Becoming a Private lender

[Neil Andrews]

I have just decided to get into real estate investing .

I am a retired engineer, 37 years at Boeing. I thought that acting as a private lender would be a good place to start. I have high six figures in saving currently invested in a 401-K that I can tap into to lend. I also own my own home free and clear that I thought I could get a HELOC on for use in private lending.

My plan is to set up an S-corp, create a solo 401-K and transfer my 401-K money into that. I have already met 2 potential investors that could be future clients, but have not vetted them yet. One, I think is pretty new to the industry and is a part of Fortune Builders (Than Merrill). The second is a guy, I just met at the gym who has been doing it for 15 years. We are planning to get together for lunch next week.

Do you have any comments about my beginnings of a plan? Is an S-corp the right way to go? Or would an LLC be better? Are there any other important first steps that I am missing? What is you personal opinion of Than Merrill's Fortune Builders? Is it reasonable to trust that people in that system know what they are doing at least to some degree? I plan to bring a list of questions to the lunch next week. What questions you ask a prospective REI when considering a new client?

Thanks for any help or advice you are willing to provide.

[Jeff S.]

We do almost exactly what you are asking about, @Neil Andrews. Below is a top-level, actionable explanation of our process, from a post I made here several years ago. With minor modification, it's still 95% accurate and should work well for you, as it still does for us.

[Note: In CA we use mortgage brokers, escrow, and title companies. I suspect in KS you use closing attorneys and title (?). For the purposes of what I wrote below, you should be able to make the adjustment so long as you understand the process.]

1) You’ll need to spend some time with a good lending attorney. This is not the same as a real estate lawyer. Attend some real estate clubs. Meet and call some hard money lenders in your area and ask them if they sell their notes and need investors or if they run a mortgage pool. (As an aside, investing with a local HML in local loans is another way to get into the business.) Also ask which attorney they use. Lending attorneys are a rare breed and you’ll likely only hear the same few names. Pick one and spend an hour or two with him or her.

Lending attorneys sell their paperwork to HML's. You could wait on this until you do a few deals and instead use those from a broker or HML at first. Never find your loan documents online or obtain them from a borrower.

2) Ask some of your potential borrowers for a broker recommendation. Take him or her to lunch and get to know each other a bit. Never do business with anyone you don’t know, like, and trust. Negotiate a flat dollar amount per loan they originate for you. Don’t pay a percent of the loan amount. Your borrowers will pay this anyway so you’re really negotiating on their behalf.

3) Go to some real estate clubs and let people know you have money to lend. In general you can't advertise at all. Nada. Not even on a business card or website. State specific, but your lawyer might tell you that (ours did). Everyone will want to know your terms. Set one interest rate and point amount. Don't get into making deals up or negotiating on the fly. They'll also want to know the note duration, what happens if they need an extension, amount you'll lend, location, LTV, and a handful of other questions you'll eventually have to develop answers to.

Don’t loan far from home because you’ll want to drive and see every property you loan on. (The easiest way to lose money as an inexperienced lender is to respond to solicitations here, lending out-of-state, to those you don't know, against homes you've never seen, in areas you don't know, and where you don't know the state law. People actually do this!!)

For LTV, we loan on a percent of the purchase price, not ARV. Purchase price is an easy number to establish and our percent is very high. The higher the percent, the more popular you will be so long as you only loan on good deals and follow any state laws restricting high LTV loans, as applicable. Your biggest challenge will be to learn how to evaluate the numbers behind a flip and ensure it's a good deal for both your borrower and you.

4) MOST IMPORTANT OF ALL: Only loan to those with experience and who do this full time. No newbies, hobbyists, first timers, or anyone learning on your dime. Before you lend to anyone, spend some time driving around with them looking at their properties. Go to lunch or dinner a few times. The idea is to get to know, like, and trust them and vice versa. If you don’t, then don’t loan. See a theme here?

5) Soon thereafter, they will call you with a property they have under contract that fits the criteria you defined for them. Tell them honestly if you don’t have the money to lend at this time or if it doesn’t meet your criteria (which they should already know because you previously discussed this with them over lunch). Never agree to fund a deal if you don’t have the cash in the bank. Never rely on one deal closing on time to fund another. Ever. The cash must be in the bank.

Meet your borrower as soon as possible at the property but no later than 24 hours from the phone call. Bring comps with you and ask them to bring theirs. As a lender you don't have to hit the ARV exactly, but you should generally agree with their estimate. Ditto rehab costs, which you can generally estimate with a walk-thru after you've done this for a while. No need for appraisals or contractor bids, unless required by law. That only holds things up (and I personally find them worthless). You should disclose in writing how and why you agree with their ARV & rehab estimate. SECOND MOST IMPORTANT: Make sure you understand the property enough that you're confident it would sell to another flipper if the deal goes bad.

Confirm the amount you’ll loan and shake your borrowers hand at the site.

6) Call your broker and put him in touch with your borrower. You don’t care about most of the paperwork except the Note, Deed of Trust, the sales contract, preliminary title report, hazard insurance, and lender instructions to escrow. I know that still seems like a lot.

We go so far as to fill out our note & deed-of-trust for our broker, which we obtained from our lending attorney. Read and understand everything – at least at first. Your broker (who is very experienced at this, yes?) should be able to explain it all. If not, call your lawyer, but don’t obsess.

Adding, to avoid TILA, RESPA, SAFE Act, Dodd-Frank, etc., etc., this must be a business purpose loan (and that does not mean non-owner occupied). To establish this, you should obtain and evaluate, at the time of application, a handwritten statement from your borrower describing the purpose of the loan proceeds. It's easy, but you might need your lending lawyer to initially help set your parameters.

7) I don't know how it works in Kansas. In CA, your broker will work with your borrower, escrow, and title. There's really little for you to do except review the documents for completeness and wire money (or have your SD-IRA custodian do that once you've rolled your 401k over -- probably what you want).

8) You chose professionals so let them do what they do well and rehab the property without your help. Visit maybe once and take them to lunch or dinner. Attend the open house. Maybe look at more deals with them.

9) When the property is about to sell, you will receive an email from escrow asking for a payoff amount (called a “demand”). Calculate the amount owed and document it in a demand letter. Be clear and show all work. Your borrower will authorize this and should understand your numbers. So should title, because they will be wiring the money into your account.

10) When the money hits your account check the amount. You can now commit it again. Not sooner.

I left out many steps, and I'm certain others here might be horrified, but this process works for us and is completely legal (at least in CA). Always put yourself in your borrowers shoes. They appreciate extreme speed, fairness, and someone who is easy to deal with. They also work their asses off and earn a lot of my respect. Keep it mutual. Good luck.

Jeff