Raising Capital through Note Hypothecation

[Lupe Santiago]

Hi! I am looking to raise capital from some family / friends for my real estate lending business. I am an unlicensed hard money lender (legal in my jurisdiction - no broker license needed for non-owner occupied) and have a substantial sum of notes that I have lent upon.

Problem: Need to raise more money to continue lending w/ current clients, but probably can't sell the note via assignment of note & deed of trust because I'm not a broker. I operate as an unlicensed sole proprietor.

Here's my idea: Say I have 10 notes, each with principal at $100,000, with properties my borrowers purchased for $125,000 securing each note. Now I want to raise $90k from a friend so I can continue lending to my borrowers. Therefore, I would execute a note in favor of my friend for $90k, then pledge one of the notes of principal $100k as security. Upon an event of my default on the $90k note, the note & deed of trust would automatically vest in my friend, and he would step into the shoes of the lender to my borrower with the $100k obligation and property - friend is ultra secure and is basically getting 90 / 125 LTV based on not the market value, but the purchase price of borrower. That, in a nutshell, is how it would work.

Question...

1. My friend wants to be damn sure that he's the only person who has a claim on that note. How can I assure him of that when there doesn't exist an equivalent, well-established land-title recorder system for notes? How does he know I didn't already hypothecate it to someone else?

2. Any other issues or does anyone have experience in this area? I'm still trying to figure out how it would legally and operationally work!

Thank you very much!

[Ben Reese]

The underlying security in this transaction is the mortgage and if I were your friend I'd want a recorded interest in it via an assignment. You probably should bounce this off a real estate attorney, but mortgages change hands all the time and I doubt you have to be a broker to assign an interest in this one.

Let us know what you learn.

[Bill Gulley]

Assigning notes as collateral for another note is creating a bond in some instances so you need to meet SEC requirements and are the investors "qualified investors" or immediate family? See an attorney!

Next, if you acquired the notes with your money and they are held in your personal portfolio, you can sell your notes as they are a personal investment and you are not trading as a business operation but to manage your portfolio. :) Note: if the selling of your notes yields a significant income and is not reinvested and the income is more from your other activities you may be seen as being in the business, see your tax advisor.

[Account Closed]

Lupe: For a fee you could have a broker do the assignment for you, that way your friend can be sure.

It sounds like you have done some research. I'm curious, is there a limit to the number of loans you can make without a license in NV? I'm told there is no usury limit in NV, is that your understanding? In California you don't need a license for the activity you describe unless you make more than 8 loans, or, the interest rate is over the usury limit of 10%.

[Lupe Santiago]

Thanks for the responses, everybody!

Bill Gulley, A few other details - These notes were originated with my own capital. I am looking to raise more capital to meet the needs of my borrowers, however I will end up making a profit on it. Here's an example of how my loans work.

Let's say borrower needs 100k. With my fee of 4 points, I net fund 96k at escrow and the principal is $100k. What I want to do is sell that note to my close friend (not family) for par value at the stated APR. Then I can continue to service my borrowers with more capital. In effect, I'm making 4 points when I sell the loan to my friend. The sale would occur within a week of funding the note myself.

David C., There is no limit to the number of loans you can make in Nevada as long as you fall within one of the exemptions set forth in NRS 645A/B/C. In my case, I make non-owner occupied loans on residential real estate so I'm exempt from any kind of licensing requirements.

[Lupe Santiago]

Although one could argue that I'm making the profit when escrow closes and the borrower receives $96k for a $100k obligation. I guess my friend would be stepping into my shoes at $100k, and it wouldn't be considered a profit. The profit is booked at close of escrow, but the cash flow is received when my friend buys it.

[Jon Holdman]

This sounds like you're brokering private money to me. I've been on the lending side of this sort of deal. You're acting as a broker, making the loan, and collecting the points and then I collect the payments. IMHO, you're trying to dress this up with some complexity, but ultimately, its your close friends money you're lending and you're keeping the points for brokering the deal.

Here in CO, you must be both a licensed mortgage broker and have an additional license when you're brokering private money. The guy I do this through has both of those licenses.

If, and you really MUST assume "when" at this point, you and your friend end up in court, I'm not sure this more complex structure would pass muster with a judge, if a license is required in NV. If it is, why not just get the license? This is a pretty common business model for hard money. But it is regulated and you have to play by the rules.

[Lupe Santiago]

Jon Holdman, thanks for the response.

Is my strategy not the same as taking out a personal loan and then using a note I already own to securitize the repayment of it? Forget about selling the loan A to friend after funding loan A. I agree - that's probably brokerage.

What about borrowing money from friend to make Loan B, and securitize his note with Loan C, that I already funded a month ago and hold in my portfolio? Would I be able to use a note as security to borrow money that is essentially a personal loan?

