Could becoming a private money lender be the most advantageous way to invest in real estate? Many people rightly see both residential and commercial real estate as a tried and trusted investment vehicle. Appreciation tends to assure capital gains and mortgages become cheaper, in real terms, over time. This is because inflation increases rental income while mortgage payments remain approximately the same. Meanwhile, investment properties offer a predictable and reliable ROI – so far, so good.
However, buying and managing an investment property, whether it be a residential rental property or a commercial property, inevitably requires a fair amount of time and energy. Tenants leave, requiring replacements to be found with new agreements and leases, buildings require repairs and regular maintenance; it can be quite a headache for a landlord. Similarly, buying a property with the intention of flipping it requires a considerable investment of time and energy, whether doing the necessary renovations oneself, or overseeing a major project, and capital may be tied up for months. Neither option is exactly ‘hands-free’.
Becoming a private mortgage lender, on the other hand, offers all the benefits of hands-on real estate investment – the predictable stable ROI and long-term appreciation – without any of the hassle; private money lending can indeed provide a truly passive income flow: putting your money to work instead of yourself. Too good to be true? Obviously, private money lenders need access to spare capital sums, and must also ensure they carry out their due diligence in respect to checking out their potential borrowers, but there is no doubt that the private lending market offers investors a very attractive alternative while adding useful diversification to a portfolio. Let’s take a quick look at the pros and cons:
Advantages of Private Money Lending
- History – private lending has an historically proven success rate.
- Predictability – reliable and stable returns.
- Diversification – real estate offers diversification for portfolios and a hedge against inflation.
- Security – lending is collateralized by tangible property; loans are based on equity rather than credit history.
- High ROI – interest on private loans may range from 8% to 16%.
- Passive income – once set up, the loan provides excellent cash flow without further involvement.
Disadvantages of Private Money Lending
- Need for disposable capital – access to large capital sums may be needed at short notice to meet a closing date.
- Risk of default – due diligence on the part of the lender will considerably reduce this risk; however, there is always some risk, and it is incumbent on private lenders to research prospective borrowers, in much the same way as a traditional bank would, also the property itself provides collateral. Low loan-to-value ratios can further protect the lender.
It’s tempting to say that private lending is a win-win scenario, so there are no disadvantages; however, caution is needed. No investment is entirely risk-free, but due diligence on the part of the lender can considerably mitigate the risk factor.
How Do You Become a Private Money Lender?
There are different options for beginners wanting to enter the private lending market:
- Entire Loan Provided at Closing
- The entire amount being leveraged becomes due on closing, either from just one investor, or from multiple investors (fractional loan); the property now becomes collateral for the loan.
- Loan Purchased After Closing
- Some borrowers may arrange alternate funding for the initial purchase and later seek refinancing from a private lender. The advantage for the lender in this situation is that urgency is reduced, giving the potential investor longer to make an informed decision.
- Mortgage Funds
- The lender invests in a fund – in this scenario, the decisions are made by the fund managers, making this a truly passive investment, but removing an element of control from the lender. Some funds may be constructed as REITs; the benefit to lenders, especially those new to private lending, is the ability to access the private debt market at a far lower entry point.
At the end of 2020, the private debt market was one of the fastest-growing market sectors with $412 billion assets under management. Borrowers have various reasons to seek out private lenders rather than more traditional sources; such reasons may include the need to close swiftly on a property in a competitive market – private lenders are much faster than banks – or possibly an income source that is difficult to prove. As a private lender, you are considering the equity in the property to provide collateral for the loan, so your loan is collateralized by a tangible asset. Default risk is low and returns far higher than those offered for more traditional investments.