How legally binding is a promissory note ?

Question

I have a good friend who is a GC and investor here in the DC area. Long story short, he’s able to locate offmarket deals and uses private lenders to help fund the rehab costs, in exchange for a percentage of the profit.

He’s asking me to invest in a deal that he and his partner are looking to close, however he says that what he offers the lender, is a promissory note that they can register. I’m not able to come in first position as he’s using a bank loan to fund most of the project.

My RE attorney friend claims that a promissory note is not legally binding and I’d be putting myself at significant risk if I don’t record a deed of trust against the property, so that I could have the power to foreclose if the proverbial S hits the fan.

Can any private lenders shed some light on this? I’m trying to take action however I need to understand the risks as I’d be putting a significant portion of my savings into my first deal.

Thanks in advance !

Tom Gimer · Answer

It's not that a promissory note is not legally binding, it's that it is unsecured. The promise to pay is only as good as the person making it. There are ways to increase the likelihood of collecting on the note, such as including a confession of judgment provision and personal guaranty (or additional guarantors)... but it's just paper.

If you insist on a secured position (recommended), you need to understand all that foreclosing a junior lien requires.

If you insist on a secured position (recommended), you need to understand all that foreclosing a junior lien requires.

Jay Hinrichs · Answer

for someone with significant assets a prom note is fine.. there is no defense for not paying .. so you can go right to judgement. but if they have no assets then as stated above you wont get paid.

Tom Gimer · Answer

@Jeff S. I agree with all you said but you missed the part where OP would be in 2nd position at best. The acquisition itself would be with secured private money.

Jeff S. · Answer

You've gotten some really bad advice from your "good friend," @Daniel Pitta, and from a few here.  First, notes do not get registered, or recorded if that's what that means.  Has your friend ever done this before?  As an example, the county recorder here in LA, will not accept a note for recordation and I suspect your local one won't either.  Nor do notes get notarized.  This is generally reserved for documents that do get recorded, like mortgages and deed-of-trusts since recorders will not accept a non-notarized signature.

Loaning money to an LLC that you are a member of offers little protection either if any of your partners goes belly up or otherwise walks.  Do you really want your only recourse to be suing anyone personally or an LLC to recoup your investment?

Instead of playing these charades, why don't you do it properly?  Use a legitimate real estate lawyer, or preferably a lending lawyer, and have them prepare a set of loan documents for you.  This would include a note and a mortgage that secures the loan (i.e. a lien on the property – and hopefully in first position).

The mortgage would be signed, notarized, and recorded at your local county recorder, or whatever it's called in your state.  The loan documents would also include personal guarantees, 1003's, and all the necessary disclosures that no one here ever seems to mention.  You would also get a lenders title policy, paid for by your borrower at closing to insure your position.

You lawyer would take care of all of this, ensuring a properly originated loan with a mortgage that is properly recorded.  This gives you access to the property in the event of a foreclosure and (state specific) the ability to sue if necessary.

It's no surprise that real estate prices now are flat at best and likely dropping.  Loan defaults are soon to increase.  Poorly originated loans, with missing documents, are easily attacked.  Don't think this couldn't happen. You might be good friends now, but this could change in a heartbeat if your deal goes south.

It's your money, Daniel.  Protect yourself properly.  Good luck.

Jeff S.  --  Private Lender in Los Angeles

Jay Hinrichs · Answer

it does not change the validity of the note.  I borrow large sums for construction loans. in the multi millions and my banks do not have me notarize the note..  but like you said it cant hurt.. and in many instances having the notary allows you to record it.. for nothing else than a small cloud.

Tom Gimer · Answer

Partners are generally responsible for their proportionate share of the LLC's profits as well as its losses... on all of its business.

Also, becoming a member of the LLC would not make your loan to or investment in the LLC secured in any way. Sounds like you would be the only one with skin in the game on this project.

Be sure to get your professional advisers on board with you here.

Jay Hinrichs · Answer

that works but if you own 20% or more of the LLC most lenders will want you to sign for the loan and do a personal Gurantee

Randy Thomason · Answer

Without the mortgage filed you have no security for the note. It is considered an unsecured investment. With that being said, who is the note from? His company or him?  or both?

A mortgage even in a second position, it is better than no collateral.  If he signs personally guaranteeing, then you could tie up all his assets if he defaults, that is if he has any that you can find and he doesn't file Bankruptcy. The property (collateral) is what you want.  CLTV (combined loan to value) of the first and second mtg should not exceed ___?  my suggestion is 75% tops but preferably 70% or below. A lot depends on your market there. When the market turns down, and if it goes quickly, you only have a 30% buffer.  Remember how fast it went down in 2007 and 08?

If you are in the second position and he pays the first but not the second then you have to foreclose and still have the first mtg ahead of you. Do you have the money to take it over?

Jay Hinrichs · Answer

I like the reference to cattle :)

Javi Chipi · Answer

@Jay Hinrichs right I agree with all of that.

How legally binding is a promissory note ?

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