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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 inpartial payment.. THE ‘‘HARD MONEY’’ LOAN VER

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 209INTRODUCTION

The two most common ways the private real estate investor becomes a lenderare:

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 inpartial payment

There are ramifications associated with either strategy Combinations arealso possible, an example being a loan made as part of a sale that is thenpurchased by another private investor Like many real estate opportunities,the permutations are numerous

In this chapter we will:

policies

code

Lending requires a host of special skills Local laws govern many of theconditions under which loans are made This chapter is not about those legaldetails Rather, it is about the economic, financial, and tax ramifications ofthese activities

237

THE ‘‘HARD MONEY’’ LOAN VERSUS THE

‘‘PURCHASE MONEY’’ LOAN

A loan secured by real property made directly to a borrower via a cashadvance from the lender is known as a hard money loan Loans granted tobuyers 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 considercash loans from third parties purchase money simply because the proceeds ofthe loan constitute part of the purchase price A common misconception isthat because cash was paid for a hard money loan it should be held to somesort 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 bepaid and want good security that will redeem the debt in the event ofborrower default Nonetheless, sellers sometimes make desirable loans toinduce buyers to purchase, perhaps at a higher price This will be taken up indetail later

As hard money lenders, institutions put borrowers and their propertythrough a rigorous and time-consuming examination prior to granting theloan Borrowers and properties that do not meet their standards are declined.Borrowers often seek out private parties because the loan can be made fasterwith fewer formalities This is not to say that private loans are or should bepoorly thought out or that private lending is a casual matter A few simplerules 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

Although it is possible for a private investor to own a portfolio of loans, realestate lending involves an entry cost close to that of the purchase of a parcel ofreal property Because most private investors have relatively small amounts toinvest, they cannot achieve the same diversification benefits a large lendinginstitution can For this reason, the first rule of private real estate lendingmust always be observed:

management view is that he faces some probability that he will own theproperty sometime in the future The most common remedy for a lender whodoes not receive payment is foreclosure Thus, from an economic and riskperspective, the lender must view his situation as having made a loan to theproperty For it is the property, not the borrower, that is expected to repay theloan Many states do not permit a lender to collect funds from the borrower in

The private investor should make the loan as if he were buying theproperty at some unspecified time in the future under economic and physicalconditions that are less rosy than the day the loan was made After all, whydoes a buyer default? Why is no one else willing to rescue the buyer andobtain 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 standardsset forth in Chapters 3 and 4 To deal with the ‘‘deferred’’ portion one needonly choose the loan-to-value or debt coverage ratios carefully

Underwriting ratios are meant to prevent the lender from ever becomingthe owner The second rule of private real estate lending is:

to become the owner of the property

Following those two simple rules (and some other technical rules ofdocumentation) 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 theopportunity to obtain the property, perhaps at a discounted value, but onethat is still greater than the loan balances

Good rules are boring (and make short chapters) There are some interestingquirks of real estate lending that can take us in a very different, but still usefuldirection Suppose the investor sees the market in a bubble condition asdiscussed in Chapter 9 He can wait until those buyers stumble and have tosell or he can loan to those buyers with the knowledge that they mightstumble into foreclosure This is a case where only the first rule of privatelending is being observed Such an investor views the possibility of obtaining

1 These laws are complex and many exceptions apply.

the property in foreclosure as a valuable option to acquire a property at aprice below the last round of appreciation (or the last puff of inflation into thebubble).

This strategy has its own difficulties One never knows what the borrowermay do when trouble calls

the lender should receive a high return, presuming that the loan wasmade at a higher interest rate than other alternatives, at least in partbecause the loan-to-value ratio was higher

its cost

at a discount, but at a price that is still greater than the loan balance

during the foreclosure process, reducing its value below the loanbalance

The line between lending and owning blurs as the interest rate charged on theloan 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 aremet Such a lender might even welcome the opportunity to own the property.The lender’s ultimate source of repayment is always the property As theloan is presumably for a term of years, it is important to know the property’svalue at various times, such as the loan funding date, the maturity date, thedate the buyer defaults, and the date the lender takes possession in aforeclosure Let’s begin by defining a simple future value function that willgovern the property’s value over time

fv ¼ pv 1 þ g
t

ð10-1Þ

This function anticipates a simple monotonic increase of a certain percentper 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 10-2shows the loan balance over time, assuming that interest is accrued andadded to principal at a relatively high interest rate This is a simplifying, but

realistic assumption A borrower may take out a loan on vacant land callingfor 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 thelender 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 theproperty’s value at any given time and the loan balance at that same time Atthe point the loan balance is equal to the value, the borrower has no equity

Time1000000

20000003000000

Flat ValueValue Growth

FIGURE 10-1 Value over time with and without growth.

