One real estate investor responded, “To have more passive income than expenses.” The question asked was, “What is your goal for real estate investing?”
The ultimate goal is to do what you want, with who you want, when you want. This goal is the dream of every driven investor or entrepreneur. I remember playing cash flow as a young adult with other motivated business minds thinking, is it possible to earn more than you need without working for it? The game made me a believer, but after all, it was just a game.
The longer I am in the business of real estate investing and real estate lending, I see more and more everyday people, like you and me, become financially free. They work hard and learn how to have their money work hard for them. It all starts with a few real estate books and a few seminars, and then the first deal. That first deal is probably a little condo or single-family home, and that is where their journey gets launched. It goes from one deal to two, then three. And before long, it becomes larger projects with bigger paydays and 100% passive investments.
Wealthy individuals learn to put their money into passive investments to focus their time on making more money. It is the combination of money working for you and leveraging your skills to earn more money that catapults your success. And when it is time to hang it up, the shift to all safe and passive investments occurs.
How Does Hard Money Lending Work?
Hard money lending is a fantastic investment if you are looking for actual passive investment. Real passive investment is one where you don’t need to think about it. Although I love rental properties and believe most investors should explore them as an investment, it is not passive. Even with excellent management in place, rental properties will take some effort.
Hard money lending is loaning other real estate investors the money to do their deals. The real estate investor finds the deal, performs all the work, and sells the deal to pay back the loan. All the lender has to do is make the loan, allowing them to enjoy a passive return. There is a lot less risk for the lender and virtually no work. Because the loans are secured by real estate, any potential loss is mitigated. If there is a default, there may be some work involved, but you can reduce or eliminate that with an excellent servicing company in place.
Who Qualifies As A Hard Money Lender?
It does not necessarily take a pile of money to get your feet wet as a hard money lender. There are a few options for ordinary investors to get started too.
One With A Substantial Amount Of Idle Money
If you have money on the sideline, you can lend that money to someone else. Lending money secured by real estate provides a highly safe return with monthly income.
One Actively Seeking A Passive Income Source
Because you are loaning money to an active investor, your investment should be passive. The only time it would not be passive is if there was a problem with your borrower. The potential of such a problem is why we would recommend using professionals to underwrite and service your loans.
One With A Smaller Initial Investment
Investing with a company like Pine Financial Group makes it easy with a $25,000 minimum investment. It is much safer to invest with a professional hard money lender than to make small second mortgages. A small second mortgage is often referred to as gap funding, which means you would cover what another lender is unwilling to lend. There is a reason another lender is not willing to lend it, so be careful with gap funding.
1. Decide On Your Source Of Funds
There are many options to put the funds together to make a hard money loan. The obvious one is if you have the funds available. That is the most common for small hard money lenders, but not everyone has piles of cash lying around.
When I was getting started as a hard money lender, I did not have the funds to make the loans. Instead, I found the deals and brokered them to other lenders. As I learned more about the business, I became more comfortable raising money from private investors and then started loaning my own money. It took time. Other sources of capital to consider are lines of credit, loans against your rental properties, or friends and family. Although all of those work, they all have unique risks. For example, borrowing money to loan can be risky if the borrower defaults. You will want to be sure you can afford the payments on any borrowed money, even if your borrower isn’t making their payments.
If you bring in private capital, as we do, or brokering loans to other lenders, you may need a license. A license is commonly required in many states, so I would suggest checking with a real estate or securities attorney before making a mistake. I strongly recommend an attorney and not calling the regulators directly. In my experience, regulators want to regulate, even if they don’t have jurisdiction, so it is best to get this advice from someone that will look out for your best interest.
2. Identify Investment Opportunities
One of the best parts of being a hard money lender is that you do not need to find real estate deals. You see a handful of quality borrowers and let them find the deals. I say this because the real estate deal is much harder to find than borrowers. Real estate inventory is tight, so it takes a lot of effort and many offers to find one property worth buying. We have many qualified clients out there hunting all the time, and we only hear when there is a quality deal for us to fund. This process saves us a tremendous amount of time and allows us to focus on real deals.
The best place to find borrowers is word of mouth, but that takes time. While you are building your reputation as a hard money lender, you should be out there telling people that you have money to lend. Merely saying you have money for deals gets investors’ attention. The best places to find these investors are typically real estate investor meetings. I have also had a lot of success calling the ugly “We Buy Houses” signs and asking them if they are ever looking for money for their deals. I have also had success driving through neighborhoods, getting out of the car, and talking to contractors when I see houses being remodeled. Often either the contractor will get you in touch with the owner, or the contractor wants to borrow money for their deals.
3. Learn The Trade
If you are not working with a professional, you will want to learn the real estate investing business to keep your money safe. Overall, this is a safe investment, but there are some pitfalls that you will run into if you are not careful. Youtube is a fantastic resource for information on real estate investing. Check out our Youtube page at www.YouTube.com/pinefinancial. You are already doing what it takes to get educated by reading articles online, but you can also attend training and classes. Check out the free events on our events page. Once you have a solid understanding of what to look for, you are ready to start analyzing deals.
Review Credit Standing
The first step to originating quality loans is to find quality borrowers. As a hard money lender, you will want to underwrite each of your borrowers’ credit quality.
Check Credit History
Many hard money lenders don’t even look at credit reports. I think that is a mistake. The way an individual handles their credit speaks volumes about them and what you might expect when doing business with them. But we also understand that people fall on hard times at times. We don’t put a ton of weight on credit reports when we are approving a loan, but we will look through them. I am looking for debt that could cause the borrower a problem in the future and current or very recent defaults, especially on home loans. Public records such as judgments will also appear on a credit report.
