The Ultimate Guide: Real Estate Private Lenders
Welcome to the definitive guide to learn about real estate private lenders. This guide is intended for experienced real estate investors and people who are just getting started. Our goal is to help you grow your real estate investing operation by providing you with a thorough educational resource that covers all things private lenders.
Hard Money Lender vs Private Lender
A lot of people use the term hard money. Some people are offended by the term hard money as they believe it has a negative connotation with which they don't want their private lending business associated.
There is no difference between hard money and private money as long as the loan is backed by a hard asset, such as real estate. Private lenders do not have standardized terms, so terms vary from private lender to private lender.
What is a Real Estate Private Lender?
A private lender is a non bank lender that provides asset backed loans to real estate investors. Private lenders are either companies or wealthy individuals.
What is a Business Purpose Loan?
Private loans backed by real estate made to investors are considered business purpose loans. This means that the real estate investor is using the loan for an investment property -- it is not to be used for a property that the investor intends to live in, which would be considered a personal residence or a primary residence.
What is a Direct Lender?
A direct lender has the ability to fund your loan directly or as a loan originating affiliate of an institutional capital provider who provides reliable funding based on clearly defined guidelines.
Direct lenders differ from mortgage brokers in that mortgage brokers work with multiple lenders and charge a fee as a middleman.
Should I work with a private lender?
Real estate private lenders are critical to the real estate investing ecosystem, especially for fix and flip and rental investors who want to scale their real estate investing business quickly by leveraging reliable and competitively priced debt capital.
Real estate private lenders are specialized in specific real estate asset classes (i.e. single family, multi-family) and loan types (i.e. bridge loans, DSCR rental loans, ground up construction loans) and are comfortable evaluating, underwriting and funding deals for experienced real estate investors in a manner that allows the investor to close transactions quickly and reliably.
Private lenders in real estate do not need the borrower to be a W-2 salaried employee with a stable source of employment income and therefore empower real estate investors to pursue full-time careers in real estate investing.
Private Lenders vs Banks
Most traditional lenders -- financial institutions, credit unions -- are very strict with their lending guidelines, and investment property loans are very carefully underwritten. It's typical that you're required to have a W-2 and provide tax returns. Otherwise you don't qualify and they cannot lend to you. If you are working with a private lender, you do not need to worry about that. A private lender will happily lend on a "no-doc" basis.
Do private lenders require a personal guarantee?
Most private loans are recourse loans and require a personal guarantee. Some real estate private lending companies offer non-recourse loans, this is most common for portfolio rental loans where the loan is secured by multiple properties in the portfolio and no personal guarantee is required. Non-recourse loans tend to have a slightly higher interest rate and a "bad boy provision".
Real Estate Private Lender Qualification
The private lender underwriters look at the following items to determine whether or not you are approved for a loan.
Real Estate Investing Experience, Track Record
The private lender will review your experience with fix and flips, rental property investing, and ground up construction. The lender wants to understand your level of experience:
- How many flips have you completed?
- How many rental properties do you own?
- How have each of your deals performed?
Private lenders look at what is called a Schedule Of Real Estate Owned (SREO). This includes your previous flips: purchase price, rehab budget, sale price, average time from purchase to sale .
Personal Financial Statement
They will look at your individual financial status using a Personal Financial Statement.
The loan underwriting will want to understand your financial and risk profile:
What are your assets? Cash, real estate, brokerage, real, retirement, life insurance cash value.
What are your liabilities?
- Mortgage debt
- Credit card debt
- Notes payable
- Auto loans
What is your income?
- Salary (not required)
- Rental property income
- Investment income
What is your legal profile?
- Are you a U.S. Citizen?
- Have you ever had a foreclosure, deed-in-lieu, or loan modification?
- Are you defendant in any legal action or have unsatisfied judgments against you?
- Are you under indictment, on probation or parole or ever been charged or convicted for a criminal offense?
- Have you ever gone through a bankruptcy?
What does Hard Money mean?
Hard money means the loan is backed by a hard asset. If you are not able to repay the principal and interest, then the lender has a claim on the hard asset that the loan is for, as well as other assets that you own as part of your personal guarantee as recourse.
So hard money lenders use hard assets as recourse and lend against hard assets. You'll see hard money lenders in real estate, and hard money lenders that provide personal loans and auto loans, etc.
What is a Bridge Loan?
