Financing is one of the most critical components of real estate investing. In today’s competitive real estate market, a growing number of real estate investors are turning to private money lenders to get deals done faster, increase property values, and improve ROIs.
The challenge with private money lenders is that good ones can be difficult to find. Let’s take a look at what private money lenders do and how they work, potential benefits of using private money, and how to find and vet a reliable private money lender.
- Private money lenders make loans to real estate investors and are an alternative to traditional funding sources like banks or credit unions.
- Private money loans, sometimes known as hard money loans, can be used to fund a variety of real estate deals, including fix and flip properties and single-family rental homes.
- Because a private money lender works directly with an investor, loans can be more easily structured to meet the needs of a borrower.
- When reviewing a potential loan, a private money lender generally is more concerned with the before and after property value rather than a borrower’s credit score.
- Private money lenders can provide funds faster and with more flexible terms, although an investor may pay a higher interest rate and larger loan fees.
- Steps to find and vet a good private money lender include asking for referrals, creating a pitch book of the intended deal, and reviewing past transactions a private lender has funded.
What do private money lenders do?
A private money lender is a type of investor who makes loans to other investors, such as people looking to buy rental real estate. Also known as “hard money lenders,” capital used to fund private loans may come from a private lender, or from other investors who provide capital to the private lender in exchange for a percentage of the profits.
Private money lenders make money the same way that a traditional lender like a bank or credit union does, with fees generated from loan originations and interest payments on the funds borrowed. However, instead of serving as a middleman the way a mortgage broker does, a private lender works directly with a borrower. This allows a private lender to customize a loan that fits the needs of both the borrower and the private lender.
Qualifying for a loan and funding may be faster, with more flexible terms and conditions based on the property type and intended use of the loan. As a rule of thumb, a private money lender will use the before and after property value when deciding whether to fund a loan, and to a lesser degree a borrower’s credit score or personal financial situation. The trade off is that fees and interest rates on a private money loan may be higher than with a traditional mortgage.
Why real estate investors use private lenders
Real estate investors looking for flexibility and fast funding may find a private lender to be a good option for obtaining investment capital. Private money loans may be made for all types of real estate, including single-family rental homes, small multifamily buildings, and fix-and-flip properties.
Some of the main reasons an investor might seek private money lending include:
- Easier to qualify for because private lenders focus more on the specifics of a transaction and less on a borrower’s credit score.
- Faster funding and less paperwork because private lenders fund and hold private money loans in-house.
- Cash deals may put an investor’s offer ahead of a buyer with a financing contingency.
- Can fund multiple transactions at the same time, helping to bypass the loan limits that traditional lenders may place on real estate investors.
How to find a good private money lender
Private lending is based more on relationships compared to larger banks or even a local credit union. Once a private lender knows they’ll be repaid on time and can trust a borrower, the greater the odds are of obtaining funding for future deals.
Since private lenders usually get business through word-of-mouth versus advertising to the general public, they can be a little more difficult to find, but also well worth the time and effort.1. Understand how private loans work
The first step is to look at a private money loan from a lender’s point of view. Unlike a major bank that is backstopped by the Federal Reserve, a private money lender is putting their own personal capital at risk.
In addition to learning about the property and how a private loan will be used to add value, a private money lender will also want to know:
- Will the loan be secured by the property value, a borrower’s other assets, or a combination of both?
- How do potential risks compare to predicted rewards, such as getting zoning approved to convert a basement into a studio apartment in order to generate more rental income and force appreciation?
- Does the potential return to a private lender outweigh potential investment risks, like a borrower not completing a project or having a poor track record of success?
- When will a private money lender receive a return of capital (the funds borrowed) and a return on capital (interest on the funds borrowed)?
Real estate is a people business, and nearly everyone in the business knows someone who knows someone who knows someone. A good private money lender can usually be located by asking fellow investors and other people in a real estate investors network of contacts including:
- Insurance brokers and property appraisers.
- Contractors, handymen, and suppliers.
- Title agents and escrow officers.
- Property managers and investor-friendly real estate agents.
- Even a mortgage broker or traditional lender who isn’t able to fund the transaction but knows someone who can.
Private money lenders can be found both inside and outside of the real estate industry. A lender who doesn’t have real estate experience may still be willing to provide funds if a prospective deal is attractive. However, working with a private money lender outside of the business may require an investor to spend more time explaining the dynamics of a deal to the private lender.3. Create a pitch book for the deal
As with any other lender, a private money lender doesn’t want to have to chase down a borrower for the monthly payment, foreclose on a loan and take the property back, or earn a lower return than expected.
A pitch book or deal book is a presentation an investor puts together for a private money lender that explains what the deal is, how it works, and how an investor and the private lender will make money.
Information to present to a private money lender includes:
- Summary of the transaction including purchase price and appraisal, intended renovations or additions and costs, after repair value (ARV) based on recent comparables, and projected return on investment (ROI).
- Resume of the investment team involved in the transaction, such as an investor’s business partners, contractors handling the renovation, insurance agent, and title company or attorney handling the closing.
- Copy of the purchase and sale agreement showing that the deal is ready to close once funding is received.
- Photos, videos, drone aerials, floor plans, and site plan of the property being purchased to make the transaction easier to visualize and understand.
Building a relationship with a prospective private money lender works in both directions. While an investor wants to feel comfortable with a lender, a private lender also wants to be impressed by a borrower.
When meeting with a private lender, the slow and easy approach generally works best. An investor may increase the odds of receiving a private loan by walking a lender through each step of the proposed deal, including anticipated expenses, timelines, and how projected profits will be split.
The more comfortable a private money lender is with the borrower and proposed deal, the more likely an investor is to receive capital from a private lender.
Tips to vet a private money lender
Literally anyone with some extra capital can be a private lender, but that doesn’t mean that all private lenders will be a good match for a real estate deal. Some top tips for vetting a private money lender include:
- Request references from a private lender for other real estate investors that have had recent transactions funded by the lender.
- Verify that a private money lender is licensed if state law requires a lending license.
- Review past deals a lender has been involved in, such as funding renovations on an investment property, to better understand a lender’s familiarity with various real estate projects.
- Understand where a private money lender’s capital is coming from, such as the lender itself, or a syndicated loan with funds contributed from various investors.
- Ask if funds are released in one lump sum, or if there is a draw process where loan money is received at different stages of the transaction.
- Study loan terms from the private lenders, including documents required from a borrower, annual interest rate, points and fees, length of loan and amortization period, penalty for early loan prepayment, requirements to extend a loan, time required to fund a loan, and whether or not the private money lender has every backed out of a loan.
Private money loans may be obtained for all types of real estate transactions, including fixing and flipping a home and purchasing a single-family rental property.
Because private loans are generally based on the merits of a specific transaction, private lenders generally fund faster and are less concerned with a borrower’s personal credentials compared to a traditional lender.
Since private money lenders don’t advertise to the general public, locating and vetting a good private money lender may take more time and energy, but may be worth the extra effort to raise funds for an upcoming real estate deal.