Thanks

[Jon Holdman]

No. The personal loan isn't secured by or in any way related to the note you've already originated. Even if you use the income when you qualify for the loan, the two loans are in no way linked.

In your previous posts, you explicitly talk about selling, assigning, or otherwise securing the new loan from your friend with your existing note. In the law, there is a concept that "a thing speaks for itself". I'm sure a lawyer could tell you the name for this concept. You can create all the complexity you want around a series of transactions. A judge (and the plaintiff's lawyer, who is really your concern here), will "do algebra" on the contracts and get to the net effect - you're brokering your friends money.

Again, you can do anything. Until you get caught. When, and you MUST, MUST, MUST assume this is "when" not "if", you end up in court, how will a judge look at the situation.

Borrowing and lending is a highly regulated business. "Selling securities", which is what you are almost always doing when you take someone money and make a profit from it, is also highly regulated. If you're a lawyer, or have a good lawyer, and thoroughly understand the rules you may find a way to do things with a minimum of paperwork and licensing. By your own admission, you're unlicensed. I suspect that means you do not understand the law and regulations thoroughly. You're playing with fire to try to do this. It may work out fine. But if these loans don't work out for your friend, and he has to repossess a house (I've had to do this, it sucks), you may well end up in court.

[Jeff S.]

We’re actually considering the same strategy, Lupe Santiago, and I recently spoke to our lending attorney and another CA securities attorney about it. Miraculously, they provided identical answers. This is this is completely legal in California. I suspect in Nevada too, but that was not part of my discussions.

If you own a note you can use it as collateral for a personal loan someone makes to you. Here, as David C. said, your personal loan would have to be at less than 10% since it would not be secured by real estate and originated by a RE broker, but that’s a California thing. You would not need a broker to do this since it’s just a personal loan to you secured by a real estate note you already own (which presumably, was brokered appropriately and assigned to you properly). In fact, now you're the borrower.

These are your personal assets, you are not brokering or otherwise originating real estate loans, and there is no transfer of any title. There’s no limit on how many of these you can do here. In this obscenely smothering regulatory climate, I know it sounds like a loophole of some sort, but it’s not. I thought the same thing.

None of this answers your original question, “How do you satisfy your lender that your real estate note doesn’t secretly secure five other personal loans to you from different individuals?” Obviously, you can’t commit fraud, but that’s not much of an answer.

If I were your lender, I’d ask you to sign and notarize an assignment of the note to me that gets held in escrow and recorded in the event of your default. Escrow would also hold the original note and present it to me if the assignment is recorded.

The escrow instructions would have to be clear about what’s a default, how it’s claimed, what the remedies would be before recording, and probably a hundred other things a lawyer could help you with. Alternately, a note servicing company might be help here and you might call a few – after you speak with a Nevada securities attorney to confirm that all of this applies to you in your state!!!

Also, your lender would be wise to have his attorney review your collateral to ensure it's legal and enforceable.

Good question, Lupe. Please let us know what your lawyer says. We'll exchange "notes" :-).

Jeff

[Account Closed]

I've never hypothecated a note but escrowing the note/dot/assignment, as Jeff suggested, is the way it is normally done, or so I've been told. Then the question becomes, what is cheaper, escrowing or simply paying a broker to do the assignment. A broker will, or should, vet the note buyer for suitability, even if there is no law in NV like there is in CA in that regard, it should be done.

[Lupe Santiago]

This is all great information. Upon doing further research, I don't believe I can alienate any part of the loans I've made. I operate under an exemption in NRS 645B.015 (7), which reads:

"Any one natural person, or husband and wife, who provides money for investment in commercial loans secured by a lien on real property, on his or her own account, unless such a person makes a loan secured by a lien on real property using his or her own money and assigns all or a part of his or her interest in the loan to another person, other than his or her spouse or child, within 3 years after the date on which the loan is made or the deed of trust is recorded, whichever occurs later."

----
The key starts with "... unless such a person makes a loan secured by a lien on real property using his or her own money AND ASSIGNS ALL OR A PART OF HIS OR HER INTEREST IN THE LOAN TO ANOTHER PERSON, OTHER THAN HIS OR HER SPOUSE OR CHILD, WITHIN 3 YEARS..."

So looks like a no go for this way in Nevada! At least, if you're operating under this exemption.

[Bill Gulley]

Lupe, first your discount is to be recognized when earned which is at the time the note is made with the discount, not when the note is sold. You receive consideration in the note, the same as cash. You may look into amending your tax returns. If your accountant doesn't understand this get another accountant.

I did exactly what you are considering, David C. touched on issues to be considered, that's the tip of the iceberg. Selling the notes at par or borrowing at the par value assigning the note has collateral issues to the one lending to you taht need to be underwritten, professionally.

