Private Money Real Estate Loans: An Overview of Good Reasons
Dan Harkey, at DanHarkey.com writes great articles about real estate on his website. You can read more articles by visiting his website. In this article, he discusses “Private Money Real Estate Loans”
A subset of the real estate lending business exists where the loans are funded by private party investors rather than banks or other institutional lenders. This is referred to as bridge lending, private party lending, or hard money lending. The purpose of these privately funded loans is to serve as a short-term or intermediate term borrowing solution for problematic borrowers and/or property related deficiencies. Borrowers who experience problems such as unexpected bank declines, not having the time for long and drawn-out complex banking processing and underwriting requirements, poor or marginal credit qualifications, needed property upgrades, paying off judgements and liens, curing defaulted payments arrearages may now have an excellent alternative lending solution. This solution will solve their immediate problem and allow them time for future planning such as property refinancing into a longer-term lower interest rate loan or sale of the property. The term of these loans is usually for a period of 1 to 10 years.
Most privately funded loans are made and/or arranged by real estate and mortgage brokers who represent private party investors and act as their agent and fiduciary. Private party investors are also called lender/beneficiaries because their names are placed on the promissory note and recorded deed of trust as the lender/beneficiary. The Borrower will sign a promissory note which as a promise to pay and sign a deed of trust which is recorded with the closing of the loan transaction. Possessing a signed and recording deed of trust by an investor proves that he/she has a security interest as a matter of public record in the subject collateral property.
Purpose of this article: This article is meant to be a general educational overview of the private party lending industry and to list circumstances why real estate borrowers may benefit from these loans. This overview is not intended as a solicitation for loans.
Licensing: Most states require both state and federal lender licenses for single family consumer lending of 1-to-4 residential units, both owner and non-owner occupied. Many states do not require a license for 1-to-4-unit business purpose lending. A few states require a license for all lending activity. Licensing fees make an excellent money grab for state governments as an alternative to forced taxation. Many states do not require a license to make loans on 5 or more residential income units, commercial, industrial, and land loans. For all types of properties other than single family 1-to-4 units licensing and regulations to engage in the business of procuring loans with the expectation of compensation will differ in each state. Also, this will depend on the type of real estate, purpose of loan, use of loan proceeds, use of the property, location, and conformity to zoning and building regulations.
Generally, the real property lending industry is governed by both federal and state real estate laws, contract laws, agency laws, securities laws, and in some cased Department of Labor laws. Department of Labor laws are involved for pension plan related trust deed investors who are governed under The Employee Retirement Income Security Act of 1974 (ERISA). Individual Retirement Account (IRA) related investors are governed by the Internal Revenue Service. Most of the laws governing what a plan trustee or plan fiduciary may or may not do of mirror each other.
California regulatory oversight for the private money lending industry: California has a long history of real property transactional regulations affecting private money lending, including a required real estate license by the state for all individuals who engage in the business of making or arranging loan transactions with the expectation of compensation. Additional state regulations apply for contract laws, real estate laws, trust accounting, and agency relationships. For personal property that is attached to the real property and noticing of the lien the Uniform Commercial Code (UCC) applies. There are also state required disclosures for both the borrower(s) and trust deed investor(s) which is the responsibility of the procuring mortgage broker to complete and get signed by the respective parties.
The reason for pointing all the regulations out is to remind people that the business of making and arranging privately funded real estate loans is highly regulated. Many states outside California have fewer regulations, and some states have little or no regulations.
The private party lending industry has separate underwriting guidelines in almost all cases and a less rigid process than institutional or bank lenders. Standards for analyzing the borrower(s), credit, income, and value of the collateral property is more flexible. Whether considering government regulations, stricter bank underwriting, borrowers’ special circumstances, or COVID-19 related business interruptions and personal life disruptions the private money lending industry provides a substantially more flexible option that is currently in high demand. This demand will only rise in the future as interest rates start to creep up because of inflationary pressures and/or institutional lenders underwriting tightens up or they decide to delay all lending altogether.
Borrowers: Real estate borrowers will always choose the lowest interest rates and most favorable terms for their own circumstance. And they should! But banks, institutional lenders, and government sponsored entity lenders (GSEs) who have the lowest interest rates and best terms will also have a much more rigid underwriting and approval processes that limit, delay, or possibly kill many loan approvals. Interested borrowers who expect those great low rates with banks must be ready for a seemingly endless maze of paperwork demands and ready for frustration that they will experience in the seemingly endless and unclear drawn-out processes.
Trust deed investors are investing in securities: Private party Investors who make the decision to invest in real estate loan(s) are investing in the purchase and ownership of a promissory note and secured by a recorded trust deed or mortgage secured on one or more pieces of collateral property(s). The ownership of a trust deed investment is a form of personal property ownership rather than real property and is considered as a security. A promissory note and deed of trust is defined as a security under federal and state law under the Securities Act of 1933 because the documentation represents evidence of indebtedness. A security is defined as 1) Property that is given or pledged to guarantee the performance of an obligation. 2) An instrument that functions as proof of a security interest in a public or private body. One may review the legal definition online of a security under Section 2(a)(1) of the Securities act of 1933 if desired.
