buyer will typically use cash to make a down payment on the property (25% of the purchase price is pretty standard). The remainder (75%) is financed using a loan (mortgage) from the bank, or other financial institution, that will paid off over a number of years and have either a fixed or variable interest rate.
However, the loan doesn’t always have to come from a bank or financial institution. Private lenders can provide the up to 100%, or more, of the financing to purchase a property.
Why Use Private Money?
In most cases, banks and other financial intuitions have strict lending guidelines, and not all properties will meet their criteria. However, private lenders have their own investment criteria, and can be more flexible than a bank.
Plus, cash offers are more favorable to sellers than traditional financing. Sellers know that a cash buyer will have a 100% chance of closing, and they don’t have to risk the bank not approving a loan. Also, sellers won’t have to wait 30 to 60 days for the buyer to have a loan approved. For these reasons, having cash ready from a private lender allows buyers to move quickly and negotiate more favorable terms with sellers.
Also, there are times when the real estate entrepreneur might have the maximum amount of loans that a traditional lender will allow. At that point, private money loans may be their only option.
A real estate entrepreneur finds a seller that has to sell their property quickly because they are behind on their mortgage payments and risk foreclousure. They don’t have the luxury of waiting 30-60 days for a buyer to be approved for a loan. In exchange for paying cash, the seller is willing to sell their property below market value.
The buyer wins the deal because they have a relationship with a private money lender and can quickly come to the closing table with cash.
After the buyer renovates the property, they have it reappraised, and refinance the property using traditional bank financing, and pay off the original private money loan with the proceeds.
Becoming a Private Lender
By choosing to become a private lender, you will replace the bank in a transaction in most cases. In other cases you will become a supplement to traditional financing, and the proceeds from the loan you provide will go towards a down payment or be used to renovate a property.
The loan you provide to a real estate entrepreneur will be secured by the property, also known as collateral. The loan will have a specified length and interest rate. Many private money loans have interest-only payments that are paid on a monthly, quarterly, or semi-annual basis. At the end, there will be a balloon payment that returns the lender’s principal. The balloon is usually paid using the proceeds from the sale or refinancing of the property.
However, private money loan terms can be structured in whatever way the lender and borrower agree makes sense.
Continuing the previous example, you are the private money lender.
You provide the buyer of the property with a loan of $100,000, which represents 100% of the purchase price of the property. You and the buyer agree to the following terms:
Length: 3 years
Interest Rate: 8%
Payment Interval: Quarterly.
This means that you will be paid $2,000 on a quarterly basis, totaling $8,000 ($100,000 x 8%) anuually for 3 years. At the end of the loan you will receive your $100,000 back in full.
Advantages & Disadvantages of Being a Private Lender
- Loan is secured by the property purchased.
- Income is passive, stable, and predictable.
- Higher returns than typical savings accounts and CDs at the bank.
- Loans are typically short-term.
- Loans are typically not as liquid as cash, stocks, and bonds.
- Unlike investing in equity, loans don’t have any appreciation component to them. (If the property performs on a high level, the lender does not benefit from the upside.)
- The short-term nature of these loans will require you to continually find new projects to invest your capital.
Who Should Consider Becoming a Private Lender?
Private lending is a great fit for investors with large amounts of capital who are looking for a stable and steady stream of income, and don’t want to deal with the hassle of managing rental real estate, or the risks that come with being an equity investor.
This strategy is also well suited for investors with large amounts of money in retirement accounts and want to diversify their portfolio outside of traditional assets such as stocks and bonds. A portion of these retirement accounts can be self-directed and used for private money lending. Interest received from loans in self-directed retirement accounts are 100% tax free.
Babylon Property Group, LLC provides private investment opportunities for qualified investors looking to diversify their portfolio outside of traditional assets found in typical 401(k) and IRA plans. For a FREE consultation, please fill out our investor questionnaire, or contact us directly by phone at (631) 253-1609 or email at email@example.com.