Next, there are alot of folks who have money, read state statutes and decide that non-owner occupied (lending to landlords) meets commercial lending assumptions, that alone may not be true.

Many seem to feel that if they meet state exemptions they are home free, not completly true either. With respect to single family dwellings (1-4 units) owner or non-owner occupied, HUD has jurisdiction over any state law. In any event where the intent of the SAFE Act fails to be met through any state law, the SAFE Act prevails.

You really can't expect to ask the average RE attorney about lending functions, banking and finance is a specialized area, getting "off the top of my head" opinions and relying on such is dangerous.

I love BP, but there are limitations here on receiving advice in lending matters as I know of no mortgage loan compliance officers, no finance regulators (other than my past experience) and no finance attorneys on this site, if any are lurking, chime in! What we have are HMLs with very limited legal and compliance experience giving advice. To that I'd say proceed at your own risk.

I've noticed too that people tend to research compliance issues (in RE or any other lending matter) only to the extent they become satisfied for the desired outcome and stop. There are many other areas of law that pertain to lending, there is, to mention a few, the SEC, the CPFB, the FTC, Homeland Security, Money Laundering (FBI), HUD, Treasury Dept., and even Postal Inspectors can come into the picture if there is a violation and the postal system was involved.

When you begin getting friends or the public involved in any financing conduit, more than likely you will be entering areas of servicing a financial product or loan, totally another area of lending.

As I mentioned above, acting in the interest of your own private portfolio of investments is a right we all have, beyond that you can easily be under the scutiny of various agencies, not just your state finance department. My suggestion is to invest in your business and get expert legal and accounting advice.

Sorry I don't recall his name, my appoligies to him, but there is a mortgage compliance company individual who has posted here, I'm not endorsing any company but there are companies that specialize in setting up lending compliance operations.

In my examination experience I have never seen any lender who was ever in total compliance in all areas of thier operations. Chances of you violating compliance issues won't put you on death row, but could put you in jail, depending on who lost money and how much and what you messed up in. Besides the serious infractions, the minor ones can cause you to lose money in fines and the loss of the ability to collect on your loan, fair collections practices alone can deny you the ability to collect in addition to fines. It is only prudent to follow any law that could remotely be related to your activity even if you are an unregulated lender and every time some private lender gets creative they increase thier chances of falling under some regulatory compliance issue.

Lastly, if you are like me, retired and dealing in your own portfolio, spreading your wings beyond your own portfolio management can have unitended consequences. If you are seen as being "In the business" earning most of your income from activities by the IRS, it is highly likely that other agencies can follow suit and apply applicable rules and regulations to a lending business. For that reason, I'm investigating getting my MLO license and meeting registration requirements, even though I'm not really active now. :)

[Steve Babiak]

Originally posted by Bill Gulley:

...

Sorry I don't recall his name, my appoligies to him, but there is a mortgage compliance company individual who has posted here, I'm not endorsing any company but there are companies that specialize in setting up lending compliance operations.
...

Bill Gulley - is this the party you were referring to in that snippet?

http://www.biggerpockets.com/users/RishelGroup

[Bill Gulley]

Originally posted by Steve Babiak:

Originally posted by Bill Gulley:

...

Sorry I don't recall his name, my appoligies to him, but there is a mortgage compliance company individual who has posted here, I'm not endorsing any company but there are companies that specialize in setting up lending compliance operations.
...

Bill Gulley - is this the party you were referring to in that snippet?

http://www.biggerpockets.com/users/RishelGroup

Yes, thanks Steve! Ken, sorry I couldn't recall the name, you're not on enough. :)

He seems to be doing compliance issues as an outside/external audits. :)

[Will Barnard]

It appears to me this thread had answers that went way off track. The topic stated "note hypothecation" which would be borrowing funds from a party and using the already generated notes as collateral, it would not include selling the note and using funds from sale to re-lend.

With that said, I have no clue regarding the legal aspects of what you propose Lupe, however, I did reserach this a bit as i wanted to do the same with my 401k notes. After all, banks do this all the time, that is how they can lend 10 times+ the amount they actually have through hypothecation along with creative accounting.

I spoke with Chase bank and although they use the practice, they would not allow me to borrow funds secured by my notes.

I intend to speak to my local community bank to see if I can get any further with them. This of course would, I would assume, be all legal as i would be borrowing from an institution and not a "friend".

[Dave Van Horn]

Lupe Santiago I think I can answer all of your questions. What you're after is what is called a Collateral Assignment of Note and Mortgage. Just to give a quick definition: a collateral assignment is the transfer of ownership rights of an asset from a borrower to a lender (e.g. one investor to one note), in exchange for the granting of some type of loan.