Deed of trust and mortgage Investments are securities: A mortgage broker who offers trust deed(s) or mortgage investments to the public must be aware of the federal and state securities exemptions and safe harbor rules. Various federal securities exemptions from registration are commonly used to comply with federal securities laws. Federal exemptions for privately funded real estate loan transactions and real estate loan related pooled investors are usually found in Regulation D, Regulation A, Rule 147 and 147A of the Securities and Exchange Commission Rules. Exemptions and definitions can be found on www.sec.gov<https://danharkey.
On the California state level for securities, the Corporations Commissioner’s Rules covers the offer and sale of certain securities such as trust deed investments. There are several exemptions from registration. These include the private offering exemption 25102, specifically safe harbor rules contained in 25102(e) (f) (n), 25113, and 25102.5. The fractional note exemption 25102.5 covers multiple investors up to 10 investors (lenders/beneficiaries). Under the 25102.5 exemption a maximum of 10 private investors can co-invest into a single trust deed as tenants-in-common. The fractional note exemption rules are defined in the Business & Professions Code 10237-10238, 10232., and Civil Code 2941.9. Interested parties should consult a real estate or securities lawyer specialist.
The investor’s individual beneficial interest portion of ownership would be represented by the percentage of the entire trust deed that they own. For example, if the trust deed investment was for $1,000,000 and the investor purchased $200,000 then they would own a 20% undivided interest as tenants-in-common. He/she would rely upon the loan servicing company to collect the payments from the borrow then forward percentage of the total to each individual investor. This process is subject to a well drafted servicing agreement between the loan servicer or collection agent and the investor. The investor will give or convey a certain number of delegated responsibilities/rights to carry out the payment collection function as an agent/fiduciary until the loan is paid off and a reconveyance is issued.
Private party investors may invest individually or into pooled type of entities with other investors. Private party investors include, individuals, family trusts, corporations, IRAs, and pension plans and family offices.
- Here is a partial list of reasons that private lending industry participants have suggested as to why private loan transactions could benefit borrowers.
- Fast Loan approval with possible 2-to-4-day funding for bank declines and fallouts. Maybe the bank has already done significant underwriting including opening escrow & title, obtained an independent appraisal, and completed application and financials. Some private lenders may be able to use bank’s information to fund faster, particularly when they have a mortgage pool or immediate capital available to fund.
- Debt consolidations of businesses, consumers, or a combination of both. In most cases, the loan may be used for debt consolidation that will lower the borrower’s total monthly payment obligations. Also, when the loan is a second deed of trust the averaging of the interest rate on the first and the second may be calculated to show net-effective rate. This is the averaging of the two rates. This should give the borrower some breathing room to improve his/her credit to then obtain a long-term bank loan.
- Payoff loans coming due or past due. Refinance and payoff existing first, second, and third lien position loans which may be coming due. This is available for both owner and non-owner occupied residential and commercial properties.
- Borrow money secured by the real estate with the intention to get cash out. The primary security is the based upon the protective equity of existing real estate. The cash out may be used for most business and consumer purposes. The Federal Government and some states such as California require a special license to engage in consumer purpose lending.
- Second lien position or junior lien loans on both owner and non-owner-occupied dwellings for business purpose.
- Construction completion, rebuild or upgrade a property that is in poor or marginal condition. The loan is usually necessary because the collateral property and/or the borrower does not meet bank underwriting guidelines in its distressed or partially completed condition. Consideration by the lender will be given for the as-is-value and the as-completed-value.
- Marginal credit worthiness where a borrower is not bankable, and approval of a loan request is primarily property equity driven.
- Post COVID payment consolidation is possible. Borrower may need to catch up and give themselves breathing room for accrued payments. One may refer to this as a “fresh start loan.”
- Borrower may own and operate a cash based small business that shows limited financial strength on paper. The borrower will still be required to prove that they or he/she can make required payments.
- Leverage equity of existing real estate developed over time to borrow additional funds purchase additional investment properties or invest in a business enterprise.
- Purchase a property with a combination of cash down payment, sweat equity, and/or seller’s agreement to carry back a subordinated junior lien. The seller of the property would have the borrower sign a promissory note and a deed of trust with a set interest rate, payment schedule, and due date. The subordinated second would be recorded at the same time of the first trust deed but with a recording number that is after the first.
- Inherited property where successor trustees or beneficiaries need funds for distribution to the beneficiaries, pay legal costs of the estate, or to fix up of the property for future rental. Another option is to fix up and be sold on the open market.
- Loan on unimproved raw land. Loaning on land can be a complex process. Is the land part of an existing subdivision referred to as an infill lot, a commercially or industrially zoned parcel within a subdivision, or a larger parcel held for future development? Borrower may need to use the property as collateral to raise funds to pay for future entitlements including engineering, architecture, various reports, and fees to come up with a fully entitled parcel ready to build. The borrower would pay the loan off as part of the construction loan.
- Retail strip and community centers, industrial or other properties which need upgrades or repositioning. Many centers are in distress due to the COVID shutdown where tenants have not had the ability to make their rent payments.