Time1000000

20000003000000

Aggressive LoanFlat ValueValue Growth

and is only nominally the owner That is, he may be in title, but he has noeconomic interest in the property From an economic standpoint, the lender

is the de facto owner of the property Thus, we are interested in when the twoplots meet Given a fixed set of loan terms but two different possible propertyvalues (one flat, one increasing), we have two possible break even points.Note for Figure 10-2 that the first of these is a little more than two years afterthe loan is made and the second is a longer time, slightly less than three yearsfollowing the funding of the loan The reason for this, of course, is that theincrease in property value in the second instance delays the time when theborrower’s equity is exhausted Imagine what happens to the break even point

if the value of the property falls (g < 0) after the loan is made

This carries an additional lesson in property rights A well-establishedlegal concept warns: ‘‘The Law abhors a forfeiture.’’ Courts frown on pre-determined penalties in contracts Most states provide for minimum periods

of reinstatement or redemption during a foreclosure or after a borrower loseshis property in foreclosure This gives the borrower an opportunity to avoidhaving his equity unceremoniously ‘‘captured’’ by a lender who may have had

a hidden agenda or superior bargaining position when the loan was made.High loan-to-value loans combined with restrictions on lenders’ foreclosurerights mean the borrower can at least ‘‘live out’’ some or all of his remainingequity during the time (including redemption time) it takes the lender toforeclose and obtain clear title

By changing the variables in our example, one concludes that whatever

‘‘blurring’’ there is of the line between lending and owning, it is dependent onthe loan-to-value ratio, the interest rate on the loan, the change in propertyvalue during the period of any default, and the time involved in foreclosure.Now let’s change the situation to reflect the more conservative loan made

by a lender whose only motive is lending In Figure 10-3 the lender observesboth fundamental rules of private lending Rather than loaning 75%, he onlyloans 60% With this improved security the borrower is entitled to a lowerrate, say 10% per annum Note the change in the break even points to morethan five years if the property does not increase in value and nearly eightyears if it goes up slightly

We now turn to an example of a purchase money loan In keeping with ourwish to consider the twists and turns in the process that make life interesting,

we will examine a private loan with tax deferral benefits for the lender

THE INSTALLMENT SALE

While every sale transaction requires at least a buyer and a seller, for mosttransactions a third party lender is also required We have noted that

institutional lenders impose expensive and burdensome requirements inconnection with making loans Many of these requirements are appro-priate for any lender, but some are peculiar to how a lending institutiondoes business A private lender may elect to suspend or waive certainrequirements, making the financing process easier and less expensive forthe borrower.

Separate from underwriting standards, a third party lender introduces itsown profit motive When the seller agrees to be the lender, profits from thetransaction that would have gone to a third party lender remain to be shared

by the buyer and seller This section is about that allocation

Chapter 7 showed that tax deferral is a good thing and that timing theexchange closing is critical Private lending can materially assist thisprocess What will unfold in this section is an intricate weaving of economicinterests and property rights in a transaction involving only two parties

As in Chapter 7, we will plumb the murky depths of the U.S tax system

to discover how parties modify their behavior to accomplish after-taxinvestment objectives

We will examine alternatives from the standpoint of each party Conflictinginterests abound in this area Reconciling these is the art of real estatebrokerage Placing numerical values on the tradeoffs is the science

We will continue the example begun in Chapter 4 and further oped in Chapter 7 For reference, our exchange–buyer client in Chapter 7expected or had achieved (depending on whether one is projecting

Time1000000

20000003000000

Conservative LoanFlat Value

forward or looking back at the exchange acquisition) the results shown

in Table 10-1

To maximize investments of any kind, one must control costs The cost

of financing is an important buyer concern The seller keeps a watchfuleye on taxes For each party there are both long- and short-termconsiderations

THE BUYER

Until now we have been silent on the source of financing, merely assumingthat buyers obtain loans from conventional lenders These lenders offerfinancing at market rates and terms that include origination costs We ignoredthese costs for simplicity thus far, but now wish to look at them closely.Suffice it to say that if the exchange–buyer in Chapter 7 can avoid these costs,

he is better off Also, if he can obtain a below-market interest rate, that is inhis best interests

Suppose an institutional lender charges 2.5% of the initial loan fororigination If the seller is willing to provide the financing, these costs arereduced considerably They are not reduced to zero because there are alwayssome costs in documenting a real estate loan We will assume the seller could

TABLE 10-1 Client Status

Terminal year cash flow data ($) Equity reversion data ($)

Sale price 5,196,898 Beginning loan balance 2,321,146 Ending loan balance 2,273,804 Net operating income 504,646 Original cost 2,604,683 Debt service 234,209 Sale costs 389,767 Depreciation 66,301 Accumulated depreciation 293,212 Income tax 77,501 Capital gain 2,401,351 After-tax cash flow 192,936 Capital gain tax 389,524.

