Lending funds through private mortgages has gained popularity as an investment strategy over the past few years – primarily because of the double-digit returns the strategy generates (9% to 11% on a first mortgage; 12% to 16% on a second), but also because it is a passive strategy that doesn’t require tenant management.
Private mortgages involve lending funds on your own or with a group of other lender investors to a borrower who may not qualify for institutional mortgage financing or who requires private money to supplement institutional financing. The funds are secured by real estate typically in first or second position.
As with any other strategy, there is a certain amount of due diligence you should conduct before lending out your funds. Risk management is the heart and soul of private lending; it is what distinguishes a good deal from a bad one. Reaping the rewards of being a private lender boils down to managing the risks associated with the four building blocks of any private mortgage deal.
The property you are lending against is the most important component in the private lending equation. It determines how soon you can recoup your funds in case the deal goes sour and the borrower defaults on your loan.
Depending on the type of property and its condition, a property can sit on the market for months before it sells, so it’s important to rely on the professional opinion of a third-party certified appraiser to confirm the value of the property. Once you receive it, review the appraisal report and pay close attention to the following:
Value: As your funds are secured against the value of the property, it’s important to ensure the value is reasonably justified, given the comparables the appraiser used in the report and any adjustments made to the valuation due to its condition. This will determine the relationship between the property value and the loan amount.
As an example, let’s say a single-family house in Barrie has been appraised for $450,000 and that the first mortgage on the property is held by a major bank with a balance of $300,000. You’ve decided to lend the owner of the property $50,000 for a one-year team, to be secured against his home in second position.
The loan-to-value [LTV] ratio on this property would be 77.7%. This means that there is a roughly 22% equity cushion in the property to cover foreclosure expenses in case things go haywire. If that happens, the bank will get their money first. You will be paid any leftovers because your funds are secured in second position. Generally, the lower the overall LTV or the lower the priority of the mortgage, the better protected you are as an investor.
Depending on the quality of the property you are lending against, current market conditions and the length of time your funds are tied up, you can limit your exposure by controlling the LTV.
Time on market: Pay special attention to the section in the appraisal report that pertains to the length of time it will take to sell the property if it is listed. If you are in a market where it will take more than 120 days to sell, be prepared to carry the property expenses in case of a foreclosure until the sale takes place.
The area and location of the property have a great influence over its future value and ability to sell in case of a foreclosure.
You may come across a great property and a good borrower in a depressed market. This doesn’t mean you should stretch yourself thin and increase the LTV. Instead, you should keep in mind the impact of the market on the future value of the property. In a depressed market, you may choose either to not lend, lower your risk by reducing the LTV and shortening the term of your loan, or charge higher interest or fees because of the risk you’re taking on.
It’s important to assess the borrower’s ability to pay back the loan, given all the other debts they have and the income they make. While traditional lenders have clear rules about what the total and gross debt coverage ratios should be for each deal, private lending does not have any black-and-white rules with respect to these ratios.
Every deal is different, and the risks private lenders are willing to take also vary significantly. Our philosophy is to use a common-sense approach to private lending, which boils down to understanding:
- Why borrowers’ credit may be shut down or bruised, and observing their most recent behaviours as to how they are meeting their obligations
- How the borrower derives their income, including how much they really make and the stability of the income
- The reason the borrower is seeking a private loan
Working with an experienced mortgage broker is crucial to understanding these credit and income components.
4. Exit Strategy
The exit strategy refers to the plan the borrower has in place for paying back your principal at maturity:
- Is the borrower going to sell the property at maturity?
- Are they going to get the property refinanced with a traditional lender, and will they qualify for a mortgage at the time in order to do so?
- Are they going to find another private investor to replace your loan?
You need to understand what the long-term plan is for getting your money back.
The harder it is to get your money back or the longer it takes to get it back, the higher your risk.
When it comes to private lending, do not be seduced into rushing in by the high returns. Understand all the variables of the deal that drive your risks and returns, do your homework, and work with an experienced mortgage broker to assist you with due diligence and help you structure the deal. This way, you can enjoy healthy, risk-managed returns and supplement your portfolio with a solid strategy.
Dalia Barsoum is an award-winning mortgage broker, real estate investor and finance advisor with more than 20 years of experience. She is the best-selling author of Canadian Real Estate Investor Financing: 7 Secrets to Getting All the Money You Want. To learn more about private mortgages, contact her at email@example.com or visit streetwisemortgages.com.
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