ATHOL DICKSON

4 Criteria For Hard Money Loan Investments

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4 Criteria for Investing in Hard Money Loans
4 Criteria for Investing in Hard Money Loans

Every investment should be considered from a risk/reward perspective. Ideally of course you want minimum risk and maximum reward. From that perspective I think loans secured by real estate are one of the best investments out there at the moment. A few days ago I discussed Peer Street and Patch of Land, two companies that offer crowdfunding “hard money” investments which are indirectly secured by real estate loans. In that earlier post I explained my reasons for building a portfolio of these investments. The main appeal is the fact that the collateral—real estate—is theoretically worth more than the amount of the underlying loan, so a sponsor like Patch of Land or PeerStreet can sell the collateral to recoup your investment if necessary. Obviously, that only works if someone is willing to buy the underlying property for a price equal to, or more than, your investment amount.

…we’re looking for underlying real estate that could be sold for enough money to recoup our investment if it’s necessary to foreclose.

In a future post I’ll explain how to do a seat of the pants appraisal to verify the property value. It’s important to do your own estimate, because the values assigned by PeerStreet and Patch of Land are sometimes overly optimistic. That could mean the property can’t be sold for enough money to return your investment. But before we get to that, here are four preliminary criteria I use to quickly decide if a loan is even worth that effort. Remember, we’re looking for underlying real estate that could be sold for enough money to recoup our investment if it’s necessary to foreclose:

1. The underlying property’s planned selling price must be within the limits of a “conforming” loan. Most home buyers finance their home purchases with mortgages. Most of the banks or credit unions who originate those mortgages are insured by the Federal government through the FHA, Fannie Mae, or Freddie Mac. All of these organizations have the same top end limits on the loan amount they will insure. Currently those “conforming” limits are $417,000 in most places, up to $625,500 in areas where home prices are significantly higher than the national average. Real estate priced at or below those limits usually sells faster, because home mortgages to purchase them are widely available and relatively easy to get, with fairly low down payments. Fewer home buyers can qualify for non-conforming loans, and fewer still can pay all cash. So if a hard money loan investment is secured by a property worth more than the conforming loan limits, usually you should not invest.

2. The property must be in a major Metropolitan Statistical Area, or “MSA”. This is a term used by the U.S. Census Bureau to describe a geographical region with a densely located population of at least 50,000 people and close social and economic ties throughout the region. While 50,000 is the low end of the MSA spectrum for the Census Bureau, I only invest within MSA’s that are at least two to three times that size. This is because real estate sells faster when there are more people around to buy it. If a deal goes south, I want my money back as soon as possible, but rural real estate can sit on the market for years. While the Census Bureau publishes lists and maps of MSA’s, I find the fastest way to check is to locate the subject property on the satellite view (they call it “earth”) at Google Maps. Enter the property address in the search bar there and zoom to the view that shows 1 mile on the scale at the lower right. If your computer screen is mostly filled with streets and roofs, chances are there are plenty of potential home buyers in the area. On the other hand, if you see mostly Mother Nature, you should probably not invest. Leave this page open at Google Maps for the next step.

3. The property must have reasonably good curb appeal. Most people won’t buy an ugly house. It doesn’t have to be gorgeous, but it should at least match the other houses in the same neighborhood. Don’t judge a property based on your own taste. You don’t have to live there. You just want to make sure there are plenty of other people who would like to live there. To decide, start with a common sense reaction to the photos of the property on the investment page at PeerStreet or Patch of Land. Google the street address to find old real estate listings for the property and drill down into the photos on those pages, too. Finally, to see the property in comparison to others in the neighborhood, go back to the property’s address at Google Maps and this time zoom into “street view.” Move the view up and down the block. How does the subject property compare to the neighboring houses? It doesn’t have to be the nicest looking house on the block, but it should at least be average. Sometimes this process takes imagination, because the underlying loan is for a “fix and flip” investment, which by definition means the underlying property needs work. In those cases, you’ll have to try to visualize how the property would look with fresh paint, a new roof, and so forth.

