real estate success

By Dan Harkey

Summary:

Often constrained by banks’ rigid underwriting and lengthy approval process, real estate borrowers find a liberating escape in alternative lending sources (private/hard money loans). This subset of the lending business, designed for non-bankable loan transactions, not only provides financial solutions but also empowers borrowers, showing them that there is an alternative and they have the power to choose it.

Private money is often more in demand when economic constrictions, a recession, or regulatory tightening result in an exodus of institutional lenders from the market. When interest rates are super low, mortgage brokers primarily focus on the refinance market’s easy picking. When interest rates rise and their business disappears, many turn to private money as a business strategy to generate fee income. Other mortgage brokers specifically focus on private/hard money lending as a career focus.

This article on Dan Harkey’s Website:
https://danharkey.com/post/private-moneyhard-money-overview

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Article:

• Short-Term Bridge, Private Money, or Hard Money

The originating mortgage broker representing borrowers has a fiduciary obligation to their client.

The mortgage broker representing private-party investors acts as a fiduciary on behalf of their clients. This bifurcated role ensures that both parties (borrowers and trust deed investors) are professionally represented. The mortgage brokers and agents must be well-versed in agency laws, ensuring everyone is fully informed and knowledgeable.

The trust deed investment broker’s fiduciary duty is to the private investor parties. This includes conducting due diligence on the borrower, negotiating terms, facilitating the loan process, disclosing all material facts known, and providing a valuable service to both the borrower and the lender.

The broker’s expertise and network of private lenders can often give borrowers more favorable terms and a faster approval process than traditional banks. This intermediary role ensures a smooth and fair transaction for all parties involved, as the broker acts as a trusted advisor, negotiator, regulatory requirements expert, information gatherer, disclosure expert, and facilitator throughout the lending process.

Sometimes, the broker will act as a dual agent for both parties. This arrangement, however, assumes that all parties are professional and well-versed in agency laws, ensuring everyone is fully informed and knowledgeable.

In a real estate loan, the lender is the beneficiary and the individual or entity whose investment interest is safeguarded. Private-party investors are the lender/beneficiaries whose names appear on the borrower’s promissory note (a written promise to repay a specified amount under specific terms), deed of trust (a legal document that gives the lender a security interest in the property), and title insurance policy (a policy that protects the lender’s interest in the property). The promise to pay in the promissory note and the security instrument, called a deed of trust, are contracts between the borrower and private-party lenders, not the broker. After the loan closing, the investors or their loan servicing agents retain the executed documents as evidence of the investment.

• Borrowers:

Real estate borrowers always choose the lowest interest rates and most favorable terms for their circumstances. However, banks, institutional lenders, and government-sponsored entity lenders (GSEs) with the lowest interest rates and best terms also have a much more rigid underwriting and approval process that limits, delays, or possibly kills many loan approvals. Institutional lenders must also comply with strict state and federal regulations, which can further complicate the lending process.

Interested borrowers who expect tremendously low rates with banks must be ready for the maze of paperwork and a drawn-out underwriting and processing period. In many cases, the frustration will be overwhelming and extend beyond the period allowed to close the transaction.

Many borrowers find that alternative lending, particularly private money loans, is a better or the only option. These loans offer a faster approval process, more flexible terms, and a higher likelihood of approval, making them a more attractive option for borrowers looking for a quick and efficient lending process. A two-week turnaround from start to closing the loan transaction is standard, and sometimes faster, providing borrowers with the speed and flexibility they need in the competitive real estate market.

• Lenders, trust deed, or mortgage. Investors are private parties:

Private-party Investors who invest in real estate loans as lenders willingly invest in purchasing and owning a promissory note, trust deed, or mortgage. The ownership of a promissory note and deed of trust is considered personal rather than real property, providing a sense of security to the investors. The promissory note, deed of trust, or mortgage is also considered a security instrument because it represents evidence of indebtedness.

The ownership of a promissory note and deed of trust is a security under the federal Securities Act of 1933 because the documentation represents “evidence of indebtedness.”

Security is defined as:

• Property given or pledged to guarantee the performance of an obligation.
• An instrument that functions as proof of a security interest in a public or private body.

If desired, one may review the legal definition of a security under Section 2(a)(1) of the Securities Act of 1933 online.