I was in your same situation in 2008 and I started doing Collateral Assignments on a one off basis and later on as a private offering. Since then I've done over $2 million of these both individually and as a private offering. When doing one of these on a one-off basis, it only requires 2 documents, a promissory note with the new lender and the Collateral Assignment of Note Mortgage doc (including a legal description of the property that is tied to the note).

1. You're NOT recording the note, you just record the Collateral Assignment of Note and Mortgage document. This includes a legal description of the underlying property, the original mortgage origination date, the original lender, the original loan amount, county and state where it was recorded, book and page numbers or ID number. This recording (recorded in the county the property behind the note is located) perfects the collateral (your performing note) for your friend's loan to you. The recording date is what will assure him of priority over other liens, so he will see he has the first claim to the note. And if he REALLY didn't trust you, he could do an encumbrance report on title because that would show no other collateral assignments would have been recorded. If you want a copy of my Collateral Assignment, just message me with your email and I'll send it over.

2. Word to the wise: Since I went from doing it from a one off basis to a higher quantity, my securities attorney recommended that I start a private offering. Most offerings are only worth it if you're raising $1 million or more. It looks like you're starting to get to that point with your 10 notes. Setting up a Private Offering could cost up to $7-$10K to set up, but it might very well be worth it, it was in my case. I also have a copy of our private offering as well, so you can message me if you're interested in seeing it.

ANOTHER TIP: I would also be sure to include a substitution of collateral clause in your promissory note. In case the original homeowner wants to refinance or sell, you would then have the right to substitute another note of equal or like value instead of paying your lender back early.

*ANOTHER BIG TIP*: When you go to record your Satisfaction of Collateral Assignment of Note and Mortgage, MAKE SURE the recorder's office doesn't mistakenly satisfy the actual mortgage instead of the collateral assignment.

And just to be clear a Collateral Assignment of Note and Mortgage has nothing to do with mortgage origination or a transfer/escrow of an assignment because the original owner of the note is still maintaining the rights unless there is a default.

Hope this helps,
Dave

[Lupe Santiago]

Dave Van Horn, wow that was a really great description and exactly what I was thinking of doing. That's so helpful. Thank you very much for your words of wisdom and experience. I will look into this more and message you if I have questions. Have a great day!

[Will Barnard]

Any updates Lupe?

[Bill Gulley]

Lupe Santiago, giving a collateral assignment in a note will put you under SEC restrictions as well as banking activities. The exemption you posted won't exempt you in such an activity.

If you sell the note, you can not service the note as an individual, you need to comply with loan servicing requirements.

If you sell part of the note and retain an interest in that note then you could continue servicing the note, but as you sell the notes you will get into brokerage operations.

It being your own money or doing business with a friend is totally irrellivant, and if you are taking the funds and making new loans, that absolutely is not a private loan, it's a business loan and now, you're in the business and unregulated without a license.

I think too, that if you investigate who can charge points on a loan, you'll find that only regulated lenders can charge points and loan fees, not individuals, charging fees is a business activity.

I used a couple banks for hypothecation of notes. I owned the mortgage company, the files were conforming to thier underwriting requirements, I was bonded and insured, files were approved before funded, title insurance was provided and assigned, the funding was 80% of par. Otherwise, I'd simply originate the note for the bank, which is another ball of wax.

I also had hypothecation activities with individual investors, friends yes, but friends has nothing to do with it, they were qualified investors known to me with past business dealings. If it was simply a loan arrangement it was at 80% of par, otherwise, they bought the note and as a registered company I retained servicing.

IMO, if you take an investor over 80% of par (forget the collateral right now) you will be putting them in an investment beyond thier understanding and ability to access risks involved unless they have wholesale mortgage brokerage/banking experience, IMO. And, since things happen in life, you better be able to take out any investor within 30 days, regardless of what your agreement is.

Another point, at 80% you should be able to sell a note to payoff an investor if it comes down to it, over that you may be making up the difference.

When you get into assigning other collateral as Ken mentions, you better make dang sure you can back up the values of notes and collateral assigned and do so with the consent of your investor, absolutely not at your whim. That's another brokerage/banking activity as well. There is a broker who had his office about a mile from me who was doing that and today, he woke up in prison!

There are many areas of RE where, when someone posts a question here asking how to do something, that indicates they should not be doing that activity since they need to ask, this is one of those areas. If you want to get into brokerage activities and conduct a lending business, then become a lender/broker. You can't have the best of both worlds, being an individual part time HML on the side and then do what brokers or banks and servicers do. All said with good intentions, it is what it is. :)

[Will Barnard]

I agree that hypothecating a note for greater than 80% of par is risky and places the "lender" in a precarious position. Not something I would recommend.

[Dennis Shannon]

Dave, We buy Non Performing loans and normally foreclose and sell the property. We have private  lenders who would like to lend us capital for our note business. Is there anyway to hypothecate using the note(s) as collateral?