A bridge loan is a short term loan intended to bridge the gap between two events. In real estate, bridge loans most commonly serve as gap funding between initial purchase and refinancing, or sale.
Let's say you want to purchase a property that is in poor condition for $100,000 and you plan to invest $100,000 into the renovation. Once the renovation is completed, based on comps, you're confident you can sell it for $275,000 or you refinance it at a loan-to-value ratio of 75% and cash out just over $200,000.
But you don't have enough cash on hand to cover your initial investment of $200,000. So you contact a private lender who offers competitive bridge loan terms. The private lender agrees to lend you 90% of the purchase price ($90,000) and 100% of the rehab budget ($100,000). In this case, all you have to come up with is $10,000 plus closing costs.
The bridge loan carries a higher interest rate, typically 7% - 12%, and is only intended to be used over a short period of time, no longer than 18 months in most cases.
Check the rates for bridge loans from OfferMarket Capital
Bridge loans are commonly referred to as "fix and flip loans" because it's a common source of capital used by flippers. The truth, however, is that many savvy rental property investors use bridge loans for the BRRR investing strategy -- Buy, Rehab, Rent, Refinance. The Buy, Rehab and Rent phases are enabled by the bridge loan.
What is a Draw Request?
When you use a bridge loan or a ground up construction loan, the construction portion of the loan is based on a pre-defined scope of work ("SOW") and the private lender reimburses you based on receipts and invoices for progress made according to your SOW.
The reimbursement funding is called a draw and is ordered through a "draw request".
You may be wondering, how am I supposed to afford the materials and labor and then be reimbursed? The answer is net terms from your vendors. That means your vendors allow you to pay a certain number of days after they deliver materials or complete your service order. Most net terms are 15, 30, 60 or 90 days. Credit cards effectively afford you net terms. Vendors commonly offer net terms with a small discount if you pay early.
100% funding for Bridge Loans
Across the private lending industry, the maximum loan-to-cost ("LTC") you will see is typically 90% of purchase price and 100% of rehab. If a lender is offering you 100% of purchase price and 100% of rehab, it should be considered a red flag and you should be careful (speak with borrower and title company references).
Ground Up Construction Loans
The next style of lending that a lot of private lenders offer is ground up construction loans. Let's say you find a parcel of land that is zoned for residential development and you want to build a house on it to either sell or rent out.
Real estate private lenders are a great source of capital for new construction projects. The private lender will in many cases provide up to 50% of the purchase price for the land and up to 100% of the construction costs.
Once construction is complete you either sell the property and repay the loan, or you refinance the property and hold it as a low maintenance rental property.
Rental Loans
Rental loans from private lenders, much like commercial investment property loans, are based on debt service coverage ratio (DSCR).
How to calculate Debt Service Coverage Ratio
DSCR = (Rental Income - Operating Expenses) ÷ (Mortgage Principal + Mortgage Interest)
DSCR = NOI ÷ Debt Service
Debt Service Coverage Ratio is your Net Operating Income divided by your Debt Service.
This is how much your property pulls in, minus its expenses which include property management, maintenance, taxes and insurance divided by the monthly principal and interest that you would be expected to pay if you have a loan in place on that rental property.
Typically a private lender has a minimum debt service coverage ratio of 1.2. This means the amount that they're willing to loan, the maximum loan-to-value (LTV), is based on the minimum debt service coverage ratio.
For example, let's say you buy a property that already has tenants in place, and it's generating $1,500 in net operating income per month:
- Rental Income: $1,900/month
- Insurance: $100/month
- Property taxes: $100/month
- Maintenance: $100/month
- Property Management: $100/month
NOI: $1,500/month
And your monthly debt service (mortgage and interest payments) will be $1,000.
DSCR = $1,500 ÷ $1,000
DSCR = 1.5
A DSCR of 1.5 meets the minimum debt service coverage ratio requirement.
Let's say that same property was only rented at $1,100, and it appraised at the same amount as a previous example. So you would be otherwise looking at $1,000 principal interest, taxes, and insurance on your monthly loan costs. Unfortunately, that is a DSCR of 1.1 which is too low. So your lender would need to reduce the loan amount to get your DSCR to the 1.2 minimum.
If you're taking out a DSCR rental loan and you don't yet have tenants in place -- because you're buying a vacant property -- your lender is going to go based on market rents, and they're going to look at the appraisal to determine what loan amount they can ultimately offer based on the expected debt service coverage ratio.
