Re Academic Press Private Real Estate Investment_9

C H A P T E R 10 The Private Lender The contemplation of difficult mathematics, Wolfskehl realized, was far more rewarding than the love of a difficult woman. Paul Hoffman, The Man Who Loved Only Numbers, p. 209 INTRODUCTION The two most common ways the private real estate investor becomes a lender are: 1. Originate or purchase a loan for cash. 2. As the seller of investment property, provide a buyer with financing for a portion of the purchase price by taking a note rather than cash in partial payment. There are ramifications associated with either strategy. Combinations are also possible, an example being a loan made as part of a sale that is then purchased by another private investor. Like many real estate opportunities, the permutations are numerous. In this chapter we will: Examine motives of private investors who choose to become lenders. Discuss the difference between aggressive and conservative lending policies. Measure some of the true economic costs of private funds. Describe specific loan provisions that accomplish tax objectives. Warn against a few of the ‘‘traps for the unwary’’ that exist in the tax code. Lending requires a host of special skills. Local laws govern many of the conditions under which loans are made. This chapter is not about those legal details. Rather, it is about the economic, financial, and tax ramifications of these activities. 237 258 238 Private Real Estate Investment THE ‘‘HARD MONEY’’ LOAN VERSUS THE ‘‘PURCHASE MONEY’’ LOAN A loan secured by real property made directly to a borrower via a cash advance from the lender is known as a hard money loan. Loans granted to buyers by the seller as part of a sale are referred to as purchase money loans. While this is our convention, the language is imprecise. Some states consider cash loans from third parties purchase money simply because the proceeds of the loan constitute part of the purchase price. A common misconception is that because cash was paid for a hard money loan it should be held to some sort of higher underwriting standard. This is not true. A loan is a loan. Lenders, regardless of how they came by the instrument, usually want to be paid and want good security that will redeem the debt in the event of borrower default. Nonetheless, sellers sometimes make desirable loans to induce buyers to purchase, perhaps at a higher price. This will be taken up in detail later. As hard money lenders, institutions put borrowers and their property through a rigorous and time-consuming examination prior to granting the loan. Borrowers and properties that do not meet their standards are declined. Borrowers often seek out private parties because the loan can be made faster with fewer formalities. This is not to say that private loans are or should be poorly thought out or that private lending is a casual matter. A few simple rules can successfully guide the real estate investor who wishes to make loans. The fact that these rules are simple does not make them any less effective. THE DIVERSIFICATION PROBLEM Although it is possible for a private investor to own a portfolio of loans, real estate lending involves an entry cost close to that of the purchase of a parcel of real property. Because most private investors have relatively small amounts to invest, they cannot achieve the same diversification benefits a large lending institution can. For this reason, the first rule of private real estate lending must always be observed: Rule 1: Never make a loan on a property you are unwilling or unable to own. This rule opens the discussion on just what it is that a private lender obtains when he makes a real estate loan. Of course, the textbook legal answer is that he gets a security interest in the property. Perhaps. A financial or risk 258 The Private Lender 239 management view is that he faces some probability that he will own the property sometime in the future. The most common remedy for a lender who does not receive payment is foreclosure. Thus, from an economic and risk perspective, the lender must view his situation as having made a loan to the property. For it is the property, not the borrower, that is expected to repay the loan. Many states do not permit a lender to collect funds from the borrower in excess of the amount realized from the sale of the property in foreclosure.1 The private investor should make the loan as if he were buying the property at some unspecified time in the future under economic and physical conditions that are less rosy than the day the loan was made. After all, why does a buyer default? Why is no one else willing to rescue the buyer and obtain the property? If these questions cast a chill on the reader’s enthusiasm to be a real estate lender, that is understandable. If lending is a deferred ownership opportunity, to deal with the ‘‘opportunity’’ portion one need only follow the acquisition analysis standards set forth in Chapters 3 and 4. To deal with the ‘‘deferred’’ portion one need only choose the loan-to-value or debt coverage ratios carefully. Underwriting ratios are meant to prevent the lender from ever becoming the owner. The second rule of private real estate lending is: Rule 2: Never make a loan at a loan-to-value ratio that will permit you to become the owner of the property. Following those two simple rules (and some other technical rules of documentation) should prevent most real estate lending problems and result in timely payments. On the few occasions when borrowers get in trouble, someone else will enter the picture to cure the problem in return for the opportunity to obtain the property, perhaps at a discounted value, but one that is still greater than the loan balances. OTHER POSSIBILITIES Good rules are boring (and make short chapters). There are some interesting quirks of real estate lending that can take us in a very different, but still useful direction. Suppose the investor sees the market in a bubble condition as discussed in Chapter 9. He can wait until those buyers stumble and have to sell or he can loan to those buyers with the knowledge that they might stumble into foreclosure. This is a case where only the first rule of private lending is being observed. Such an investor views the possibility of obtaining 1These laws are complex and many exceptions apply. 258 240 Private Real Estate Investment the property in foreclosure as a valuable option to acquire a property at a price below the last round of appreciation (or the last puff of inflation into the bubble). This strategy has its own difficulties. One never knows what the borrower may do when trouble calls. He may gather his resources and see the problem through. In this case the lender should receive a high return, presuming that the loan was made at a higher interest rate than other alternatives, at least in part because the loan-to-value ratio was higher. He may file bankruptcy, delaying the foreclosure process and increasing its cost. He may find a financially stronger third party to purchase his interest at a discount, but at a price that is still greater than the loan balance. He may neglect the property through a long period of decline before and during the foreclosure process, reducing its value below the loan balance. DID WE MAKE A LOAN OR DID WE BUY THE PROPERTY? The line between lending and owning blurs as the interest rate charged on the loan rises. Let’s examine this statement closely and see why it may be true. Imagine a lender who is indifferent about whether the loan obligations are met. Such a lender might even welcome the opportunity to own the property. The lender’s ultimate source of repayment is always the property. As the loan is presumably for a term of years, it is important to know the property’s value at various times, such as the loan funding date, the maturity date, the date the buyer defaults, and the date the lender takes possession in a foreclosure. Let’s begin by defining a simple future value function that will govern the property’s value over time. fv ¼ pvÿ1 þ gt ð10-1Þ This function anticipates a simple monotonic increase of a certain percent per year (g>0) and is compared in Figure 10-1 with a flat value over time (g ¼ 0). High interest rates should accompany high loan-to-value ratios. Figure 10-2 shows the loan balance over time, assuming that interest is accrued and added to principal at a relatively high interest rate. This is a simplifying, but The Private Lender 3000000 241 Value Growth Flat Value 2000000 1000000 0 2 4 6 8 10 Time FIGURE 10-1 Value over time with and without growth. Value Growth Flat Value 3000000 • •• Aggressive Loan • • • 2000000 • • • • • 1000000 • • • • 0 2 4 6 8 10 Time FIGURE 10-2 An aggressive loan with and without growth in property value. realistic assumption. A borrower may take out a loan on vacant land calling for annual payments and then, unable to make even the first payment, default. The result is a foreclosure that may take a year or more, at which point the lender then has invested his original principal plus interest accrued up until he is able to take title and sell the property. The borrower’s equity in the property is the difference between the property’s value at any given time and the loan balance at that same time. At the point the loan balance is equal to the value, the borrower has no equity ... - tailieumienphi.vn