Pre-tax net equity 2,533,327 After-tax net equity 2,143,803 Net present value ¼ 1,039,896 IRR ¼ 0.46205

provide financing at 5% of the initial loan, a savings of 2 ‘‘points’’ on theBeginning Loan Balance in Table 10-1, or approximately $46,000.

This has four major ramifications:

1 The buyer and seller would both like to capture these savings Theseller’s position to the buyer is, ‘‘You were going to pay it anyway.’’The buyer replies, ‘‘But, you were not going to get it if I did pay it.’’

2 Should the buyer and seller agree on how to divide the loan costsavings, the natural way for the seller to receive his share is in the form

of a price increase This has tax ramifications for both parties The sellerhas a higher capital gain, but under the doctrine that after-tax money isbetter than no money, he does not complain The buyer has a higherbasis resulting in a higher depreciation deduction and lower futurecapital gain But as it is cheaper to pay taxes than lose money, deduc-tions are a small consolation

3 As part of reaching agreement on the division of the financing costsavings, the question arises as to the form of payment The buyer can(a) increase his down payment, effectively paying the seller in cash;(b) increase the amount of the loan the seller will carry, effectivelyfinancing the cost; or (c) pay the amount in any combination of cashand higher loan balance

4 The decision required in item 3 introduces secondary considerationshaving to do with underwriting risk, interest deductions, amortizationperiod, etc

Using the tools provided in prior chapters, we can calculate the effect ofmany of the above decisions, or a combination of them, on either party Theadvanced mathematics of game theory and matrices in multiple dimensions ofEuclidian space might suggest a global optimum for both parties Such aneffort, while interesting, is beyond the scope of this book In practice, theparties depend on the bargaining and negotiating abilities of their respectiveagents to reach an acceptable agreement

It is easier for us We make assumptions

THE SELLER

Before looking at the seller’s position we will make some assumptions abouthis circumstances We will assume he is a mature investor whose propertyrepresents the latest in a series of exchanges Along the way he has addedlabor, but now has reached the point where his effective return on his realestate has dropped due to his lack of time, interest, or ability to continue toactively manage his property The combination of long holding periods, a set

of sequential exchanges, and the addition of costless (from a tax standpoint)labor means that he faces a large capital gain tax upon sale Although he may

be able to retire on the after-tax cash proceeds, he is intrigued at theopportunity to continue in a real estate lending capacity that is passive—orrelatively so—and that offers continued tax deferral

The foregoing qualitative assumptions lead to the requirement of specificinformation about the seller’s tax basis, cost of sale, and loan balance.Table 10-2 provides this information followed by calculations for two capitalgain reporting methods

Without the installment sale the seller of the second property in Example 2

of Chapter 7 (dataEG2b) must take $24,806 from other sources in order toclose the sale and pay his taxes This is clearly an unappetizing result.Fortunately, Section 453 of the U.S tax code provides for the reporting of acapital gain under the Installment Sale method By this rule the gain is dividedinto two parts, the recognized (cash) portion and the non-recognized(promissory note) portion The result, in the right column of Table 10-2, is

to tax only the cash received at the time of sale and defer remaining taxesuntil the seller receives cash payment of any principal due under the terms

With installment sale ($)

Seller adjusted basis 300,000 300,000 Seller sales costs 156,908 156,908 Seller loan balance 300,000 300,000 Capital gain tax rate 0.15 0.15 Recapture rate 0.25 0.25 Seller accrued depreciation 250,000 250,000 Sale price 3,276,132 3,276,132 Downpayment 954,986 954,986 Loan from seller 2,321,146 2,321,146 Seller capital gain 2,819,224 2,819,224 Seller recognized gain 2,819,224 954,986 Sale year capital gain tax 522,884 168,248 Seller net proceeds (24,806) 329,830

must be considered:

1 The seller, having deferred a portion of his gain into the buyer’sinstallment note, has retained investment dollars that would haveotherwise gone to the payment of taxes

2 The retained investment dollars are not only larger in nominal amountthan the after-tax figure, they probably earn an interest rate higher thanwhat might have been obtained in fixed interest passive securities (ofcourse, there may also be a higher risk)

3 The seller should compare, in nominal dollar form, his interest earningsfrom the installment obligation to those that might be obtained fromreinvesting the after-tax proceeds from the outright cash sale in alternateinvestments

