Sophisticated investors are always looking for ways to diversify their portfolios. An increasingly popular option for these investors is private mortgage funds. Private mortgage funds are so attractive to investors seeking diversification because they are able to generate investment income that isn’t subject to the volatility of traditional stock or bond markets. The premise for choosing to invest in a private mortgage fund is often a combination of the limited downside risk of capital invested, an attractive return and trusting experienced professionals to manage the fund according to the prescribed investment criteria.
Many individual investors have had success with real estate investments in some form or fashion throughout their lifetime. Making real estate investment loans available to borrowers via a private mortgage fund is simply a variation of generating profit from investment real estate. Instead of receiving equity from the sale of an investment property, the private mortgage fund simply collects interest from the borrower in exchange for loaning a percentage of the value of the property. The leverage provided on a real estate investment loan can vary, but typically doesn’t exceed 65% of the property’s value. There are additional items to be reviewed and considered aside from just the amount of leverage placed on the property. These include: the experience level of the borrower, their liquidity position, the amount of any improvements required for the property, their repayment ability, and the exit strategy for repayment of the loan.
The premise of making money from buying real estate, holding it, possibly improving it, and then reselling it for a profit is not a foreign concept to many investors. Real estate investment loans allow the borrower who purchased the property to actively utilize some of their capital, expertise, and active management to generate a profit on the real estate, while the passive mortgage holder receives interest income from the loan. Of course, holding a lien on the property is good security in the event of a loan default, but typically obtaining the property back through foreclosure isn’t the goal for most private mortgage funds.
The collateral position of the loan, commonly referred to as the loan-to-value ratio (LTV) is one component of the real estate investment loan equation. This ratio is calculated in two ways. It can be calculated based upon the as-is or after repair value of the property compared to the loan amount. This option looks at the loan amount strictly based upon the as-is or after repair value, but usually the purchase price paid by the buyer is also considered when determining a loan amount. The private mortgage fund may look at the loan to cost ratio (LTC). This is the percentage of the lender's cash compared to the buyer's cash placed into the transaction. To highlight the distinction between the two ratios, let’s consider the following example:
An investor puts a single family home under contract for $80,000 and the home requires $40,000 of improvements, which once completed will make the home worth $160,000.
For XYZ Private Mortgage Fund, they allow 60% of the after-improved value for a loan amount which would be:
$160,000 x 60% = $96,000 max loan amount
For funds like the one I manage, we allow up to 60% of the total project costs to be financed:
$80,000 + $40,000 = $120,000 Total project cost x 60% = $72,000 max loan amount
As the above two formulas illustrate, there are variations of how private mortgage funds look at the value and analyze the risk of exposure for a real estate investment loan. While knowing the collateral position is certainly important, the liquidity of the borrower is equally important to ensure against a loan default. Borrower liquidity level requirements can vary between lenders, however for a fix and flip type loan, the monthly interest, an overage amount for the improvement budget, and holding costs should at minimum be verified by the lender.
The author Oscar Wilde famously stated, “Experience is one thing you can’t get for nothing”. This sentiment translates very well as it pertains to real estate investing. While not a requirement for many real estate investment loans, it is something we look very closely at in our fund. We feel that private real estate investment loans should not be the borrowers first “go round” for making money in real estate. Often Murphy’s law of, anything that can go wrong will go wrong, can at times, apply to real estate investments. Because of the complexities and unknown factors involved with real estate investments, there can be a significant learning curve. Having previous experience to deal with setbacks, in my opinion, make for a more resilient borrower when difficulties come up, and ultimately assists in reducing the risk of a loan default.