No Doc Loans
No-doc means is you don't need a W-2 (salaried employment), and you don't need to provide tax returns.
The term "no doc" is a bit misleading because there are certainly documents involved. If you go through a private lender's underwriting checklist, you will provide several documents.
If you're organized and you periodically work with real estate lenders, the data request is straightforward.
What information does a private lender need?
A private lender needs the following types of information:
- personal information
- entity information
- property information
Personal information
- Legal Name
- Social Security Number
- Authorization for credit report and background check
- Personal Financial Statement
- 2 most recent bank or investment account statements
- Schedule Of Real Estate Owned (SREO)
What is a Personal Financial Statement?
A Personal Financial Statement, also referred to as a Loan Application, is a 1-2 page overview of your Assets, Liabilities, Income and legal profile.
Assets include cash, investments, real estate, retirement accounts, insurance cash value. Liabilities include personal loans, credit card balance, auto loans, real estate mortgages. Income does not need to be a W-2 (salaried employment), it includes rental income, real estate flipping income, investment income. Legal profile is a short list of yes or no questions to better understand your history and risk profile. Questions commonly include are you a US Citizen? Have you ever gone through bankruptcy? Have you ever gone through foreclosure?
What is a Schedule Of Real Estate Owned?
The Schedule Of Real Estate Owned or SREO is a simple list or spreadsheet that details your real estate investing experience. This includes your current real estate holdings, as well as real estate that you have sold. For fix and flip investors, it will show how much you purchased each property for, your rehab budget, how much you sold it for, and the amount of time from purchase to sale. Private lenders want to understand your performance and the real estate you own which can be used as collateral in the event of default (i.e. you are unable to repay your loan and the subject property of the loan is not enough to cover the loan amount).
For rental property investors, the SREO will detail your current portfolio in terms of monthly rent and occupancy status (occupied, vacant). It will also detail properties you have since sold.
The beautiful thing about the Schedule Of Real Estate Owned is that it's easy to keep track of once you fill it out. Simply update it as you buy and sell properties.
Entity information
If you own a property that you're trying to get a loan for in a business entity, or if you intend to purchase a property through a business entity, you'll be required to provide thorough documentation for that entity.
In real estate, and most business for that matter, the entity type is a Limited Liability Company or LLC. Here are the documents you will be required to provide to the private lender:
- Formation: Articles Of Organization (LLC), Articles Of Incorporation (Corporation)
- Operating Agreement (LLC)
- Certificate Of Good Standing
- IRS EIN (if multi member LLC)
Ownership Structure & Personal Guarantees
If you are investing with non-operating passive members, you may want to avoid the need for them to serve as personal guarantors and be subjected to data requests from the private lender. For that reason, it's important to understand the most common requirements of private lenders as it relates to personal guarantees:
- Many private lenders require personal financial information, credit and background check for all members of the entity, even if the member is a passive investor in the property.
- Some lenders only require personal financial information, credit and background check for members who own 20% or more of the entity.
- Some lenders only require members representing a 51% ownership interest in the entity to serve as personal guarantors.
Property Information
The final set of information that you'll be providing to your private lender is property-specific information.
- Contract Of Sale (for pending purchases, not for refinancing)
- Scope Of Work (for construction component of bridge loans)
- Existing leases (if purchasing or refinancing a leased rental property)
- Proof of security deposit receipt (usually only required for purchases of vacant properties)
- Settlement Statements (i.e. HUD-1 or ALTA, usually for recent purchases)
- Insurance Policy and Mortgagee Clause (needs to meed the lender's insurance coverage guidelines)
The lender will coordinate the following property-specific evaluations:
Airbnb Loans
If you plan to purchase an investment property to rent on Airbnb, which had 4 million hosts at the end of 2020, or you want to refinance a rental property that is used for Airbnb short term rentals, you will have a more difficult time finding a private lender who will approve your loan.
Most private lenders require 12 month leases for their rental products. Here are some reasons why many private lenders do not offer Airbnb loans:
- Lack of certainty: demand for Airbnb rentals can be seasonal, and Airbnb rental income in low demand periods may not cover your PITI.
- Insurance risk: proper insurance coverage for Airbnb rentals may be difficult to obtain and expensive. Lenders are risk averse and there are many unknowns about risks associated with Airbnb lodging. What happens if your property is damaged, guests violate conditions of their stay or a crime occurs and insurers refuse to cover a resulting claim?