4 The seller, after making a series of calculations, may find that hisprimary motive in selling is to obtain an installment sale and that cashoffers will not be entertained

5 In order to induce buyers to make offers that suit the seller’s taxmotives, the seller may offer loan terms slightly more attractive thanconventional lenders offer

6 As a lender, the seller bears responsibility for all the underwriting,management, servicing costs, and potential foreclosure risks any otherlender would face

7 Depending on whether any existing loan can be assumed, the seller may

be able to choose between carrying a smaller second loan behind theexisting first loan or retiring the existing loan and receiving a largerinstallment note from the buyer secured by a first mortgage

8 The documentation of the loan, known in the law as ‘‘perfecting thesecurity,’’ is a technical process requiring careful attention to detail andsome documentation costs

9 Once the installment obligation has been incurred, the seller’s tax fatelies in the hands of the buyer/borrower who, if he is allowed to, mayprepay the note at any time, triggering full payment of the remainder ofthe seller’s taxes

10 The buyer knows all of the above and has an interest in capitalizing oneach of them for his own benefit

While each item on the list above may be quantified in some fashion, thereare a number of qualitative issues that we will dispense with by making somereasonable assumptions We will assume that the seller is still healthy andactive enough to retake title if foreclosure is necessary, is technically qualified

to document and manage any loan and is sufficiently familiar with his ownproperty and its surrounding environment to be able to appropriately pricethe loan by selecting an interest rate consistent with its risk The seller prefers

to hold a first mortgage rather than a second so will use a portion of the cashproceeds to retire the existing loan This will leave the buyer’s down paymentunchanged and the seller with a loan that is approximately 70% of the saleprice of the property.

To construct an actual transaction, some quantitative assumptions are alsoneeded We will assume the interest rates on intermediate term governmentbonds are 7% The buyer, having a projected time horizon of ten years, hasagreed to a so-called ‘‘lock-in’’ provision prohibiting prepayment of anyprincipal during the first seven years of the loan In return the seller hasoffered 8.5% interest, 1% below the market rate The buyer has agreed toincrease the purchase price by an amount approximately equal to theorigination costs (2.5% of the Begining Loan Balance  $60,000) by increasingthe amount of the loan The seller will pay for all costs of documentation

In the foregoing paragraph there are a number of tradeoffs The buyer mustretain the property subject to the loan in its present form for seven yearsregardless of changes in the lending market Should he decide to sell beforeseven years, he must do so with the loan in place Thus, the lock-in prohibitsvaluable options The question becomes: Is the total value of the seller’sconcession package (lower interest rate, financed documentation costs) worthmore or less than the buyer’s concessions (higher purchase price, locked-inloan)?

IS THE SELLER’S FINANCING A GOOD DEAL

FOR THE BUYER?

In the interests of brevity we will make a point only about how much one can

‘‘afford’’ to pay for below-market financing terms The choice is between twofinancing methods, each producing a different set of cash flows and finalreversion We cautioned in Chapter 7 against paying for tax benefits This issimilar in that the buyer must be sure he will actually receive any privatefinancing benefits he ‘‘purchases’’ from the seller We use dataEG2b from

benefits

2 The full dataset and all intermediate computations are provided in Excel format among the electronic files for this chapter.

1 We can test the net present value (NPV) for the seller financingalternative to insure that it exceeds the conventional loan alternative.

2 We can perform the same test using the internal rate of return (IRR)

3 Ignoring the tax implications, we can calculate the point in time whenthe higher price is recovered by interest rate savings

THE NPV TEST

For the first two tests we need the terminal year to be variable Thus, the onlydifference between dataEG2b and dataEG4a is that the fixed terminal yearvalue in dataEG2b is replaced with ‘‘tyear’’ in dataEG4a For the sellerfinancing we create a second Example 4 dataset, dataEG4b, in Table 10-3 forwhich we make the variable tyear substitution in dataEG2b, but we also adjustthe interest rate down from 9.5 to 8.5% and the initial loan balance up

$60,000 to reflect the benefits and costs of the seller’s financing

The larger purchase price and larger loan require the Exchange of Basis

to reflect this additional consideration For this we define exchData3 inTable 10-4 by making the appropriate substitutions into exchData2

Plotting the different NPV for each terminal year in Figure 10-4, the financed alternative consistently plots above conventional financing Theseller financing, notwithstanding the increased price, is preferred

seller-We can pick a specific time horizon from Figure 10-4 and subtract the twopoints to determine, for that holding period, how much the seller financingenhances NPV For instance, NPV is $47,002 higher with seller financing ifthe property is held for ten years

TABLE 10-3 Data Input dataEG4b