How to do due diligence with private lending offer

Question

I had an opportunity come my way with a couple fellow real estate investors are refinancing a short term rental property and the appraisal came in a bit low and they are looking for gap funding and are offering 15% interest amortized over 18 months with a 3 month extension option. This would obviously be in 2nd position to the refi lender. I've never done private lending, but know lots of people do so looking for advice on how to do due diligence and protect yourself, especially since it's in 2nd position. What documentation would you ask for? Do the terms seem fair? Do you get some type of insurance on the note? Who pays for the attorney fees to draw up the note or any other ancillary fees?

Really looking for any advice from those are have experience in this realm.

Kyle J. · Answer

@Cale Delaney While we don't know the amount of money at stake, or your relationship to these investors, loaning in second position is generally a risky endeavor (especially for someone brand new at private lending). However, I realize you may do it anyway, so I'll try to answer the questions that you posed. - What documentation would you look for? There's so much more that's needed beyond just a note. (If truly all you had was a note, you wouldn't even have a second position loan. You'd have an unsecured loan.) Rather than list everything you do need though, I'll just refer you to this post which has a comprehensive list in the third response down from Jeff: https://www.biggerpockets.com/forums/49/topics/413352-private-lender---forms-required - Do the terms seem fair? The terms can be whatever both parties agree to (provided they're legal in the state where you're doing business). So really this is a question for you and the other party. I personally wouldn't do it for less than 15% to account for the added risk on your part of loaning in second position. I would, however, confirm if that's 15% APR or 15% total return over the life of the loan. It wasn't clear to me from the way you wrote it, but it would make a big difference in how much return you ultimately earn. - Do you get some type of insurance on the note? You'll want to make sure the borrower gets a lender's title policy. They should pay for this. (Speaking of insurance, you'll also want to make sure the borrower has the appropriate dwelling and liability insurance for the property, with you also named on the policy.) - Who pays for the attorney fees to draw up the note or any other ancillary fees? You'd use your attorney, but the borrower would pay for the cost of drawing up the loan documents. One other thing you didn't ask about, but I feel the need to comment on. With regard to your reference to this potential loan as being "amortized over 18 months", I just wanted to mention that it is NOT common to do fully amortizing private/hard money loans. While I suppose it is possible, do you know how to figure out an amortization schedule? And what if the borrower elected to do the 3 month extension? Point is, if you do this loan, you should keep it simple and just do an interest-only loan. Lastly, my post is not meant to cover everything you'd need to know about private lending. Mainly, I just wanted to answer the questions you asked. But one thing I did want to touch on, even though you didn't specifically ask about it, is that you should question these borrowers about what their exit plan is for this loan. I noticed that you said this is a rental property, so I'm assuming they're not planning to exit by selling the property (which is a common exit strategy when a flipper borrowers money short term). So how EXACTLY are these guys going to pay you back in 18 months? And does what they say sound reasonable to you? I mean, if the property didn't appraise for what they needed it to now, is it just going magically appraise for some great deal more in 18 months? Or do they have a solid plan to get it to that higher number? Or some other plan? Point is, you need to be satisfied that they have a REAL plan to pay you back when the loan matures. Hope this helps.

Frank Y. · Answer

@Cale Delaney We never do 2nd position but I know some people do. You have to make sure there is enough equity in the properties to cover you and the first lien holder. You will need a mortgage and promissory note (but that will not guarantee you collect anything if something goes wrong because you are 2nd). The borrower should pay all the loan documents fees. Good luck.

Cale Delaney · Answer

@Kyle J. Thanks! Very helpful info.

Rob Beeman · Answer

@Cale Delaney I have never had a second position note go down the right road. Not saying that it couldn't, just hasn't worked for me. The worst part is, in order to recover the funds, I had to buy out the first position! My take - only do the loan if you can live with the outcome if it goes wrong - or be able to buy out the first position if needed.

Darius Ogloza · Answer

Assuming you are talking about more than a couple thousand bucks, ask for security and not necessarily limited to the subject property itself. Cars, boats, brokerage accounts are all fair game. Your butt will be hanging out for almost two years. A serious borrower will not flinch at the request.

Todd Goedeke · Answer

How much equity do property owners have in property?