How Private Lending Works

Private lending is a necessary and legitimate function in the world of real estate. Without it, many successful projects would have never gotten off the ground. Unfortunately, not too many consumers are aware of private funds with the result being too many opportunities being left behind. In this article, I’ll explain how private lending works, where such funds come from and who can benefit.

What is Private Lending

Private lending is so-called because private lenders don’t have to apply third party guidelines when evaluating a potential real estate investment. Conventional loans such as those that follow guidelines issued by Fannie Mae and Freddie Mac do have certain rules to follow when approving a loan application. Nearly two out of every three loans are approved with these conventional guidelines and when doing so allows these loans to be sold into the secondary market to other investors, primarily Fannie and Freddie. Private lenders however do not have a place to sell a loan but that isn’t in the private lender’s interest.

A private loan can be issued from an individual or a group of individuals who invest in real estate properties that other lenders won’t touch. A private loan will ask for a larger down payment, sometimes as high as 50 percent or more. Interest rates are also much higher compared to traditional mortgages. Private loans are also for relatively shorter terms, ranging anywhere from three months to three years. Why would anyone seek out a private lender when down payments are so much larger and rates higher? To turn an unprofitable project into a profitable one.

A Common Scenario

There is a four-unit property that needs a bit of work. Three of the units are for residential use while the bottom floor unit is zoned for commercial space. The commercial space, formerly a coffee and breakfast shop, is unkept and abandoned. An investor wants to buy this property and rehabilitate the structure. But because the property is in such poor shape, no traditional lender will finance the project. That is until the property has been repaired. And that’s where private lending comes into play.

A private lender can use its own funds to acquire and rehabilitate the property where it can be rented out and restored to its previous condition. An investor can take a look at the project and put together a business plan that shows how much the purchase price would be plus how much the renovations would cost. Then, using local sales of similar properties in the area, determine how much cash the property would generate each month. The investor approaches a private lender with the business plan, showing the investor how much money would be generated each month and how much the property could be sold for once the project has been completed. At the completion stage, the property would be in such a condition that traditional lending could be found.

What About an Exit Strategy

The most important factor with private lending is this exit strategy. A private investor wants to know how to get its money back at the end of the loan term. A buyer would identify a project and show how and when the private lender would be paid back. This is accomplished by documenting recent sales and rentals of similar properties in the area. Private lenders pay more attention to the ultimate return on investment and the property itself, and less so on the credit profile of someone seeking private funds.

Some private lenders have a host of investors that will get to individually review whether or not to participate in a particular project. If a project will cost $1 million, then 10 individual investors might want to contribute $100,000 each. Other private lenders operate from a traditional credit line established at a local bank. I have access to both of these resources, for instance.

Rates and terms will vary with private lenders as do their own personal taste for certain types of properties. Some private lenders might be exclusive to apartment buildings while others prefer strip centers.

Takeaway

The end game for a private lender is the exit strategy. If you can identify a property in need of financing that doesn’t currently meet traditional guidelines and can show how the investor can ultimately get its money back, then a private loan might very well be your best course of action.