In every investment, there are risks involved. Working with a real estate investor who is knowledgeable in mitigating those risks is essential to success as a private lender.
These days, we hear a lot about “bending the curve” downward and mitigation practices. In real estate lending, the concept is no different.
If you are considering becoming a private lender in residential real estate, I believe the number one quality to look for when lending to a real estate investor is integrity. Will he or she keep their word? Is everything they do legally, morally and ethically above board? In my 25+ years of investing, I’ve always paid my private lenders in good times and bad, so I think integrity is of the utmost importance. A background check on the real estate investor and a request for reference letters is not out of the question.
The next thing to look for is an analysis of the property itself. A knowledgeable real estate investor will always keep the loan to value (LTV) of the property at no more than 70%.
For example, if an investor wants to borrow $70,000 from you for a rental property or flip, then the house needs to be worth at least $100,000 after it has been renovated. This is done by confirming similar home sales in the area over a period of 9-12 months. The reason for this is to ensure you have a “risk cushion” of 30% at all times.
Here is the next crucial step in mitigating your risk… always, always, ALWAYS close the purchase of the property with a reputable Title company. They will insure there are no title issues, and in fact will not close if they cannot guarantee a clean title. This protects you from any potential claims to the property in the future. If a claim does come up, it’s the Title company’s responsibility to protest and negate the claim. And when it comes time to close, you will want to wire funds directly to the Title company, especially if you’re working with a real estate investor for the first time.
Another component of mitigating risk is insurance. Before closing, it is essential to have the property insured for (at least) the amount of your loan, preferably indicating you as Mortgagee or “Party of Interest”. I always request a “Fire Only” policy so in the unfortunate event of a fire, I would be able to repay my lender through an insurance claim. This step is the responsibility of the real estate investor. You can also request a Mortgagee Policy for you as the lender. This gives you even more protection on your loan.
The final piece of this mitigation process is obtaining legal documents that secure your interest in the property. Always insist on receiving a Deed of Trust and Real Estate Lien (Promissory) Note which shows a legal description of the property, funds loaned, terms, etc. These documents will need to be recorded at the county courthouse in which the property resides, and they ensure you are in a position to take back possession of the property through foreclosure if need be. Although a prolonged and uncomfortable process, foreclosure at least gives you the option to take over the property and sell it at market value to recoup your loaned funds. Remember the 30% “risk cushion”?
So, after closing you should insist on receiving copies of the following:
• Recorded Deed of Trust
• Real Estate Lien Note signed by the real estate investor
• Insurance Declarations page on the property showing you as the Mortgagee
• Amortization Schedule (if the loan is amortized)
As in any investment, it’s always wise to do your “due diligence” before parting with your money.
But unlike the stock market, at least investing in real estate gives you a tangible asset you can see and appreciate. Another way to look at it is this… money invested in stocks can be worthless if the company offering the stock goes bankrupt. At least with real estate, the value will never go to zero. You will always have some value to work with, in good times and bad.
All of the suggestions I have outlined in this post are exactly what I use with my private lenders and are of the utmost importance if you want to “flatten” your lending risk curve.
If you are ready to become a private lender in residential real estate, please call me. We have several opportunities available for you to earn a safe, consistent 10% on your money. ~ Samuel Madrid (210) 228-8023
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