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Top 5 Pitfalls To Avoid In Private Lending

October 16, 2024

chrisseveney

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Creating Wealth Simplified | Private Lending

 

In this episode, Chris Seveney dives into the critical topic of lien position in private lending. With many investors turning to passive income through private lending, understanding lien position is essential to protecting your investment and avoiding costly mistakes. Christopher discusses the top five key factors to consider, including borrower experience and market conditions, to ensure you’re not exposed to unnecessary risk. If you’re looking to make smarter lending decisions, this episode is a must-listen.

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Top 5 Pitfalls To Avoid In Private Lending

Introduction To Private Lending

Welcome back, everybody. I want to talk about a topic that I see a lot of people starting to get into, and I want to put some cautionary warnings out there. We’re going to talk about passive investing through private lending and the silent risks that could drain your wealth. Real estate is very expensive and interest rates are high, but we’ve seen a lot of individuals make that shift over to private lending.

Just like any aspect of real estate, experience is so important that you want to make sure that you surround yourself with people who are smarter than you, who’ve been there, done that, so you can learn from them, but also give you some guidance and make sure you avoid some of the mistakes we’re going to talk about. I’ve got the top five key points that we’re going to discuss in private lending to make sure that you are not putting yourself at additional risk.

First, and probably the most important, is lien position. What do we mean by lien position? Lien position is, if you think of a train, are you at the front of the train or the back of the train? Front of the line, back of the line, wherever you want to evaluate. If you’re at a concert, are you in the front or back row? Lien position is important because when you’re in first position, you are in control. Meaning, if the borrower defaults, you don’t have to worry about junior liens or other money they’ve borrowed. Typically, you have to worry about taxes and potentially other violations. When you’re in a second lien position, that’s why I really want to focus on it, you are at significant risk because there’s that first lien that you have to pay attention to, but also, it’s typically at a higher loan-to-value, which we’ll talk about property valuations later.

Creating Wealth Simplified | Private Lending

Private Lending: The first lien controls everything. Make sure you’re in control when it comes to private lending.

 

Let me share a story about somebody who was in a second lien position and thought they had significant equity because the borrower took out a first lien at about 50% LTV, and it was a private loan at 12%. They also gave a second position loan at 12% or 25%, and the borrower put down 25%. Really rough numbers, $500,000 property after it was renovated.

The first position gave $250,000, they gave $125,000, and the borrower was putting an extra $125,000 in. I’m thinking, I’ve got plenty of equity. What can go wrong? Let me tell you a few things that went wrong in this situation. The borrower defaulted, and the interest rate on the first position loan went from 12% to 25%. They went from essentially a $2,500 a month payment to essentially double. Those fees just started accruing, and it was in a judicial foreclosure state that would take about a year to get that foreclosure through.

Over the course of that time, essentially with fees and everything, about $75,000 worth of fees got tacked on in that first position. Meanwhile, your loan wasn’t getting paid and got tacked on as well. The next thing you realize is you just, equity position-wise, lost 15% of your equity. You’re thinking you’re at 75%, now you’re at 90%. After that, the property wasn’t valued worth what they thought it was, and your second lien position, in this instance, pretty much got mostly wiped out. It’s really important to understand lien position and those risks. There’s a type of lending going on, which is called gator lending, which is lending to people who can’t even put down an earnest money deposit. They have zero money.

The Importance Of Borrower Experience

When you’re lending, it’s important to understand, too, how you are going to get paid back because you’re in a subordinate lien position, but the person also has no money at all. If somebody has to borrow money for an earnest money deposit, you’re basically giving them credit card debt. If you want to charge 30%, go ahead, but just realize you’ve probably got a 40% default rate. The lien position I want to touch upon and spend a few moments on is to make sure people understand their position and the ramifications that can occur. Next, I want to talk about borrower experience and understand how important experience is. I’ll share an example that we were looking at. We’re updating some of our corporate documents for our fund.

I’m going through this, and attorneys are great. Attorneys will do what you tell them to. From experience, I’ve learned to tweak things here and there. I was telling my wife, and I said to her, “This is like, I don’t know, 7 days, 9 times, I lost track of how many PPMs I’ve updated and reviewed.” I said, “If I was doing this my first time, I would be completely lost.” All the things I would leave out, I wouldn’t even know. You don’t know what you’re missing. It’s the same thing in any business, especially private lending. Understanding that borrower experience is critical, especially if it’s like a new construction project you’re lending on.