• Licensing:

Most states require state and federal lender licenses for single-family consumer-purpose lending on 1-to-4 units, both owner-occupied and non-owner-occupied. The key is 1-to-4, where the loan proceeds are used primarily for consumer purposes rather than business purposes.

Many states do not require a license for 1-to-4-unit business purpose loans. A few states require a permit for all lending activity. Many states do not require approval to make loans on five or more residential income units, commercial, industrial, and land loans. However, it’s important to note that licensing fees can be significant and vary from state to state. Understanding these regulations and their implications is crucial for borrowers and investors to make informed decisions and feel fully informed and knowledgeable.

For all properties other than single-family 1-to-4 units, licensing and regulations to procure loans with the expectation of compensation differ in each state of the union. Also, licensing and oversight depend on the state’s political power structure, type of real estate, the purpose of loan proceeds, the use of the property, the location, property quality and amenities, and conformity to zoning and building regulations. Understanding these regulations is crucial to feeling fully informed and knowledgeable.

Generally, state and federal real estate laws govern the entire property lending industry, including contract, agency, securities, and, in some cases, Department of Labor laws.

• Consumer vs. Business Purpose Lending:

A consumer-purpose loan is one in which the proceeds are primarily used for personal, family, and household purposes. In simpler terms, it’s a loan for things like buying a home, paying for education, or covering medical expenses.

Business-purpose real estate loans can be used for various purposes, such as purchasing a property to rent out, using the property as collateral for a business loan, or investing in a property to renovate and sell for a profit.

Business purpose loans are loans on real property where the loan proceeds are used primarily for business purposes. “Primarily used for business” is essential. That means that a portion of the loan proceeds, more than 50%, must be used for business purposes. A percentage of the loan proceeds (less than 50%) may be used for consumer purposes.

Understanding the distinction between business and consumer-purpose lending is crucial. It empowers borrowers, allowing them to navigate the regulations and requirements set by federal and state governments and make informed decisions about their loans. This knowledge is a powerful tool for borrowers, giving them the confidence to make the right choices for their financial needs and making them feel more informed and empowered.

These additional requirements have extreme punitive consequences for any mistakes or deviations by the lender(s) and the procuring mortgage broker(s). These onerous changes, which can include hefty fines and legal action, have caused most private money lenders to exit consumer-purpose lending altogether, as the risks and potential liabilities outweigh the benefits. It’s crucial for all parties involved in private money lending to fully understand and adhere to these regulations to avoid these severe consequences.

While some borrowers search for a loan, they discover they can only find a lender who makes business-purpose loans. They often construct a narrative to make their loan a “business purpose.” Some legitimate examples include using a loan to finance a rental property or a property used for business operations. However, some narratives are not legitimate, such as claiming a personal residence as a business property. Borrowers who claim the need for a business-purpose loan must provide substantial documentation. Borrower documentation evidencing the business purpose is essential.

• Deed of Trust Investments are Securities:

Federal securities exemptions from registration are available to comply with federal securities laws. Federal exemptions for privately funded loan transactions and loan-pooled investors are in Regulation D, Regulation A, and Rules 147 and 147A. Definitions and exemptions are on the www.sec.gov website.

The California Corporations Commissioner’s Rules cover offering and selling specific securities, such as trust deed investments. Several codes allow for exemption from the qualification requirement. These include the private offering exemption 25102, specifically safe harbor rules contained in 25102(e) (f) (n), 25113, 25100(p), and 25102.5.

The fractional note exemption 25102.5 covers multiple investors who may invest in a transaction and allows up to 10 investors (beneficiaries). Under the 25102.5 exemption, ten private investors can co-invest in a single trust deed as tenants-in-common. The fractional note exemption rules are disclosed in the Business & Professions Code 10237-10238, 10232.3, 10232.5, Civil Code 2941.9, and many others. Interested parties should consult a real estate or securities lawyer specialist.

• Regulatory oversight in California for the private money lending industry:

California has specific lending transactional regulations affecting private money loans, including a required license by the state for all individuals who make or arrange loan transactions with the expectation of compensation.

Additional rules apply for trust accounting, agency relationships, and both borrower and investor-required disclosures by the procuring mortgage broker. Many states outside California have fewer regulations, and some have none. This is pointed out to remind people that making and arranging privately funded real estate loans is highly regulated.