- Platform risk: what happens if you get a a complaint and Airbnb suspends your ability to list your rental?
- Loan re-sale risk: most mortgage loan originators and private lenders do not keep your loan on their balance sheet. Instead, they sell the loan on the secondary mortgage market. The purchases of these loans have clear guidelines that exclude vacation rentals, short term rentals such as Airbnb.
With higher perceived risk comes a higher interest rate. If you do find a lender who offers loans for Airbnb rental properties, you will likely be offered a higher interest rate.
As demand for Airbnb loans and vacation rental loans continues to grow, we expect loan products to arise and a robust secondary market to organize. In the meantime, it will be difficult to finance investment properties with the intended use as Airbnb rentals.
Rental Loans: Lease Terms
Here are the key takeaways regarding leases for rental loans:
If your rental is on a month-to-month lease, that may be OK as long as your original lease with that tenant was at least 12 months. If you do not have a 12 month lease in place, that can cause delays while you implement minimum lease terms in order for underwriting to approve your loan. If you intend to refinance with a rental loan from a private lender and your leases do not meet minimum lease term requirements, to avoid delays, you may want to get a jump on that by implementing twelve month or longer leases.
For purchases of vacant properties using a rental loan, many private lenders will require that you have a lease in place and security deposit received within a specific timeframe from the purchase date.
To reiterate an important point, the majority of private lenders do not lend for properties that are being used as short term rentals like an Airbnb. So you'll want to check with the private lender to understand their policy.
Now this is not an exhaustive list, there may be a few other items required by your lender. That said, you can imagine, if you keep your information organized, you can just run through the checklist fairly quickly for each loan approval moving forward.
Best Private Lenders for Real Estate
Finding real estate private lenders that are the best fit for your requirements varies on the following:
Private Lenders Near Me
Many borrowers prefer to work with private lenders near them who are specialized in the local market. Local private lenders may offer less competitive terms but faster speed.
Few private lending companies operate nationwide. This may be due to state-specific licensing regulations or strategic market focus on the part of the lender.
Private Loan Type Specialization
Many private lenders specialize in one loan type. Perhaps it's bridge loans and they do not offer rental loans. Or perhaps they offer other loan products that with terms that are less competitive and slower to process. For this reason, it's important to speak with several lenders to understand their strengths and limitations.
Do private lenders need to be licensed?
Private lenders offer business purpose loans and are therefore not subjected to the same state and federal consumer protection provisions and licensing requirements. While regulations are always evolving, here is an overview of specific licensing limitations among states:
States where private lenders need NMLS license
NMLS or Nationwide Multi-State Licensing System is the system of licensure for mortgage companies and mortgage loan originators (MLO) in the United States. Most stats only require an NMLS license for consumer mortgage loans. These states, however, require private lenders to have an NMLS license:
- Arizona
- California
- Nevada
- North Dakota
- South Dakota
- Vermont
States where primary residence cannot serve as collateral
In the following states, the private lender cannot use the borrower's primary residence as collateral for the personal guarantee of the loan:
- Georgia
- Iowa
- Kansas
- Maryland
- Washington
States where single family residential real estate (1-4 units) cannot serve as collateral
For properties located the following states, the private lender cannot us any single family (1-4 units) property owned by the borrower as collateral for the personal guarantee of the loan:
- Idaho
- Minnesota
- Oregon
- Utah
States where loans to individuals under $25,000 are require NMLS license
The following states require an NMLS license if you are lending an individual (not a business entity) $25,000 or less:
- Alabama
- Florida
- Kentucky
- North Carolina
- Virginia
Loan Seasoning
Many private lenders and commercial mortgage lenders require the borrower to own a property for a specific period of time before refinancing. This is called a seasoning period, and it is typically 6 months.
One reason lenders require a seasoning period to avoid a common fraud where a borrower buys a property on the cheap that has undisclosed major defects (i.e. foundation) and then does a low cost cosmetic rehab and goes to a lender looking to cash out refi. In this situation, if the defects go unnoticed by an appraiser, the borrower can pull out more cash than they invested into the deal and leave the lender with a property that is not worth the amount of the loan.
Lenders that do not require seasoning stand to attract more investor borrowers, at the risk of also attracting borrowers who may not be operating in good faith.