4. The property must be in a state with a reasonably fast foreclosure process. Due to differing legal processes and the local volume of foreclosures, the process of gaining possession of real estate collateral after a borrower defaults can take as little as nine months (Alabama) to as long as three years (Hawaii, Oregon). You can view a table of the time frames at Fannie Mae’s website. Note that the times shown there are maximums. The average foreclosure time will be less, and in some states such as Texas, much less. I don’t invest in loans secured by properties in states where the maximum foreclosure time is 18 months or longer. You may want to set your limit higher or lower, but once the monthly payments stop on your investment, you’ll want your money back as soon as possible so it’s important to be aware of the worst case scenario where the investment is located.

There are very few perfect deals, so you’ll have to compromise on these criteria from time to time. For example, I recently lent against a condo in Provincetown, MA, even though that’s not in a major MSA (it’s a couple of hours outside of Boston). Why did I break my MSA rule? The condo is directly on the beach, so the “curb appeal” is beyond fantastic. And since Massachusetts has a reasonably fast maximum foreclosure time (15 months), and the exit price is within conforming limits, I think it’s a good investment. The risk/reward calculation is a personal decision. But with a clear investment profile based on the common sense criteria described here, at least you can make educated bets.

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.

See disclaimer at bottom of page.

Investing In Investors

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Loans to real estate investors can be a good investment,
Loans to “fix and flip” investors can generate high yields with low risk

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.

See disclaimer at bottom of page.

Lending to Lawyers

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Enron Logo
A Lawsuit I’d Love to Fund

I’ve been looking deeper into the idea of investing in lawsuits. In my last post on the subject I said this only works for me ethically when the investments are used for plaintiff’s medical and living expenses. I wrote “I’ll not be lending money to lawyers.” Since then I’ve learned more about the subject from litigation investment firms, and now my opinion is a bit more nuanced.

Before, I mentioned a “slip and fall” case that was brought against my architectural firm. It was a classic example of the kind of ambulance chasing lawsuit which has given the legal profession a bad name in America. The plaintiff didn’t even actually fall, for crying out loud. But it still cost me a $10,000 insurance deductible, and five days of my life. So I was robbed, and there’s still no way I would invest in anything that enables other attorneys to do the same. But I’ve learned this is usually a non-issue when it comes to investing in lawsuits, for several reasons.

Most predatory cases are personal injury lawsuits, and it turns out personal injury cases are very seldom funded by investment sponsors. One firm I contacted indicated that this kind of case accounts for only one quarter of one percent of the total cases in their portfolio. This may be because most of their investors agree with me about the ethics. It’s even possible a high percentage of investors have been victimized by predatory attorneys, just as I was. Investors obviously have money, and targeting people simply because they have money is what predatory attorneys do.

Also, investors want to allocate their money into assets where they will achieve the best returns. Naturally, that means the vast majority of litigation funding investments are made in lawsuits where big money is at stake. The potential settlement or judgment amounts in most personal injury lawsuits are small potatoes compared to class action or mass tort suits, in which multiple plaintiffs were allegedly harmed by a defendant which is usually a major corporation with very deep pockets.

I’m much more comfortable funding law firms which are representing plaintiffs in class action and mass tort suits because it’s far less likely that their lawsuits are frivolous.

I’m much more comfortable funding law firms which are representing plaintiffs in class action and mass tort suits because it’s far less likely that their lawsuits are frivolous. In our society, it’s easy for one unethical attorney to convince one greedy client to participate in a predatory lawsuit. But usually mass tort or class action suits involve dozens, hundreds, or even thousands of attorneys and plaintiffs, all of whom are independently convinced it’s worth the effort to sue. Whatever the facts of the case may be, when that many people are willing to go to court it’s unlikely their case is frivolous.

Next, there’s the issue of timing. It seems most law firms receive investment funding only after the “discovery” period of the lawsuit it complete. All the facts are in at that point, which does two things: 1) it reduces risk, because it’s possible to evaluate the likelihood of winning the case on its merits, and; 2) it reduces the possibility that the plaintiff has lied, exaggerated, or otherwise brought suit irresponsibly or unethically, because if that were true it would probably have been found out.

Because I know what it’s like to be on the receiving end of predatory lawsuits, at first I was not inclined to provide investment funds directly to law firms. But if I can provide funds to firms that are, for example, representing crowds of “little people” who were the victims of corporate fraud (such as the Enron scandal), or whose homes and neighborhoods were environmentally polluted by a company’s negligence, or who suffered health problems because of a drug known by the manufacturer to be defective, that seems like a good use of investment money in more ways than one.

