Could You Handle Losing $250,000 When Lending Money To An Investor In Real Estate?
I was recently talking with some acquaintances about Real Estate investing and in that conversation the subject of lending money to an investor to Buy, Fix up, and Sell (REHAB) a property was discussed. The conversation quickly became rather animated. One person was saying it was a good way to make money and they had made good money doing it. Another person indicated that he had a friend that lost over $250,000 dollars lending money to REHAB a property. This immediately got me thinking, how can you have such extremes and how do you insure to the best of your ability that you don’t lose money when lending money to an investor? Even better yet, why would you lend money to an investor to REHAB a property?
The answer to the last question is rather easy. The reason you would lend money to an investor to REHAB a property is to get a higher rate of return on your money than you could in a bank money market account or bank certificate of deposit (CD). Normal rates of return can range for 8 – 12 percent when lending money to investors as compared to less than one percent you get on money market accounts and the 1-3% you get on CD.
When most people hear high rates of return, they immediately start thinking about high risk. We are trained to think that the higher the risk there is, there should be a corresponding higher return on your investment. In general, this is true in most investments. However, with knowledge, you can begin to lower these risks by putting the steps in place to protect your investment.
Lending money in Real Estate can be rather safe if you do I it properly. You cannot eliminate all the risk but you can drastically reduce your risk. In the case of the person who lost $250,000 lending money to an investor, they did not do it properly. This is rather obvious! To reduce your risk when lending money to an investor, three items should be in place before the money changes hands.
Promissory Note
First, you should create and have signatures on a Promissory Note. This is a promise to pay. It sets terms such as interest rate, time, payment schedules etc. This in itself is not security. It should clarify how the payments expected to be made, the terms, the time, and the agreement of the investor to pay the loan back under the conditions specified.
Mortgage deed or Trust deed
Second, the lender should have a signed Mortgage deed or Trust deed. This is a security instrument that is recorded by the lenders attorney or escrow agent that secures the lender’s position against the identified property. Note that “position” is important. Only loan in the first position. This means that if something did happen and the investor goes broke, you are the first to be paid when the property sells. To fully understand this, talk with your attorney.
Loss payee
Third, the lender should insist that they are added as a “loss payee” on the “Builder Risk Vacant Dwelling” property insurance policy. This would make sure that if the property is damaged or destroyed when it is being rehabbed, the lender will be a person to get paid from the insurance company. Talk with your attorney and insurance agent to better understand this.
If you do the above three things when loaning money to an investor to REHAB a property, you drastically reduce your risk. If the investor goes broke, the Mortgage deed or Trust Deed on the property is your security that you get paid (First position only). If the property burns down during the REHAB, the insurance policy make sure you get paid.
Compare the above scenario with investing in the Stock Market. If the company goes broke, the person investing in the company is the last to get paid. All the creditors of the company get paid first. If done properly, you can argue that loaning money to an investor to REHAB a property is safer than investing in the stock market.
However, do not rush out and start loaning money to investors without first talking with your attorney. Make sure you understand the concepts outlined above and have the documents in place before lending money to an investor.
Now back to the conversation on the person that lost roughly $250,000 loaning money to an investor to REHAB a property. Seems like the rest of the story was that none of the above happened. There was an agreement to repay the loan but there was no Mortgage deed or Trust deed that secured the loan against the property. The lender had no security and the investor went bankrupt. Obviously, this was a major mistake. Expensive lesson to learn!