Private Real Estate Investment: Data Analysis and Decision Making_11

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Private Real Estate Investment: Data Analysis and Decision Making_11 10 CHAPTER The Private Lender The contemplation of difficult mathematics, Wolfskehl realized, was far more rewarding than the love of a difficult woman. Paul Hoffman, The Man Who Loved Only Numbers, p. 209 INTRODUCTION The two most common ways the private real estate investor becomes a lender are: 1. Originate or purchase a loan for cash. 2. As the seller of investment property, provide a buyer with financing for a portion of the purchase price by taking a note rather than cash in partial payment. There are ramifications associated with either strategy. Combinations are also possible, an example being a loan made as part of a sale that is then purchased by another private investor. Like many real estate opportunities, the permutations are numerous. In this chapter we will:  Examine motives of private investors who choose to become lenders.  Discuss the difference between aggressive and conservative lending policies.  Measure some of the true economic costs of private funds.  Describe specific loan provisions that accomplish tax objectives.  Warn against a few of the ‘‘traps for the unwary’’ that exist in the tax code. Lending requires a host of special skills. Local laws govern many of the conditions under which loans are made. This chapter is not about those legal details. Rather, it is about the economic, financial, and tax ramifications of these activities. 237 258 238 Private Real Estate Investment THE ‘‘HARD MONEY’’ LOAN VERSUS THE ‘‘PURCHASE MONEY’’ LOAN A loan secured by real property made directly to a borrower via a cash advance from the lender is known as a hard money loan. Loans granted to buyers by the seller as part of a sale are referred to as purchase money loans. While this is our convention, the language is imprecise. Some states consider cash loans from third parties purchase money simply because the proceeds of the loan constitute part of the purchase price. A common misconception is that because cash was paid for a hard money loan it should be held to some sort of higher underwriting standard. This is not true. A loan is a loan. Lenders, regardless of how they came by the instrument, usually want to be paid and want good security that will redeem the debt in the event of borrower default. Nonetheless, sellers sometimes make desirable loans to induce buyers to purchase, perhaps at a higher price. This will be taken up in detail later. As hard money lenders, institutions put borrowers and their property through a rigorous and time-consuming examination prior to granting the loan. Borrowers and properties that do not meet their standards are declined. Borrowers often seek out private parties because the loan can be made faster with fewer formalities. This is not to say that private loans are or should be poorly thought out or that private lending is a casual matter. A few simple rules can successfully guide the real estate investor who wishes to make loans. The fact that these rules are simple does not make them any less effective. THE DIVERSIFICATION PROBLEM Although it is possible for a private investor to own a portfolio of loans, real estate lending involves an entry cost close to that of the purchase of a parcel of real property. Because most private investors have relatively small amounts to invest, they cannot achieve the same diversification benefits a large lending institution can. For this reason, the first rule of private real estate lending must always be observed: Rule 1: Never make a loan on a property you are unwilling or unable to own. This rule opens the discussion on just what it is that a private lender obtains when he makes a real estate loan. Of course, the textbook legal answer is that he gets a security interest in the property. Perhaps. A financial or risk 258 239 The Private Lender management view is that he faces some probability that he will own the property sometime in the future. The most common remedy for a lender who does not receive payment is foreclosure. Thus, from an economic and risk perspective, the lender must view his situation as having made a loan to the property. For it is the property, not the borrower, that is expected to repay the loan. Many states do not permit a lender to collect funds from the borrower in excess of the amount realized from the sale of the property in foreclosure.1 The private investor should make the loan as if he were buying the property at some unspecified time in the future under economic and physical conditions that are less rosy than the day the loan was made. After all, why does a buyer default? Why is no one else willing to rescue the buyer and obtain the property? If these questions cast a chill on the reader’s enthusiasm to be a real estate lender, that is understandable. If lending is a deferred ownership opportunity, to deal with the ‘‘opportunity’’ portion one need only follow the acquisition analysis standards set forth in Chapters 3 and 4. To deal with the ‘‘deferred’’ portion one need only choose the loan-to-value or debt coverage ratios carefully. Underwriting ratios ...