|The November before last, my father, a successful Palo Alto businessman, lent me $220,000 at 7% annual interest so I could buy a piece of property in San Francisco. Our plan was for me to pay him back within a year's time from the proceeds of another real estate investment that I intended to sell the following spring. |
Now it's been more than six months. The property I plan to sell will be going on the market in a matter of weeks, and I should have my father paid off in full by Thanksgiving. The total amount of interest he will have earned since that November is more than $15,000, far more than he would have made on a certificate of deposit, a Treasury bill, or a money market account.
Meanwhile, in Marine, MI, an innovative Realtor named Wynne Achatz arranged a $15,000 purchase money mortgage between sisters so that one could buy a home on more favorable terms than she would have gotten otherwise. Mary, the borrower, was anticipating a bonus at the end of the year, so Kathy, the lender, was confident in her sibling's ability to pay her back. Just 10 months later all of Kathy's money was repaid, along with an additional $1,125, the amount of interest her loan had earned.
SECOND DEEDS OF TRUST
If you're not ready to jump in with both feet and buy some property, personal second deeds of trust or mortgages are another way to take advantage of opportunities in the real estate market. Such loans offer a variety of benefits. What people like best about them is their ability to provide a consistent rate of return that generally exceeds the rate offered by traditional instruments. It can also be a more stable investment because real estate markets tend not to take the quick severe downturns that stock market investments are prone to.
Another unusual advantage of personal second deeds of trust is that you can keep an eye on the factors affecting your investment first-hand, because ideally you will know the person you are lending your money to and are quite familiar with the property that secures your loan. If you decide to make a loan like this, however, it's important to understand the inherent risks, and structure a deal that works to your benefit without jeopardizing your investment.
WHAT YOU SHOULD DO
Following are the most important steps to take and rules to follow when lending against a piece of real estate:
1 Keep the emotional component out of it. This seems like obvious advice, but you wouldn't believe how often people lending money to family, friends, and acquaintances ignore it. Because your personal relationships are at risk as well as your money, it is critical that you remain objective and use real estate professionals, who can arrange paperwork and render an opinion on whether the loan you're making is sound.
2 Verify that your borrowers are extremely well-qualified, with an excellent credit history. Even if you know your borrowers well, you should verify their income, like any lender, and review their credit reports. With their Social Security numbers and address, you can order a report from a local credit reporting agency or have your borrowers obtain their own directly from one of the three major credit reporting agencies: Experian, 888 397-3742, www.experian.com; Equifax, 800 997-2493, www.equifax.com; or Transunion, 800 888-4213, www.transunion.com. Income verification can come from your borrowers' pay stubs or their bank statements, which will reveal your borrowers' deposit history. Conservative lenders offering conventional loans require that their borrowers have a back-end ratio of no more than 36%. This means that their monthly consumer and real estate payments (including principal, interest, taxes, and insurance) don't exceed 36% of their monthly income.
3 Make sure that the property securing the loan is in good repair, and worth significantly more than the total of loans against it. If your borrower defaults and the property securing the loans needs to be sold, you don't want to have the proceeds from the sale fall short of the amount needed to pay you back. To be sure that your investment is protected, you need to fully understand the property's value and its indebtedness.
I recommend lending against a local property. Even if you are familiar with your real estate market, however, you should still get an expert opinion on its value by obtaining a market analysis from a competent local Realtor or by ordering an appraisal from a certified appraiser. To find out what loans may already be against the property, you can order a title report from a local title company. This report will tell you what loans already are set against the property, reveal whether your borrower is keeping current on the loan and property tax payments, and show any liens or judgments that might be set against the property. The total amount of indebtedness against the property after your loan is made should be no more than 80% of the property's value. An even more careful investor would require this figure to be 70% or less.
4 Understand your objectives and make sure they are aligned with your borrower's plans. You and your borrower need to have an understanding of how they intend to pay off your loan, whether it is through refinancing, sale, or other anticipated income. You also need to decide how long you want your money tied up in the investment and what an acceptable rate of return is for you. The typical loan period for these is usually six months to five years. However, many people have no problem keeping their loans out for longer or shorter periods, either because they like the consistent income stream, or because they want to be in a position to take advantage of other opportunities in the near term.
Smaller details you and your borrower should decide on include what the late charges will be, and whether you will require a "due on sale" clause and/or a prepayment penalty (a fee charged to the borrower when they pay off sooner than the agreed-upon term). Late charges are usually 6% of the payment; the prepayment penalty is typically six months' worth of interest.
5 Get the loan agreement in writing and have the loan professionally serviced. A real estate attorney, or other real estate professional with experience in arranging these kinds of loans, should draw up the documents necessary to formalize your agreement. If you're on the West Coast, those documents will be referred to as a deed of trust, and note. In other regions, the instruments may simply be called mortgages.
All of the details you and your borrower have discussed should go into the agreement. If the property has other loans against it, you should also arrange to have the other lenders send you a notice of default in the event your borrower does not keep up with his other mortgage payments. The title company you ordered your report from can arrange to have the notice of default sent, or you can have a professional loan servicer track the status of the senior loan and property insurance payments.
Having the loan professionally serviced means hiring a third party to handle payments so that the lenderborrower relationship remains strictly business. You don't want to make it easy for your borrower to miss a payment. Having a third party collect instead of you keeps the personal component out of it and holds your borrower to the proper level of accountability. A loan servicer can also prepare your IRS 1099 report at the end of the year. Cost of servicing typically runs 0.05% per annum of the principal balance. You and your borrower can negotiate how you want that cost to be covered.
Provided that you do your homework and put the proper safeguards in place, personal deeds of trust can be rewarding and profitable ventures. Just ask Wynne Achatz, who recently lent $26,000 to a client so he could buy a truck. "It was a great way for me to make a little more interest than the bank was paying," Wynne says happily, "and an easy decision to trust him with my money, because he held a deed of trust on another property that was going to net him well over $50,000 when it was paid off in a couple of years. He was already collecting a tidy monthly sum on that loan, so I just had him pass a portion of that payment on to me."
Cece Blase is a San Francisco Realtor and freelance writer.
Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.