Is It Ethical To Fund A Lawsuit?

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Investing in Lawsuits
Investing in Lawsuits

Today I’m considering an investment in an asset class most people know nothing about: loans secured by lawsuits. It seems there are companies which specialize in lending money in return for a carried interest in civil lawsuit settlements or judgments. If the borrower wins their case or gets a settlement, they pay back the loan with interest. Lots and lots of interest.

I only just began researching the idea, but so far it looks like there are at least two versions. Some lenders offer their funds directly to law firms. Others offer money to plaintiffs. The law firms use the money to pay their bills while they wait for big payoffs on cases they’ve taken on a contingency basis. The plaintiffs use the money to pay their personal medical bills and living expenses while they wait on the outcome of their lawsuit. I’m interesting in the second version, offering funds to plaintiffs. The first version, lending cash to lawyers, has no appeal at all.

Most people agree our society is much too litigious. Anyone can sue anyone for almost anything, and if there’s serious money involved many lawyers are all too happy to take the case on contingency. This often forces innocent companies and individuals to choose between settling with malicious plaintiffs, or paying big bucks for a legal defense. Even those with insurance against lawsuits still suffer, because the proliferation of frivolous lawsuits has driven premiums and deductibles sky high. I know this from painful firsthand experience.

I was sued by a woman who slipped and almost fell in a building designed by my firm. Allegedly, the poor dear pulled a muscle. She thought her “pain and suffering” was worth several hundred thousand dollars…

In the early years of my architectural career, I was sued by a woman who slipped and almost fell in a building designed by my firm. Allegedly, the poor dear pulled a muscle. She thought her “pain and suffering” was worth several hundred thousand dollars and she claimed we were negligent for specifying a wooden floor. The judge issued a summary judgment in my favor (meaning he threw out the case because he recognized her claim was ridiculous) but I still had to waste five days in court and working with my attorney to prepare a defense, plus cough up $10,000 to pay my professional insurance deductible. There were other similar legal attacks through the years. By the time I retired from practicing architecture, my firm was paying over $48,000 per year in errors and omissions insurance premiums, just to protect ourselves from lawyers.

America’s civil “justice” system promotes legalized extortion as far as I’m concerned, and pretty much the only thing stopping it from completely destroying the economy is the fact that the process can be as time consuming and expensive for the parasites who sue maliciously as it is for their victims. So no; I’ll not be lending money to lawyers.

But there’s another angle I like better. Sometimes a plaintiff might be someone who was injured due to the actual negligence of an insurance company’s client. For example, consider a person seriously injured by a woman who runs a red light while applying mascara, or a man who drives drunk. This person has huge medical bills, along with injuries that make it impossible to earn a living. In short, the fool who ran them over has devastated their finances. Meanwhile, the defendant’s insurance company, knowing this, might use its considerable resources to delay and draw out the legal process in order to coerce the dead broke plaintiff into accepting a lower settlement now, rather than holding out for a larger amount they really deserve. That’s where the other kind of lawsuit funding comes in. There are companies that specialize in providing funds to plaintiffs in this situation. The money allows the injured person to avoid foreclosure on their home, for example, while their attorney continues fighting for a fair outcome to their lawsuit. That’s something I can get behind.

These loans are very expensive from the plaintiff’s point of view. So far I’ve seen interest rates comparable to what someone would pay for a pawn shop loan. But unlike a pawn loan, the funds are offered on a non-recourse basis. That means if the plaintiff loses their lawsuit, they keep the funds and have no obligation to repay the money. So it’s a very high risk for the funding company, which explains the high interest rate. Also, at least two of the funding companies I’ve found so far have a policy of limiting the funding amount to 10% of the expected total judgment or settlement for the case. They specifically state that they do that so the plaintiff will still receive a substantial portion of the payment from the defendant.

I’m not sold on funding lawsuits as a legitimate alternative asset class quite yet, but it’s definitely worth more investigation. A quick search at Amazon shows they have only one book on the subject, so it may take some digging to find out if this is a worthwhile opportunity, but I’ll post more here as I learn.