In almost all cases, the private-party lending industry has different underwriting guidelines and a less rigorous process than institutional or bank lenders. Standards for analyzing the borrower, credit, income, and collateral property value are more flexible. Whether considering government regulations, stricter bank underwriting, borrowers’ particular circumstances, or COVID-19-related business and personal life disruptions, the private money industry provides a substantially more flexible option and is currently in high demand.

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• How do Private Parties invest in trust deeds?

Private-party investors may co-invest fractionally with a small group as tenants in common or in a pooled entity with other investors. Private-party investors include individuals, family trusts, corporations, IRAs, and pension plans. Most investors invest with multiple ownership methods (holding titles), such as a family trust for a portion and an IRA custodian for a portion. I have noticed numerous titles for couples who establish a family trust for themselves and their descendants and invest in each. Multiple family members living in the same home are considered one investor.

The percentage of the entire trust deed represents the investor’s beneficial interest portion of ownership. For example, if the trust deed investment is for $1,000,000 and the investor purchased $200,000, they would own a 20% undivided interest as tenants-in-common. A $100,000 investor would hold a 10% undivided interest as tenants-in-common with other investors.

• List of Good Reasons For Borrowers To Choose Privately Funded Loans Over Bank Loans:

Here is a partial list of situations where private loan transactions will benefit borrowers.

• Fast loan approval with possible 2-to-4-day funding for bank declines and fallouts: The bank may already have done significant underwriting, including opening escrow and title, obtaining an independent appraisal, and completing the application and financials. Some private lenders can use the banks’ information to fund faster, particularly when they have a mortgage pool or immediate capital available to invest.

• Debt consolidations for consumers, businesses, or a combination of both: In most cases, the loan may be used for debt consolidation, lowering the borrower’s monthly payment obligations. The funding should give the borrower breathing room to improve their credit and obtain a long-term bank loan. Also, when the loan is a second lien, the average interest rate between the first and second should be calculated to show a net effective rate.

• Marginal to poor creditworthiness, where a borrower is not bankable, and approval of a loan request is primarily property equity-driven.

• Special purpose-unique properties– Churches, synagogues, restaurants, bars, automotive repair shops, body repair shops, gas stations, and other single-purpose or limited properties.

• Limited document loans, where the requirements are a loan application, credit report, and 3 to 6 months of bank statements. The objective is to prove the ability to pay the outstanding loan payments and other debt obligations.

• Post-COVID fresh start loan. A borrower may need to catch up and give themselves breathing room for accrued and differing payments, which is referred to as a “fresh start loan.”

• Payoff loans coming due or past due: Refinance and pay off existing first, second, and third lien position loans that may be due. Sometimes, refinancing the second and providing cash out is the appropriate answer to the loan request. Loans are available for both owner and non-owner-occupied residential and commercial properties.

• Cash-out for any reason refinances are based upon the protective equity of existing real estate. Cash-out loan proceeds can 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.

• Junior lien or second-position loans on both owner and non-owner-occupied dwellings for business purposes

• Construction completion, rebuilding, or upgrading properties in poor or marginal condition: The loan is usually necessary because the collateral property or the borrower needs to meet bank underwriting guidelines in its distressed or partially completed state. Loan approval by the lender will consider the as-is-value and the as-completed-value.

• A borrower may own and operate a cash-based small business with limited financial strength. A lender will require 3 to 6 months of personal and business bank statements. The borrower is still required to prove they can make the required payments.

• Leveraged existing real estate equity developed over time to borrow additional funds, purchase other investment properties, or invest in a business enterprise.

• Purchase a property with a cash down payment, sweat equity, and seller’s agreement to carry back a subordinated junior lien. The property seller 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 is recorded concurrently with the first trust deed, but with a recording number after the first.

• An inherited property where family members and successor trustees who are beneficiaries need funds to distribute to the beneficiaries, pay the estate’s legal costs, or fix up the property for a future rental. Another option is to fix it and sell it on the open market.

• Loan on unimproved raw land. Lending on raw 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? The borrower may need to use the property as collateral to raise funds for future entitlements, including engineering, architecture, various reports, and fees to develop a fully entitled parcel ready to be built. The borrower would pay the loan off as part of the construction loan.