- Fix and flips loans for high frequency purchasers to purchase distressed property, rehabilitate with the expectation to resale and turn a quick profit. Borrowers need both experience and some of their own capital at risk.
- Litigation settlements (e.g., a partition suit), buy a partner out or pay off a pesky family member such as an ex-wife.
- Pay off civil judgments and liens, including arrearage in property taxes, association dues, and federal and state tax liens.
- Sale of existing promissory notes and deeds of trust to 3rd party investors, usually at a discount, whether preforming or non-preforming. This is a way to free up cash.
- Hypothecation or pledge of a promissory note and deed of trust owned by a borrower (assigning note and deed of trust to an investor) as collateral for a new loan.
- Cross collateralization of more than one property to meet the equity requirements of the lender. Borrower would sign one promissory note but may have recorded liens that encumber 2 or more properties.
- Small mobile home or trailer parks where the property does not meet the underwriting standards of intuitional lenders.
- Airbnb type rental income properties. Financials will be necessary to prove up the ability to make payments.
- Churches, synagogues, restaurants, bars, automotive repair shops, body repair shops, gas stations, and other single-purpose security properties.
- New ground up construction or construction completion for a partially completed project. Most requests are a result of borrowers needing to fund more money into the project to complete the project when their own personal capital or existing construction loan proceeds have been depleted.
- Collateral is a combination of real and personal property such as a motel, restaurant, carwash, or gas stations with mini markets. Valuation and decision to make the loan must be on the real property only. A trust deed will be recorded to encumber the real property and a UUC-1 financing statement to be filed with the Secretary of State to encumber personal property.
- Long-term lease on commercial property has or is expected to expire soon. This will cause a vacancy and a disruption is rental income. If the master tenant is leaving this will also cause disruption with other smaller in-line tenants because the master tenant is responsible for the primary draw of foot traffic to the center. Banks will usually not make this loan. This loan is usually made as a bridge loan until the owner obtains a long-term lease with a credit worthy tenant and manages the center back into stabilization.
- Credit approval is subject to highly sophisticated lease analysis with multiple tenants having different terms of leases including length, lease rate, and lease provisions. Maybe some tenants are on long term leases, and some are on month-to-month tenancy. Lease documents may include go dark provisions for the anchor tenant or provide for lease cancellation in the event of excess vacancy or loss an anchor tenant.
- Mutual property access easements for ingress/egress, or complex rights of usage such as reciprocal parking agreements. Many properties such as churches and retail shopping centers sign agreements with multiple property owners to use the entry/exit of the property or the parking in certain ways or at certain times.
- Foreign nationals with and without a social security number. The borrower must have a US bank account(s). The borrower must have a service of process agent which can be arranged.
- “Notice of a substandard condition” or “notice of property noncompliance,” is recorded on public records by a building department notifying the public that the property is out of conformance, or in disrepair for building and zoning codes. Institutional lenders will not make these loans. The bridge loan funded by private lenders will provide funds to make substantial improvements and modifications to bring the property up the acceptable building, safety, and zoning standards.
- Non-conforming property that does not comply with current zoning and building standards. As a result, there are strict limitations on the ability to repair or replacement of the structures in case of destructive acts such as fire, flood, windstorm, vandalism, earthquake. The property may not be able to be rebuilt to an acceptable level after the destructive event occurs.
- Earthquake seismic retrofit. Many older properties need to be upgraded with engineered reinforced steel frames bolted into the existing structure, and walls shored up with steel support fasteners to withstand earthquakes.
- Tenant improvements. Owners of commercial buildings need to provide funds to install interior and/or exterior improvements to satisfy the owner’s and the prospective tenants’ lease hold improvements.
- Cannabis related properties, both manufacturing and retail facilities. Some states have legalized lending in cannabis related operations and some states have not.
When borrowers discover that they were declined for a bank loan, or unsuccessful at closing for any reason they may discover that there an excellent alternative funding source that provides much greater flexibility in the processing, underwriting, approval, and speed of funding. Interested parties should consult a highly qualified lending specialist to help in their circumstance.
Trust Deed investor expectations: Individual private parties, private pension fund trustees such as owners of 401-Ks and IRAs, and family offices invest in trust deeds. Reasons for investing includes perceived lessor risk, consistent monthly cash flow expectations and a comparatively higher annualized yield. Also, the time outstanding for the investment from the initial date of investment until the investor regains their capital is shorter to intermediate in time, usually 1 to 5 years.
Investors will expect to receive a written disclosure package from their mortgage broker source that outlines the terms and conditions of the proposed investment. This will include a summary explanation the loan transaction, borrower’s application, credit report, and independent appraisal of the collateral property. It is necessary for an investor to spend adequate time in reviewing the disclosure package to understand material facts and risk for the purpose making an informed and prudent investment decision.
Interested borrower and investor parties should seek out loan broker professionals who understand the required regulatory compliance, transactional processing and loan underwriting, and correct documentation. Lastly, interested parties should seek out someone with an experienced track record to act as their agent and source of new trust deed investments opportunities. Having the loan broker act as a servicing agent, collecting the borrower’s monthly payments, and handling all communications all the way through the loan payoff will be very helpful.
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