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Is Private Lending a Safe Investment?

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Lending money to real estate investors for their short term investment projects can be very profitable, especially while interest rates are high, but is private lending a safe investment? Let's find out...

David Garner

Published On: September 6th, 2023

Is Private Lending A Safe Investment?

With interest rates on the rise, and banks rolling out increasingly restrictive lending criteria making investment capital harder to come by, there has never been a better time for private lenders.

Yet while being the bank can be very financially rewarding, there are always risks to consider, so just how do you keep your capital safe?

In this article, I’m going to share some of my top tips learned over the course of well over 100 private lending deals to help you make sure your private lending investment is as safe as possible.

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The 4 Pillars of Safe Private Lending

One thing I’ve learned over 10 years of private lending deals is to focus on the 4 P’s. That’s; People, Property and Paperwork and Plan.

These four factors should form the basis and foundation of your due diligence and underwriting process when considering whether to lend your hard earned money.

Ultimately, the reason for vast majority of private money loans I’ve seen that have ended badly has been down to one of these four fundamental factors.

With that in mind, let’s take a look at what you can do before you lend money to make sure your private lending investment is a safe as possible.

1. People

Private lending safe people

Whether you’re lending money for the purchase and/or renovation of property, or to refinance a property your borrower already owns, it is ultimately your borrower who is responsible for paying you back.

While one might assume a credit check would be a good idea, this is actually quite rare and fairly pointless in the private lending space.

More practically, when considering a potential borrower, you should take into account their competency, capacity and capability.

The 2 key questions you should ask are:

Are they capable of executing their plan, and can they demonstrate their competency in doing so?
Do they have the capacity to execute the plan within their projected timeframe?

There are a number of data points you can review in order to answer these questions, mostly based around their track record of successfully completing similar projects (similar market, asset type, project plan etc.).

Look for proof of completion of other projects, and references from previous lenders if available.

Of course, it goes without saying that you may also want to perform a basic background check. You don’t want to be lending money to someone with convictions for fraud, or recent bankruptcies.

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2. Property

private lending investment safe property due dilignce

One of the best features of private lending is that your investment is secured against physical real estate.

This is your ultimate backstop. If worst comes to worst, that asset can be sold to recoup your capital.

That’s why making sure you understand the property, it’s current condition, and it’s full value range from as-is to after-repair-value is essential in making sure your private lending investment is as safe as possible.

First off you want to understand the current condition of the property and it’s as-is value.

In reality, you may end up lending more than the property is worth today, especially in the case of a fix and flip type project because you’ll likely be lending a portion of the rehab funds as well.

This doesn’t make private lending an unsafe investment, but it does add risk, and that should be factored into your lending decision and the term you offer your borrower.

If there is going to be a value-add element to the project, you will want to understand the following as a minimum:

What work is being undertaken and who is doing it – look for a Scope of Work or contractor’s quote to verify.
What the expected timeline is.
At what point capital will be needed and in what amounts (the drawdown schedule).
Finally, what the value of the property is estimated to be after the work has been completed – look for a Broker’s Price Opinion.

You might also want to review the local real estate market stats. Some additional questions to ask include:

How long do properties of this style, size, condition and location take to sell?
Is the time on market increasing or decreasing?
What sales price are they achieving right now?

Once you have a handle of the value of the property right now, and the level of work, time and capital required to achieve it’s full potential value, you can adjust your lending terms to suit the level of risk.

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3. Paperwork

Safe private lending investment paperwork

The third pillar of safe private lending is your paperwork, and for the purposes of this article I’m going to include your lending terms in this.

Your basic paperwork in any private lending deal is your promissory note and lien.

The promissory note is the contract between you and the borrower. It includes important information including the loan amount, interest rate, payment schedule, maturity date, and details of the lender, borrower and property.

Your note also contains clauses defining exactly what constitutes a default, and what your recourse is in the case of a default occurring.

Your lien will be either a mortgage or deed of trust depending on which state the property is located in.

The lien is your security instrument. It provides you with a legal charge of the real estate.

You need to make sure your note and deed are bullet proof, and contain all the terms and clauses you need to ensure your private lending investment is a safe one.

My recommendation is to have an attorney draw up your paperwork. Or at the very least have an attorney check out the paperwork you already have.

There’s obviously more paperwork than just a note and deed when it comes to closing a loan, but right now we’re going to focus on the terms contained within your note… in other words, your lending terms.

The terms you offer your borrower should reflect the risk you have assigned to the loan.

There are effectively 2 levers you can pull here, your lending ratio and your interest rate and other charges. let’s look at both…

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Lending Ratio

The lower your lending ratio – the amount you lend relative to the property value – the lower your risk of losing money if the property had to be sold to recoup your investment.

There are lots of ways to measure a lending ratio, including loan-to-value, loan-to-contract, and loan-to-ARV.

Typically, private lenders will advance funds up to around 70% of loan-to-ARV.

Often, they will loan a portion of the contract (purchase price), and a portion of the rehab funds.

For example, 90% of contract and 50% of rehab funds.

In the case of bridge loans and DSCR loans (rental property loans) where there is no rehab, the lender will advance funds on a loan-to-value basis.

If you think it’s a particularly risky loan, you should adjust your loan-to-value accordingly.

Interest Rate and Fees

Now you’ve set your lending ratio, you need to figure out how much return you want for risking your capital.

As with any investment, the higher the perceived risk, the higher the return.

That said, you also want to be competitive. If other private lenders in your marketplace are advancing loans at 10% interest, chances are you aren’t going to be able to charge 15%.

You can also add points to your private money loan. That’s just upfront interest paid to you directly out of closing.

For a medium size fix and flip, you might charge 12% interest and 3 points, giving you a total return of 15% over 12 months.

For a bridge loan or DSCR loan, you might charge an interest rate of 8% and 1 or 2 points, giving you a return of 9% to 10% in year 1.

Finally, you also need to decide how long you will lend for.

This should ultimately be decided by how long the project is expected to take.

Fix and flip loans might run from 6 month to 12 months. Whereas bridge loans might run from a couple off months through a few years or longer (in the case of DSCR loans).

4. Plan

Safe private lending plan

The fourth and final pillar of safe private lending is a review of your borrowers (and your own) plan(s).

Whether it’s a fix and flip or a longer term rental or bridge loan, you really want to be confident of you borrower’s ability to make payments, and ultimately to pay you back on schedule.

Some of the questions to ask here are:

Is their project timeline realistic?
Is their exit plan realistic (sale or refinance based on accurate future value and/or credit availability)?
Do you have a contingency plan if things don’t go to plan?
Does the project have sufficient margin to absorb cost and timeline overruns?
Have you planned in a potential extension and what you might charge for that?
Are you using a drawdown schedule for rehab funds, and will you have inspections of work completed before releasing funds?

If you are happy with the accuracy of the projections and plans your borrower has provided, then you should be good to go.

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Conclusion

So there you have it… my four basic pillars of safe private lending investment.

While there is of course much more to learn, following the basic concepts of the 4 P’s will not steer you wrong when assessing potential private lending investments.

And remember the golden rule; ask then verify. In other words, ask your borrower for the information you need, then verify it independently.

Not all private lending investments are good ones, but having a solid underwriting and due diligence process will help you to weed out those loans that might potentially be a problem later on down the line.

Happy lending!

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Is Private Lending a Safe Investment?

David Garner

Is Private Lending A Safe Investment?