• Retail strip and community centers, industrial or other properties requiring upgrades or repositioning: Many centers are distressed due to the COVID shutdown vacancies, where tenants could not pay rent.

• Fix-and-flip loans allow high-frequency purchasers to purchase distressed properties, rehabilitate them with the expectation of resale, and turn a quick profit. Borrowers need both experience and some of their capital at risk.

• Litigation settlements: A loan to buy out a business partner, pay off a pesky family member, an ex-spouse, a judgment lien, or a partition suit.

• Pay off civil judgments and liens, including arrearages in property taxes, association dues, and federal and state tax liens.

• Sale of existing promissory notes and deeds of trust to third-party investors: The sale is usually at a discount, whether the promissory note is performing or non-performing. A deal will free up cash.

• Hypothecation or pledge of a promissory note and deed of trust: A borrower who owns a promissory note and deed will assign them to a third-party investor as collateral for a new loan.

• Cross-collateralization of more than one property:

• Cross-collateralize multiple properties that are used to meet lender equity requirements. The borrower would sign one promissory note but have recorded liens that encumber two or more properties.

• Small mobile homes or trailer parks: properties that don’t meet the underwriting standards of institutional lenders.

• Airbnb-type rental income properties: Financials and history are necessary to prove the ability to make payments.

• New ground-up construction or construction completion for a partially completed project: Most requests result from borrowers needing to fund more money to complete the task when their capital or existing construction loan proceeds are depleted.

• Collateral combines real and personal property with mini markets, such as a motel, restaurant, carwash, or gas station. The valuation and the decision to make the loan must be based on the real property only. A trust deed is recorded to encumber the real property, and a UCC-1 financing statement will be filed with the Secretary of State to encumber the personal property.

• A long-term lease on commercial property has or is expected to expire soon. The lease expiration could cause a vacancy and a disruption in rental income. If the master tenant vacates the property, this will disrupt 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 generally 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 analyses, with multiple tenants having different lease terms, including length, lease rate, and lease provisions. Some tenants are on long-term leases, and some are on month-to-month tenancies. Lease documents may include go-dark provisions for the anchor tenant or provide for lease cancellation in the event of excess vacancy or loss of an anchor tenant.

• Some properties require mutual property access easements for ingress/egress or complex usage rights, such as reciprocal parking agreements. Many properties, such as churches and retail shopping centers, sign contracts with multiple property owners to use the entry/exit of the property or the parking in specific ways or at certain times.

• Foreign nationals with and without a Social Security number need loans. The borrower must have a US bank account(s). The borrower must have a process agent service arranged during loan processing.

• “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. The bridge loan funded by private lenders will provide funds to make substantial improvements and modifications to bring the property up to acceptable building, safety, and zoning standards. Institutional lenders will not make these loans.

• Non-conforming property not complying with current zoning and building standards. As a result, there are strict limitations on repairing or replacing the structures in destructive acts such as fire, flood, windstorm, vandalism, or earthquake. The property may not be rebuilt to an acceptable level after the harmful event occurs.

• Earthquake seismic retrofit. Many older properties must 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. Commercial building owners must provide funds to install interior or exterior improvements to satisfy the owners’ and prospective tenants’ leasehold improvements.

• Cannabis-related properties, manufacturing, and retail facilities: Some states have legalized lending in cannabis-related operations, and others have not.

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When borrowers are unsuccessful at closing their loans or are declined for bank loans, they will discover alternative funding sources that provide much greater flexibility in the underwriting, approval, and speed of funding. Interested parties should consult a highly qualified lending specialist to help.

Private-party Investors who desire to invest in trust deeds with their available capital understand that they are securing their investment by accepting a signed promissory note from a borrower and a signed and notarized recorded deed of trust on the security property. Investors’ names are affixed on a recorded trust deed as beneficiaries.

Trust deed investments usually provide for receiving monthly interest payments from the borrower and distributing them to the investors. Investor distributions are generally a tiny fraction less due to being charged a servicing fee. The annualized yields are comparatively reasonable.

Interested parties should seek out loan broker professionals who understand required regulatory compliance and correct documentation. Lastly, interested parties should seek someone with an experienced track record as their agent and source of trust deed investments.

Thank You

Dan Harkey
Educator & Private Money Lending Consultant
[email protected] 949 533 8315
www.danharkey.com