For example, let's say you buy a property in January and you fix it up with a bridge loan. In March you're ready to cash out refinance the property into a DSCR rental loan. This is part of the BRRR playbook, you want to keep it for your own portfolio as a rental, get out of the higher interest rate bridge loan and pull cash out of the property. Most lenders will require you to wait 6 months in order to be able to refinance at the maximum loan to value (LTV) limits. Your private lender may allow you to refinance in under 6 months but they will require a 5% haircut on the LTV that they can offer you.
So instead of qualifying for 75% loan to value based on DSCR, they can offer you a rental loan at 70% LTV.
Seasoning is an important concept to be aware of as you run your numbers and do your forecasts. Seasoning can affect your project timelines and cash on cash returns.
This concept applies to situations where you're working with the same lender for a bridge loan and then refinancing into a rental loan, as well as situations where you're working with separate lenders or no lender for the initial purchase and rehab of the property.
For example, you bought a house in cash and fixed it up using your own cash, no lender involved. 3 months later you approach private lenders for rental loans and they all tell you there are seasoning restrictions because you've only owned the property for less than 6 months.
Builders Risk Insurance
This is a property insurance policy that you would need if you're purchasing a vacant property in poor condition and doing construction. It's a short term policy for a vacant property that you would then convert into a landlord insurance or homeowners insurance policy once the property is renovated to code and occupied.
Landlord Insurance
Landlord insurance is insurance specifically for a rental property. Private lenders have strict landlord insurance requirements for policy coverage as it relates to replacement cost, uncollectible rent and medical liability.
Typically, the landlord insurance policy premium is going to be a bit higher when working with a private lender, given their policy coverage requirements. It's important to understand your lender's insurance requirements, as it may result in higher than expected annual premium than you initially forecast in your deal due diligence.
OfferMarket's preferred landlord insurance provider is Steadily Insurance.
What is a Mortgagee Clause?
A mortgagee is the person or entity who provides a mortgage to a borrower. The borrower is referred to as the mortgagor.
A mortgagee clause is a very simple statement and address that the borrower provides to their property insurer to include on the policy. The mortgagee clause memorializes that in the event a claim is filed and the insurer need to pay out to the policy holder, the lender is effectively a joint policyholder because they have an economic interest in the property.
Here's an example mortgagee clause:
OfferMarket Capital LLC ISAOA/ATIMA 627 S Hanover St Baltimore, MD 21230
So if you have a $100,000 rental property and an $80,000 loan outstanding and there's a total loss on the property, the insurer pays out $100,000. The mortgagee clause ensures the lender receives 80% of the payout or $80,000, and you receive 20% of the payout or $20,000.
The mortgagee clause tells the insurer they can't give the full amount to the borrower because there's a loan in place and the lender needs to be made whole.
ISAOA ATIMA
On the mortgagee clause you will commonly see the acronym ISAOA/ATIMA. What that means is its successors and/or assigns as their interests may appear, and it provides protection to future mortgagees who may purchase the mortgage note on the secondary market.
Prepayment Penalty
A prepayment penalty is a fee that the lender charges in the event you pay off the loan early. This penalty is designed to deter the borrower from refinancing into a new loan at a lower interest rate with the same or different lender.
How does a prepayment penalty work?
The on the lender's term sheet, they will clarify their prepayment penalty policy. For DSCR rental loans, it is either a 5-4-3-2-1 Prepayment Penalty, 3-2-1 Prepayment Penalty or Yield Maintenance.
5-4-3-2-1 Prepayment Penalty
Using the 5-4-3-2-1 Prepayment Penalty as an example, you would be charges a fee based on the following schedule:
- During Year 1: 5% of the loan balance
- During Year 2: 4% of the loan balance
- During Year 3: 3% of the loan balance
- During Year 4: 2% of the loan balance
- During Year 5: 1% of the loan balance
So if you have a $100,000 loan balance during year 2, and you decide to pay off or refinance your loan, you will be contractually required to pay a $4,000 prepayment penalty fee.
Yield Maintenance
Yield Maintenance Premium is a type of prepayment penalty where the borrower is responsible for paying the rate differential through loan maturity. This makes it unattractive for investors to refinance the loan and is not commonly used.
Yield Maintenance = (Present Value of Remaining Mortgage Payments) x (Interest Rate - Treasury Yield)
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