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Private lending can be a good — if risky — way to invest in real estate

You have to calculate whether the risk of private lending is worth the return on investment. (iStock) (iStock)

A lot of people would like to invest in real estate but don’t want to be a landlord or a flipper. The Washington market is getting overpriced and overworked, so rather than run with the crowd chasing deals for myself, I just loaned money to another flipper to fund her project, and I used my IRA to do it.

This strategy is not risk-free or work-free. There’s no such thing as a risk-free investment; the closest you’ll get is a certificate of deposit with your bank.

Sure, this can be risky investing, but you can drastically reduce the risk if you know what you’re doing; and, lending money to a flipper is (typically) much less work, risk and stress than buying a property yourself. Another benefit is that the flipper usually brings money to the deal, which gives the lender more cushion.

I lend money to other investors quite a bit, but usually it’s my own money or funds raised from my network of investors. This was the first time I used my retirement account funds, about $24,000. That’s clearly not enough to fund a deal, so I networked with other investors and lenders and let them know I was looking to partner on a deal.

A friend contacted me. She used to lend me money on my own flips. She is what we call a private lender (someone who lends out their own money.) These days, she’s mostly retired but still dabbles in lending.

The sponsor (the flipper requesting the loan) had completed a couple of deals that my friend had funded in the past. My friend was confident in this sponsor’s abilities and character. That was a huge plus. A bad sponsor can destroy the best of deals. Most lenders look at the property thinking their funds are secured by a tangible asset, but that’s not a great strategy. I don’t want to foreclose on a property. I want the flipper to get the deal done and get me paid out as fast as possible.

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The property itself was a little split-level home in Fort Washington, Md. It had three bedrooms and two bathrooms. It was a complete wreck.

The home was listed for $94,000. Our loan applicant had beat out more than 20 other offers to buy the home for more than $170,000. She believed she could renovate the home on a budget of about $30,000 and thought the home would sell for about $350,000 after renovations.

She wanted to borrow the full purchase price of the home plus closing costs, but she agreed to pay all the renovation costs out of her own pocket. The total loan amount would be about $180,000.

I looked at the home and I knew there was no way she was going to fix up that place for $30,000. I figured she would need at least twice that amount. So the deal seemed a little tight, but she had enough money in her account to cover my projected renovation budget with a little cushion for emergencies, plus she was willing to pay us a premium for the money she was borrowing. She agreed to pay 12 percent annual interest, plus four points (a point is equal to 1 percent of the total sum of the loan).

My partner brought in about $156,000, and I brought in my meager funds of about $24,000 in a second position, or second mortgage.

We had a deed of trust and a note drafter, just like a bank when they lend money to someone buying a home. If the flipper didn’t come through, we could foreclose on the property. The process for foreclosing in Prince George’s County is a long, hard one, so it is not a desirable option but a last resort.

More Pierce: How to launch yourself into real estate investing

Right away, the flipper struggled. About six weeks after we closed, I went to visit the property and found a stop-work order on the door from the county. She said her contractors didn’t get the right permit, and she corrected it.

The sponsor fired her contractors and brought in a new crew. The project took a painful nine months to complete. The home did sell for the $350,000 she predicted, however.

My original loan amount was for just under $24,000, and I made just over $4,000 in returns. So that’s over a 16 percent gross return on my investment.

If you think this sound like something you’d like to try, let me give you a couple of pointers: First and foremost, revisit my warning above. This is not risk-free.

Here are a few major red flags to look for when considering the loan:

  • Never lend to an owner occupant or someone who plans to move into the home they are borrowing against. I don’t know any private lenders who do this anymore. When Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, it drastically increased a lender’s compliance requirements.
  • Unrealistic numbers: Almost every applicant overestimates the home’s value and underestimates the renovation budget. Bring in professionals to do a home appraisal and go over the renovation numbers.
  • The DIY crowd: Be wary of someone planning to do the renovations themselves if they are not a licensed contractor, and especially if they have a full-time job. Very few people have the stamina to do both.
  • Beware of rookies: They can be excited about a deal, but that often wears off after a couple weeks into the grind. Most people don’t do well on their first flip — I lost $5,000 on my first try. The deals that I see go bad for lenders are the deals where the sponsor fails to get the job done. Once it’s clear that they’re not going to make any money, many sponsors will just walk away from the house, and it becomes the lender’s problem.
  • Lack of capital: If the borrower doesn’t have a dime in their bank account, it’s a big concern. What happens if they’re off on their budget or if an emergency arises? Also, that means you’re going to have to fund renovations, which is the riskiest part of the loan.
  • Too good to be true: Be cautious of anyone who offers you a really high interest rate on your money. I don’t want to lend money to a flipper who is willing to pay 20 percent interest. There’s probably something wrong with the deal.
  • Overleveraged loans: You never want to lend more than about 65 percent, maybe 70 percent, of the home’s after-repair value. That seems low, but you will have thousands of dollars in legal costs if you have to foreclose.

Foreclosures cost time and money. The plan here is to make interest on your money, not a return on your labor. A loan that goes well only requires you to inspect the property every now and then to make sure it’s progressing and to cash the checks that come in. Foreclosures can cost tens of thousands of dollars and can take years to complete.

A good way to start is by doing just what I did on this particular deal. Partner with an experienced lender on your first few deals. You can network to find them. If you decide this is something you want to try, then do a lot of homework. Get professional legal and financial advice before you commit to any deal.