Loans are an excellent asset class to hold in an income focused portfolio for a couple of reasons. First, they’re a good way to diversify, because most borrowers continue making loan payments even when the stock market is down. Second, income from some kinds of loans can be significantly better than most bonds, with less risk. This is especially true of commercial loans secured by real estate.
That’s why I’ve been lending money lately to a couple of companies, Peer Street, and Patch of Land, both of which in turn lend to real estate investors. The companies are in the business of making what is called “hard money” or “private money” loans. Their borrowers are real estate investors who use the cash to “fix and flip” a property, or to buy or renovate a rental. They don’t lend to owner occupants.
It’s a “heads I win, tails I don’t lose” kind of investment, which is rare indeed in the current economy.
The origination fees and interest rates on hard money loans are high, and the loans are secured by a first lien on a property that is worth at least 25% more than the amount loaned, so if the borrower defaults the lender can take possession of the property, sell it, and get the loan principal back. Sometimes, even after all the fees and costs are paid, it’s still possible to make a profit on a defaulted loan when the underlying property is sold. It’s a “heads I win, tails I don’t lose” kind of investment, which is rare indeed in the current economy.
Real estate investors borrow money this way in spite of the high costs for several reasons. Traditional lenders like banks and credit unions typically lend based on a loan-to-income ratio, whereas many real estate investors live from deal to deal, so they have no salary, and thus no earned income. Hard money lenders base their lending decisions not on the borrower, but on the property (a loan-to-value ratio). So the borrower’s earned income history doesn’t matter. Real estate investors also like hard money loans because unlike banks which can take two months to close a loan, a hard money lender typically closes in just a few days. That gives the real estate investor a significant advantage in the highly competitive market for “fixer” properties that will cash flow.
In the spirit of full disclosure, although I previously wrote that hard money loans are secured by a first lien on real estate, in the case of Peer Street and Patch of Land, that isn’t technically correct. Technically, when I lend to those companies I have zero legal claim on the underlying real estate. But every loan I make to them is secured by a contract that links my loan to another specific “underlying” loan they make to a real estate investor. In turn, the underlying loan is secured by a particular property. My contract requires them to pay me a pro rata portion of all income they receive from the underlying loan, including principal or interest payments, and anything they receive by selling the property if they’re forced to foreclose.
Several companies are competing in this space, and I believe I’ve looked at all of them. I chose Peer Street and Patch of Land because of another legal technicality. Both of them have established third party LLC’s, called “special purpose entities” or “bankruptcy remote entities” which are stand alone companies designed to protect me in the event Peer Street or Patch of Land were forced to close their doors for any reason. If that happened, my contract with Peer Street or Patch of Land stipulates that their underlying loans, (the ones secured directly by real estate), would be automatically transferred to the third party LLC, which would then be operated by a trustee who is obligated by our contract to represent my interests in dealing with the loans.
In other words, even if Peer Street or Patch of Land went bankrupt, the trustee would continue to manage the underlying loan on my behalf, sending payments to my account when the borrower makes payments, dealing with late fees, defaults, foreclosures, and the disposition and sale of any properties possessed through foreclosures. Again, it’s heads I win, tails I don’t lose.
As far as I know, Peer Street and Patch of Land are the only two companies operating in this space which have that third party “special purpose entity” protection in place for their investors. If you know of another company doing the same thing, please mention it in a comment.
Of course, nothing in investing is a simple as it sounds. There are several possible ways to lose your investment in this process, which I will discuss in another blog post soon. But until then, if you’re an accredited investor looking to diversity your income portfolio, I recommend you check out Peer Street and Patch of Land.
For more on this subject, click here and here.
I received no consideration of any kind from Peer Street or Patch of Land for this blog post.
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