Experience is key in private lending. If your borrower doesn’t have it, neither do you. Share on X

Does the borrower know how to get permits? Do they know how to deal with the county? What if there are proffers where they have to increase the waterline size? There are so many “what ifs.” What if they have to connect to a sewer system they didn’t know about, and fees are involved? Do they know this? Do they not know this? There are so many things that experience comes into play. Experience is time as well, especially in real estate. The more experience you have, the better off you are at managing time.

One of the major components of private lending is doing it as a twelve-month loan, make sure you get paid in twelve months. If you’re working with somebody who doesn’t have that experience, what happens if it goes longer? What are you planning for that money for something else? Is it okay to float it? It’s important to understand. When I talk about borrower experience, it can come from different areas. A borrower could, for example, work for a residential developer as a superintendent, and they’ve built $100 million worth of real estate.

That’s a good experience to be a fix-and-flipper who’s done twenty fix-and-flips. The important thing is to understand also the experience component, is it their first deal? How much money do they have as well? Somebody who has no money and no experience is a recipe for disaster. It just is. It’s rarely successful. Everybody’s going to start somewhere. That’s why you always recommend people start with a significant amount of their own capital.

Due diligence is non-negotiable. Skip tracing your borrower could save you from serious losses. Share on X

How do you do your borrower due diligence? For us, we have them fill out a personal financial statement, list their experience, and give us properties that they’ve done and real estate agents they’ve worked with, getting this information from them to make sure they’re actually being upfront and honest. We skip trace them as well. Do they have a criminal history? Do they have liens from other properties? Maybe they had some experience, but they didn’t pay their vendors. Those are all important factors to understand as part of the borrower experience.

Market Conditions Affecting Private Lending

Next is something that is really interesting, which is the market conditions and where the property is located, it could be so significant. I’m recording this in early October 2024. We just had the strike with the union workers who worked the docks. Iran just fired missiles at Israel, and there’s a lot of stuff going on that could impact our economy and impact the markets. One of the things that’s already come into play is, and I’m seeing this in Florida, I’m seeing it in Oklahoma, and I’m seeing it in Texas, is loans where a person bought the property, they fixed it up, and their ARV, after repair value is way off.

Creating Wealth Simplified | Private Lending

Private Lending: Market conditions can turn a promising deal into a loss. Always stay informed and prepared.

 

When we looked at in Oklahoma, the borrower bought a property cash, took out a $70,000 loan, bought it cash for about $50,000, and put $70,000 into it, which was a loan that they took out from a lender. They thought the property was worth $200,000. It’s currently listed on the market for $100,000. The lender still has their equity in the property, and they’re probably still going to be okay, but the property was supposed to be sold seven months ago. It’s been sitting on the market for nine months.

When you speak to real estate agents, they’re like, Just the market. Two that we’ve seen in Florida, first-time fix-and-flipper, built two homes, brand new construction, a few blocks from each other. Took out loans, paid cash for the property, $100,000 each, and took out $500,000 loans on each property. Started the properties in the sixes. When you think about even starting in the sixes, after you pay real estate fees and stuff, you’re probably looking to make $50,000, $100,000, still good money. Each one of those properties is listed in the low fives. They’re going to have to come out of pocket to pay off the loan because not only is it taking them longer, but they’ve had to get extensions on these properties. Each extension usually costs money.

The original $500,000 loans, they’re up to like $550,000 owed on each one. They’re selling them for less than around $514,000, I think, which is what they’re both listed for. They’ve been like that for a month, and they haven’t sold. It’s probably going to go lower. What’s this person going to do? The lender has a personal guarantee, which is that we’ll talk about structure and terms later on what to get on these documents. This person could lose judgments against them, and other assets they have are at risk because of market conditions. Very important to understand, as a lender, and they could still go to foreclosure.

The lender could foreclose, say they sell for $350,000, and this borrower has nothing else to go after. That lender just lost significant money because of market conditions. It goes back to lien position, that loan to value that we talked about, making sure there’s plenty of fluff in these numbers, which rolls into number four, that property valuation. The need for accurate valuations. Accurate is the keyword here.

