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Is it time to self-regulate?

Dec 27, 2007

Be the bankMark Anthony McCraycommercial real estate, lending, income, asset appreciation, stability, hard money I would be willing to bet that neither you nor I know many bankers who are at risk of starving. Altogether, they seem to be doing fairly well within a good, stable, profitable business that has been getting better over time. As I have worked in commercial real estate finance for a number of years now, I've observed a simple truth that bankers have known since the first merchants sought financing for their next expedition--lenders don't lose. Within lending, making loans to real estate investors and projects is preferred by many creditors. Most great, lasting wealth has been made through real estate investing. Where real estate wasn't the great driver, such as the Internet and telecommunications booms of the early '90s, the smartest people redirected cash earned into real estate holdings. Buying and holding residential and commercial properties, speculating in land and serving the growing population through construction have proven to be effective paths to wealth. Even within that, many smart investors have chosen a more passive path to real estate riches. Instead of being the landlords, rehabbers, developers and builders, they have chosen to finance those who are. This is often called "hard money lending," or it can be known as "private real estate investing." Let's look at three main reasons why real estate lending works so well for those looking to build long-term wealth: Income Real estate lending offers you the chance to earn passive income. Unlike your job, where you trade your hours and effort for cash, lending allows you to leverage capital. Your money makes you more money, while you do something else or nothing at all! Asset appreciation Another great feature of real property is asset appreciation (that is, the underlying asset that is actively generating income even as it may be increasing in value). This means that the value basis of a loan you make may improve for you after you close the loan, draining risk from your portfolio for the same rate of return (according to Stability Investing through private mortgages can shield you from some of the fluctuations that exist in the stock and bond markets. While real estate does have cycles (just like any other asset class), demand is fairly consistent, especially in the Sunbelt region. This feature can be tremendous in a well balanced portfolio. How does hard money lending work? When investors make hard money loans, they usually do so at annual interest rates of 12-18 percent. This can be invested in a wide variety of income-producing real estate projects, each of which should be thoroughly researched. The loan terms are typically six months to two years, during which time the lender receives a spendable income, paid monthly. The most experienced private lenders almost never exceed 75 percent of the appraised value on residential properties or 65 percent of the current appraised value on commercial properties and land. This measure is taken to help ensure a secure loan--one that allows for a strong equity position in the case of a loan default. Why people use private money My colleagues and I have found that real estate borrowers (even borrowers with flawless credit) are able and willing to pay a higher interest rate because of the fewer time constraints and red tape than they face with traditional lenders. Private lenders can often approve and fund a loan within days of receiving a complete submission. Traditional lenders can often take 30-45 days to approve and fund even a simple transaction. This leaves the borrower a clear choice when attempting to purchase time-sensitive, below-market real estate. Obtaining a private money loan provides the professional real estate investor much greater flexibility when structuring a transaction. Instead of relying solely on his own cash or credit, a borrower is able to utilize the equity (or potential equity) in the property as collateral for the loan. This allows for a profitable and secure transaction for all parties involved. The borrower is able to acquire and/or rehabilitate a piece of real estate at below-market value with little or no money out of pocket, while the investor is able to gain higher-than-average returns with below-average risk. What could go wrong? Nobody likes to talk about investments that go bad. The fact of the matter is that all investments have some level of risk, and some investments simply do not work out. This presents another advantage to investing in private mortgages. When a traditional investment goes bad, the investor simply loses his money. He may receive nothing in return, except maybe an apology from the borrower. However, well structured private mortgage investments are secured by real estate and, in the unlikely event of default, the lender may choose to retain the property or sell it for a profit. If the loan was funded at a portion of the appraised value, the lender might have a greater than 30 percent profit potential in the property. What could go right? Investing in private mortgages also provides a monthly income stream. With a "normal" investment, you don't actually receive any income when (and if) your investment performs well. The capital investment stays with the investment, and you receive a quarterly statement detailing how much the portfolio gained or lost. This can be a great strategy for long-term growth, where the investor is secure enough to leave the investment alone. However, many people would like a monthly income from their investments. Private mortgage investors usually structure their notes to generate monthly interest checks, creating a "spendable" monthly income stream. For example, a $250,000 investment earning 14 percent could yield you a monthly income of $2,916.67. What is the formula for success? The process I follow is really quite simple. First, do not pool money. Typically, after an opportunity has gone through the underwriting process, you should issue a letter of interest to the borrower. Once the borrower agrees (in writing), draft an executive summary and forward that to an interested investor. If there's continued interest, then provide the full details, which would include a full appraisal, title insurance, a survey and various other due diligence items. After reviewing the information and upon deciding to invest in a particular opportunity, forward the investor a document that allows him to indicate his commitment to funding a portion or all of the investment. From that point, I normally advise a lender to either visit the property personally or send someone that he trusts to provide an accurate report. My partner and I visit each property, regardless of its location, and we visit with each borrower. In our view, there is no substitute for face-to-face meetings. After the recent shakeup in the mortgage industry, money is still flowing. It's just flowing in some different directions. Homebuyers are becoming renters, sellers are becoming landlords and lenders are still winning. Therefore, I believe that one of the keys to winning in the next few years is to become a lender. Lenders never lose. I wish you great success. Mark Anthony McCray, author of the upcoming book, "The 31 Rules for Succeeding as a Mortgage Broker," is the founder and CEO of Houston-based First Capital Mortgage Company and McCray Capital Partners. He may be reached at (713) 267-4040 or e-mail [email protected].
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