Investigate Past Financial Status
Aside from looking at a borrower’s credit report, it is a good idea to review their financial position. You can do this by asking for a personal financial statement (PFS) and then verifying what they tell you. For example, we will document income by looking at past tax returns, and we verify assets by looking at the most recent bank statement. When I review bank statements, I look at the current balance to ensure they have reserves, but I also want to see history. How do they handle their account? Are there bounced checks?
Verification Of Collateral Value
Although I strongly feel that qualifying the borrower is extremely important, many hard money lenders focus on the collateral. When push comes to shove, is there enough equity in the home securing your loan to get your money back if you need to foreclose? Assuming there is, you can take some risks on a questionable borrower.
The best way to verify the value is a full interior/exterior appraisal. An appraisal shifts the valuation responsibility to a licensed professional. The report will give you a ton of information about the property, including; flood zones, utilities, zoning, any non-conforming aspects, the size as measured, negative influences, and more. It will also include a gallery of photos. These reports can be a little expensive, but they are worth the price, and the cost can be passed on to the borrower. Appraisers can get backed up, so it is not always possible to get these done by the scheduled closing date.
In the cases that you cannot get a full interior/exterior appraisal, you have other options. You can have an appraiser do a drive-by-only report. Since they are not going into the house, there are cost savings, and they can complete these reports much faster. Another option that is almost as good is a BPO (broker price opinion). A BPO is an appraisal from an unlicensed appraiser. Unlicensed appraisers are agents that understand how to value real estate and perform much of the same tasks an appraiser would. I have found that BPOs are typically pretty accurate. Other less desirable options could include pulling your own comparable sales to figure out value or having an agent provide a CMA (current market analysis). If you or the agent helping you are not digging into specific comps and adjusting for things like location and size, you will likely be wrong with your value. Just because an agent is licensed to sell real estate does not necessarily mean they know how to value it. A report with numerous comps and no comments or adjustments will not be an accurate opinion of value. Do not rely on Zillow to value real estate.
I also recommend personally visiting the property or paying someone to do that. With this visit, you will probably want to take the budget or the borrower’s scope of work with you and verify, at least the best that you can, that the work that needs to be done is accounted for. You might see some needed repairs not accounted for, which would make you question the entire plan. If required, you can add to their budget and re-run the numbers to make sure it is still a profitable deal. Doing so is a smart way to keep your money safe.
Secure Title Insurance
Never loan someone money secured by real estate without title insurance. I have filed claims on multiple occasions, and the title company has always stepped up to fix an issue. For example, we had a client sell a house and not pay us off. She called and said that we no longer had collateral and asked if we would discount what she owed. I immediately filed a claim, and the title insurance company turned it over to their legal team. It turned out they forgot to record our lien, and they went at the borrower in a big way. We had our full payoff with fees within a week.
Getting a title policy is a pretty simple process. You will need to reach out to the closer in charge of your file and request help. If you don’t have a title company, you can call one and let them know you want title insurance. They will need a copy of the contract and your information as the lender to get that going.
Ensure Property Insurance Amounts Are Appropriate
It is essential with title insurance to get a policy for the full amount of your loan and be sure you are listed with your full address as the mortgagee.
4. Set Your Terms
There are many ways you can do this. Most hard money lenders will charge the borrower fees upfront and apply an interest rate. The upfront fees are referred to as points. Each point is one percent of the loan amount in a fee payable to the hard money lender. Some hard money lenders will charge points when the loan pays off, and others will charge some upfront and more when the loan pays off. There may be other fees you will want to collect as well, like credit report fees and appraisal fees. My company charges a processing fee that covers our costs and helps pay staff.
If you are working with a company that originates and services these loans for you, you won’t have a ton of flexibility here. For us, we have set terms we charge our borrowers and set terms we pay investors. Everyone is treated the same. If you are doing this on your own, you can do just about anything you want, as long as it is legal. You can get paid fees, a rate of return with monthly payments or deferred payments, or you can get a piece of the deal. Whatever works for you and your client is on the table.
5. Draft The Correct Documentation
You can get free loan documents at https://singlefamily.fanniemae.com/legal-documents/notes, but I don’t recommend it. Using these free loan documents is how I started, and I did not have any trouble, but these documents are way too neutral for me now. I now have my documents built for me by my attorneys, which have been reviewed by other attorneys. Each time we have a problem, we learn something and change our documents. They are continually evolving. As a result, you should consider working with a loan broker.
I recommend hiring an attorney to handle your loan documents for you, at least for the first several deals. After that, if you feel comfortable, you can use the template for each deal you do, but I would highly recommend getting an attorney involved any time you make a change to your documents. If you get this wrong, your entire investment could be at risk.
6. Service The Loan
Once you find the borrower, the borrower finds the deal, the borrower and the deal are qualified, you close with the documents your attorney drafted, and you close with a title company; you are ready to service the loan. Servicing is the part where you collect payments from your borrower each month. But it is not always that simple. The servicer is responsible for all debt collection efforts, including workouts and foreclosure if needed, managing construction draws if those are part of the loan, handling the tax reporting and tax forms, and all other aspects of a loan. Servicing is crucial, especially when there are issues with the borrower. A good servicer will know how to help borrowers get to the finish line, and they understand that foreclosure has to be a final option.
When everything goes well, there is not much to it. Just collect your payments. It is the challenging ones that make me recommend hiring a loan servicer to help with your loans.
Should You Try Your Hand At Hard Money Lending?
If you like money, you might want to consider lending as an investment option. You can do this on your own and make more money, or you can hire professionals and mitigate risks and make it passive. You might want to do a few through a broker to get your feet wet and then try it on your own. No matter the direction you go, learn first what you can about this fantastic business.