Assessing a Private Money Loan Transaction

By Dan Harkey

Private money, also known as hard money, is a crucial lifeline for real property owners who, for various reasons, cannot secure a bank or institutional loan. With their lower approval thresholds, private lenders provide vital support in these situations.

Private money loans are funded using the capital of private party investors as individuals and capital raised in investment loan pools created to fund such loans. Generally, the lender or mortgage broker who arranges the loan transaction will become the loan servicer, collecting the monthly payments from the borrower and distributing the payments to the private party investors.

Real estate loans are considered a security because they are evidence of indebtedness. Various securities exemptions are used to comply with federal and state securities laws. Federal exemptions usually are Reg D, Reg A, and Rule 147. In California, the Corporations Commissioners rules allow for multiple exemptions that may be applicable.  They include the private offering exemption 25102, including 25102(e)(f)(n), 25113, and 25102.5.  25102.5 is the most commonly referred to as the fractional note exemption. A maximum of 10 private investors can invest in a single trust deed as tenants in common. Rules are defined in 10237-10238 and 10232.5 of the business and professions code. Specific regulations affect private money transactions, including licensing, trust accounting, and required investor disclosures. The reason for pointing this out is that all aspects are highly regulated for those who do not understand private funding of real estate loans.

Private money financing is popular for borrowers due to its adaptability to various financial circumstances and property conditions. It offers a flexible solution tailored to the borrower's specific needs, giving them a sense of empowerment and control over their financial situation.

1)       Bank rejections, for any reason, including denial of credit due to:

·      Credit problems.

·      Debt coverage ratios.

·      Cash out.

·      Condition of property. Is the property in a poor condition, questionable condition, or partially completed?

·      A borrowing entity is a family trust, corporation, limited liability company, or some other form of entity as opposed to an individual.

·      If cash flow from the borrower’s business is difficult to determine.

·      Fix and Flips.

·      Is the property in need of rehabilitation?

·      Avoiding the lengthy hassle of bank processing.

2)        Borrower financial circumstances:

·      Credit problems and derogatory marks on their credit report.

·      Tax liens and judgments.

·      Arrearage in payments, foreclosures, bankruptcy.

·      Probate sale.

·      Complex circumstances.

3)     Purchase and sell promissory notes and note hypothecations, usually at a discount.

Each loan transaction is thoroughly analyzed for pricing and acceptable risk. Although the process is less rigorous than that of an institutional lender, it is still strict.

The loan process includes the following:

·      Identify a potential transaction, discussing the requested amount and collateral backing the loan.

·      Obtain a 1003 residential or commercial loan application for non-SFR.

·      Obtain a property profile online and download pictures from the web if possible.

·      Financial statement, real estate schedule, two years' tax returns, or, as an alternative, three recent bank statements. Some lenders may not require income verification when the protective equity is high.

·      Two things must be proved if the proposed loan transaction is a second lien.  One is to obtain a recent payment invoice to show the balance and the current loan.  The other is to review the first lien trust deed to determine whether a second lien is allowed without the first lien lender’s approval.

·      Authorization to obtain a credit report. Credit is less of an issue, thanks to banks.

·      Obtain info about the borrower’s property insurance coverage.

·      Other miscellaneous disclosures depend on the purpose of the loan, borrowing entity, property type, and state of origination.

The following information will be obtained as part of the preassessment.

·      Purpose of loan proceeds written by the borrower. The primary distinction is the difference between consumer and commercial business purposes. Consumer purpose falls under federal consumer laws, which reflect dramatically different underwriting requirements and licensing. Most private money companies only engage in lending for business purposes. The purpose of loan proceeds may be for consumers and businesses. The difference can be discussed on www.danharkey.com in the private money lending section.  The article is entitled Loan Purpose-Consumer vs Business.

·      Property type, description, and condition.

·      Property income stream, if any? Analyzing the quality of the income stream is an essential component of generating enough income to make the loan payments.

·      Protective equity, which is the difference between the property's current market value and the total amount of debt secured by the property, serves as the security for the loan.

·      Borrower's financials, strength, and ability to pay.

·      Private money lenders have less stringent credit requirements, reassuring borrowers with credit problems or derogatory marks on their credit reports. This aspect of private money financing can help alleviate some of the anxiety associated with traditional lending institutions.

·      Exit strategy refers to the borrower's plan to refinance, sell, or pay off the private money loan at its maturity.

·      Proving-up refers to demonstrating that the borrower has the financial capacity to make the monthly payments until the loan's maturity.

·      Some lenders rely more on protective equity based upon appraisal and less on recorded debt. Some lenders rely on the income generated from the property and the borrower's financial strength. Some lenders also require personal guarantees when the borrower is a single-purpose entity such as a limited liability company or a closely held corporation.

What real estate types are appropriate for private money borrowing?

·      Single-family owner-occupied and non-owner occupied.

·      Apartments, office, retail, industrial, mini-storage.

·      Special purpose, such as in restaurants and automotive-related.

·      Land loans.

·      Some, like rural land, dirt roads, and being environmentally challenged, are much more difficult.

I hope you're able to find value in the article.

Thank you

by  Dan Harkey

Educator and Private Money Financial Consultant

949 533 8315 dan@danharkey.com, www.danharkey.com