Unlike stocks, bonds and mutual funds, private money investments offer the security of the properties being funded. Private money mortgages are based on a percentage of the market value of the property. That means the lender always has equity in the collateralized property.
Private money mortgages are written at significantly discounted loan to value (LTV) ratios, typically 65 percent or less of LTV. Investors should feel comfortable that in the event of default and foreclosure, they will receive title to a property with a potential value greater than the loan amount. The short term nature of the transaction—12 to 24 months—and the low risk that the value of the secured property will drop in value, makes private money lending very attractive to the savvy investor.
Private money has an interesting life cycle. I can tell you that I started doing private money loans back in 1999, and I have been lending ever since at every stage of the market. What is interesting is that as the market heats up, private money gets more aggressive and more risky to the lender. We are actually seeing this happen now in Southern California.
If you are trying to lend money in Southern California or even the Bay area for that matter, what you are competing against is such ridiculously low cost of capital and such incredibly high LTV’s, that it is no longer what I would consider a safe investment environment, simply because many private money lenders are lending at 100 percent of acquisition. If you are going to go buy a fixer upper in San Francisco, you are probably going to spend $400,000 to $500,000 for a piece of junk. After everything is said and done you might sell it for $750,000. And after your cost of capital and your fix up and repair, you might net, net out $60,000 or $70,000. That is a lot of risk. If you are buying a piece of property in San Francisco for $450,000 and you come to me and you want to borrow $450,000 and on top of that you want me to lend you $200,000 for the renovation and repair, I have no room whatsoever for stupidity and market corrections. Those are your two biggest variables as it relates to private money lending.
Unfortunately, I got caught up in the hysteria of 2006 and 2007 and was sitting on a bunch of capital. The biggest down side of being a private money lender is when you do this as a career; if you are sitting on un-deployed capital you are actually losing money. For me, I have made commitments to my investors, I have to pay them X percent and whether I have their money deployed or not, I still owe them X percent. That means un-deployed capital is costing me money.
As the market heats up and more people enter the market from a competitive standpoint, they start lending at higher than 65 percent LTV’s. They start lending 90, 95, and 100 percent on acquisition. They might lend 20, 25, or 30 percent of acquisition cost towards fix up and repair. They won’t escrow the money, which gives the investor free reign to do whatever they want with the money, which is often not buying material or supplies for the renovation and repair of the subject property.
When the market corrects, which it always does, a lot of defaults will take place. In Southern California the cycle is every five years and it is about at its peak. The rest of the country, like where I live in eastern Washington, the market cycle is about 12 years. My office is in Coeur d’Alene, Idaho. You should Google it, it is absolutely beautiful here, but it is a very slow, conservative market, which means it doesn’t get caught up in the extreme highs and therefore doesn’t experience the extreme lows. Certainly, it plays within the variables, but not near to the extent that you see in Southern California, Phoenix, Las Vegas or Florida where you see these big sweeping changes in value over a period of months. I was talking to somebody the other day who said that their house in North Carolina is appreciating at 10 percent a month. In 12 months that is 120 percent appreciation, which means if you buy a house today for $200,000 in one year it is worth $400,000. Yikes.
These are areas where you need to be a cautious investor, but understand the two biggest risks in private money are stupidity of the person you are lending to, meaning they are uneducated in both borrowing, as well as renovation and repair and market correction. If you don’t manage that process tightly, that project can get away from you and before you know it you have an investor that has bailed and you now own an un-rehabbed, un-renovated, unsellable piece of property. Safety is key.
Lee Arnold is an international speaker, trainer, author and licensed broker who have spent many years perfecting the real estate and private money mortgage lending process through thousands of transactions. Lee is a leading expert on private money mortgages and has been featured as an investment strategy expert by Forbes, the Boston Globe, Market Watch, Reuters and Business Week. He has also consulted and taught for Donald Trump Companies.
As a master of networking, Lee connects private investors to borrowers from across the United States and Canada. To leverage the power of these relationships Lee and the Secured Investment Corp’s executive leadership team have created Cogo Capital—The Private Money Company, Lake City Servicing and The Lee Arnold System of Real Estate Investing. This family of companies has become the fast growing private money mortgage firm in the United States. Key to the company’s values is integrity and trust.
Reprinted with approval from The Lee Arnold System of Real Estate Investing.
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