Some people would just use a BPO, which is a broker price opinion, which is really just getting some comps from a real estate broker. Some do an AVM, an automated valuation model, which is a computer, like ChatGPT, before ChatGPT, that spits out what the comps are in the area and gives you a number. Appraisals also aren’t the most accurate, just be fully upfront. We’ve had appraisals be way off, but you need some type of pricing and understanding, and you need to look at that yourself and review it. Is this realistic?

Understand where, again, the market is headed, which we just talked about, because that is key in understanding. As a real estate investor, and going back to experience, a year ago, I’ve been telling people home prices can’t continue to go up, and some of these markets, they have to soften, or they would, especially in coastal areas, because of insurance and taxes. Governments were spending loads of money on COVID that they needed to recoup, state taxes, and then insurance. The cost to build everything got so expensive, and insurance is based off of replacement value. If a home that used to cost $250,000 to build costs $500,000, insurance is going to have to insure it for $500,000. What do you think would happen to the insurance? It would go up.

People reading, how many of your salaries have gone up by 20% to 30% over the last year or two? You’ve got a promotion, maybe, but most companies are still giving 3% to 4% increases. If people’s income isn’t going up, but all the other costs associated with things are, home prices just at some point become unaffordable, even if interest rates still come down. A lot of these markets, especially where the average income is only $50,000 to $60,000, you can’t swing a house for $500,000. Some people can, but the majority can’t. Eventually, there’ll become that oversupply, and that value, unfortunately, would come down. Something really important to understand.

Protecting Yourself With Proper Loan Structure

Last is, and this is the one item on this list that I would say is something that you control 100%. Experience, you can still get it wrong because it could just be a bad deal. Conditions, nobody can really predict the future. You can guess the headwinds, tailwinds, which impact the property valuation. Lien position, you can control where you want to be in first, but the loan structure and terms are completely up to you.

Always get the proper documents. A bad loan structure can turn a good deal into a disaster. Share on X

What do I mean by that? Do not go online and just pull documents from some website. I’m a member of BiggerPockets. They’ve got leases and other forms on there. Some of those documents, yeah, they’re good. If you’re giving out a loan to structure the terms and the process you go through, this is 100% in your control. You get an attorney to create the documents.

For example, there’s the note, the mortgage, the loan agreement, if it’s an LLC, the LLC, a declaration that allows them to borrow money, a personal guarantee. Your attorney can create all these for you. You can’t complain that, “It’s a cost,” because this cost is 100% passed on to the borrower on the HUD statement. It’s important to understand that you work with an attorney who can structure the proper documents. When I see people just going online and pulling a document or just giving somebody money without even putting any documents in place, typically, nothing good is going to happen from that.

The other component with these loan structures and terms is going through a title company. I can’t tell you how many times I’ve seen people just give somebody money, didn’t go through title, and then the person disappears. It wasn’t even a real name. They never got the person’s identification. They’ve got an ID, nothing. They’re just like, “Here you go,” and just sign these docs. The person’s like, “Okay,” signs the docs, sends the money, and then did not complete or fulfill. Go through a title company, have them pull title, get title insurance.

Private lending isn’t as passive as you think. It takes strategy, knowledge, and control over your lien position. Share on X

It’s all passed through. Make sure the monies that get sent go to a title company. The deed of trust or mortgage gets recorded, which is important. You secure your lien position before they give the money. This aspect of it, again, is 100% in your control. This one is, out of the five that we talked about, one that should never occur. You should always structure the terms to your desires, your likings. You never want to force a deal.

Key Takeaways For Private Lending Success

To wrap up this episode, I really wanted to talk about these five key points, your lien position, the borrower experience, the market conditions that impact the property valuation, and the loan structuring term. As we see more people looking for passive investing, private lending is much more passive than owning traditional real estate. In order to do it, you want to make sure you do it right. Spend the time and take the ample opportunity to educate yourself and learn so you don’t make these mistakes. Just like in traditional real estate, you can suffer massive losses on private loans that could take you years or decades to recover.

I hope you enjoyed this episode of the Creating Wealth Simplified podcast. As always, please feel free to reach out and leave us a review on Apple’s iTunes, Spotify, or your favorite listening station. Want to know more about us and our current Regulation A plus offerings? Please go to 7eInvestments.com or hit us up at Invest@7eInvestments.com. Take care. Thank you all.

 

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