Let us consider the way many homeowners, developers, and investors approach real estate as an investment. Individual investors, as well as institutional investors, have long realized that investing in real estate with leveraged funds is seriously advantageous since the owner benefits from appreciation on the borrowed funds as well as on their own input. It is this rationale that encourages savvy investors to borrow money to invest in more expensive property and/or to renovate and flip a property. Nothing new here.
However, being a homeowner, or even a property owner with tenants supposedly paying for the mortgage, involves considerable hassle. For both owner-occupiers and landlords, homeownership comes with continual maintenance and repair issues as well as property taxes, mortgage interest, and the risks of a sudden change in the property market, or – for landlords – the risk of tenants defaulting on their rent or leaving the property in a damaged state, not to mention calls from tenants at unsocial hours for emergency repairs. The long-term returns on real estate are great but what if there were a way to get those returns without all the hassles and risks that accompany actually owning real estate? And, what if you could be the one earning interest on funds rather than paying interest?
It is certainly feasible for an individual investor to enter the private credit market and lend money to other businesses or would-be homeowners and still build considerable wealth over time – without any of the hassles of homeownership and maintenance, or the need to find and vet tenants or finance expensive renovations, while repaying a mortgage with interest. Becoming a lender instead by holding private mortgage notes means that an investor now has a steady, consistent source of income from interest paid on the loan, as well as the expectation of full capital repayment at the end of the loan period. This is a great way to secure a fairly passive income stream. Additionally, for investors with an eye on the long term, interest payments held within a retirement account are not even subject to tax until the money is withdrawn, or – in the case of a Roth IRA – not even then. At the present time, with interest rates on ‘safe’ investments at an all-time low, alternatives such as private notes are particularly attractive.
Obviously, one cannot lend money unless one has the capital to spare. This, admittedly, is a deterrent for beginner investors who may not have disposable capital sums available as yet. However, for the investor who currently has at least some capital available, there are considerable benefits to investing in the private credit market. As with any investment, beginners in this field will need to do a risk/benefit analysis.
The main risk for private lenders is the possibility of default on the part of the borrower. While the risk of default is statistically greater with private notes, this risk can be largely offset by careful vetting of clients initially. Additionally, with private mortgage notes, the funds being lent are collateralized by real estate, a tangible – if illiquid – asset. Private lending is an alternative investment strategy and as such is likely to represent just a portion of an investor’s portfolio. Private credit lenders need to keep a careful balance between assets and liabilities to avoid having to sell assets quickly in the event of an unforeseen crisis. Being knowledgeable about the current state of the real estate market in a particular area is important to mitigate risk as is the ability to evaluate the creditworthiness, and trustworthiness of borrowers.
Benefits of Using Private Notes:
Benefits are twofold: the funds are collateralized by a tangible asset – real estate – and the interest rates charged on loans are generally considerably higher than would be payable within more traditional investment vehicles. Private notes offer a passive, consistent income stream with relatively minimal risk. Some private lenders will make short-term loans to investors who simply need to access funds quickly in order to secure a deal and plan to refinance once the deal is done, or once they have renovated and flipped the property. In this event, lenders not only receive advantageous returns in terms of interest payments but will also receive repayment of principal within a short time span. Others may prefer the option of a longer-term mortgage with years of regular payments to look forward to. Private notes allow the lender to make all of the decisions: the borrower, interest rates, and the loan term.
Investors in the private credit market may hold either private notes, making loans to other investors, or purchase discounted notes, buying notes at a discount on their face value. Notes may involve obligatory payment at a predetermined date, or more informal, such as loans within families.
What are Private Notes?
There are many reasons why purchasers may look for private loans. Would-be homeowners who don’t satisfy the more cautious requirements of major banks, investors, and developers who require short-term bridging loans so that they can close a deal quickly without waiting for the more pedestrian process followed by traditional lenders, and foreign nationals who are unable to provide extensive credit histories are all helped by the private mortgage market. In these situations, private credit provides a win-win situation for lenders and borrowers alike.
Private notes may be short-term, where an investor in need of bridging finance will repay the principal within a few months, or long-term, where a more traditional-style mortgage pays a mix of principal and interest over decades. Notes can also be sold if an investor wishes to access capital before the end of the financing period.
Finding borrowers does require a more advanced knowledge of the market and some extensive networking. Unlike the big banks, potential borrowers are not going to be knocking at the door of private money lenders. Networking is essential and this can be challenging for beginners in this field.
As the term suggests, discounted notes are purchased at a discount of the face value, which allows for increased profit margins. This is an area that may be more accessible to beginner investors. The ‘old boys’ network’ is still much used but it is possible to buy discounted notes on some websites or even to try cold calling the CFOs of local banks and credit unions and asking if they are looking to sell any notes. Investors may choose to own an entire note themselves or to own part of a note through a fund. Discounted notes can make fairly quick profits for the lender.
Not all notes are secured on assets such as real estate. A note is purely a debt instrument: an agreement between lender and borrower to repay funds. An unsecured note is a corporate debt that is not secured by collateral. As a result, it is riskier and therefore attracts higher rates of interest. If the lender is reasonably satisfied regarding the likelihood of default, these notes, normally medium-term in length, maybe a rewarding choice.
So, is private note lending an appropriate investment vehicle for beginners? There are many ways that individual investors can enter the private lending market, even without having large amounts of capital to invest. Private mortgage notes can be held through funds, jointly with others, for example. Investors who are just starting out in private lending will likely want to experiment with a relatively small portion of their investment portfolio, increasing their allocation as they become more experienced in evaluating properties and potential lenders with accuracy. For those opting to lend for purposes of purchasing real estate, the collateral provides a reasonable amount of security in the event of a default. Credit ratings, both of businesses and of individuals, can also be a useful guide for lenders, as can personal knowledge of borrowers. While networking is often key to matching private lenders with clients, there are still some other options for recent entrants into the market.