Hard-money loans can turn a 10% return for rental-shy investors

By JEFF LAZERSON | jlazerson@mortgagegrader.com | MortgageGrader.com | February 6, 2023

Article originally posted in Orange County Register on February 3, 2023.

So, you want to find the best rental property deal and invest some hard-earned money.

This is a common query from my readers.

What about the potential to make some serious shekels by becoming the mortgage bank instead of the landlord? Where else besides private mortgages or so-called “hard-money lending” can you find a 10% rate of return in a term of three years?

Hard-money lending is a close cousin to more direct rental investing. It’s worth considering. Why? Certain property owners will pay handsomely because, for one reason or another, they can’t qualify for cheaper institutional financing from commercial banks, Fannie, Freddie and the like.

Typically, a hard money loan is arranged and funded for one- to four-unit complexes, small apartment buildings and retail strip malls. An appraisal may be required, and title insurance will always be required to protect all concerned.

“The going market rate is around 10% to 11%,” said Ken Thayer, president of Newport Beach-based Residential First Capital. “Up to 10 people can invest in one fractionalized note. Ten people each put up $100,000 on a $1 million note as an example.”

Thayer, who’s been in the lending business since 1986, said 90% of his deals are for one to four units. Half the deals are seconds with an average loan amount of $300,000 or $600,000 for first mortgages. He typically stays under $3.5 million for any deal.

Private money mortgages, called a deed of trust in California, can be in first, second or third position as a lien against real property.

Thayer’s investment customers pay 1.25% of the balance to service the notes. Servicing fees such as Thayer’s are all over the map. You can find servicers charging less or even a lot less. And, of course, some servicers charge more than 1.25%. For example, if the note to the property owner is 11% and the servicer charges 1%, then the investor would receive a net 10% return excluding ordinary income taxes.

Let’s say five investors are investing $200,000 in a $1 million hard-money loan. If the note rate is 10% and Thayer charges each investor 1.25% to service, each investor would earn 8.75%. Or look at it this way: $200,000 x 8.75% = $17,500 divided by 12 months $1,458.33 to each investor each month as an interest-only payment.

Even though Thayer services $110 million in hard money loans, he thinks real estate rentals are still a better deal. “I would have made more money sticking it out in real estate,” he told me.

Thayer makes a good point. California homes, even with prices softening, are still riding 25-35% appreciation, which for long-term investors tops most hard-money profits.

My advice: Your best protection against the borrower who is willing to pay you a lot more because he or she can’t get a bank loan is the property’s remaining equity. If there is 50% remaining equity, the investor is relatively safe even if the borrower should default and property values continue to soften. Nobody wants to foreclose, but that offers a measure of protection.

In the current market, I think you’d be better off investing in hard-money loans than an actual rental property for the following reasons:

1) Real estate values are falling. (Nobody wants to catch a falling knife)

2) Carrying costs (mortgage payment of principal, interest, taxes, insurance and any HOA) are currently high.

3) Utility costs are ginormous, cutting into profit

4) California rent forbearances still lurk in these post-COVID days

5) There is talk of national rent “protections”

Back to the money. What about the staying power of these lofty 10% returns on hard-money investing? Can you get an even higher yield if we see more inflation?

Conventional mortgage rates hit an all-time low of 2.65% in January 2021, according to Freddie Mac. Even though rates have much improved over the past few months they are still very high at 6.09% as of Feb. 2.

The prime rate hit a low of 3.25% in March 2020. (December 2008 was the last time the prime rate was this low). On Feb. 1, Wall Street’s prime rate climbed to 7.75%. It hasn’t been that high since September 2007. And it’s all but certain short-term borrowing costs are going to rise more in the near term.

The typical private money loan is two to three years with a balloon payment owed by the property owner at the end, according to attorney Dennis Doss of Doss Law, an expert on private money mortgages.

As Thayer explained, Wall Street money swooped in during the COVID days, bringing cheaper alternatives for borrowers needing hard money, maybe in the 9% range. But that train has left the station. Rates have moved back up.

So, how much more can you get?

“There is no maximum rate (statutory maximum) for brokered-arranged loans,” said Doss. “The rate is market dependent.”

So why not just stick with buying a rental property? Private mortgages require little to no effort on the investor’s part while rental properties require a ton of effort to manage.

How do you know who to invest your money with? Scammers are everywhere.

“For consumers trying to ensure they are working with a good private money broker, we’d suggest they check the broker’s license, talk to references, read online reviews and get information from Better Business Bureau, chamber of commerce and other community groups,” said Rick Lopes, assistant commissioner with the California Department of Real Estate.

Doss tells investors they should figure out how aggressive the private money broker is when it comes to finding and evaluating properties on which to issue loans. Ask for a copy of the broker’s most recent business activities reports. Check for their borrowers’ delinquency rates, which ideally “should be 5% to 7% or less (60-90 days late or more),” he said.

California law requires a brokerage to review any investor’s suitability to invest in the trust deed based on a questionnaire (California Department of Real Estate form RE870). It looks at the investor’s net worth, income and investment background. The investment does not exceed 10% of the investor’s net worth minus home, furnishings, autos or 10% of their income.

Freddie Mac rate news: The 30-year fixed rate averaged 6.09%, 4 basis points lower than last week. The 15-year fixed rate averaged 5.14%, 3 basis points lower than last week.

The Mortgage Bankers Association reported a 9% mortgage application decrease from last week.

Bottom line: Assuming a borrower gets the average 30-year fixed rate on a conforming $726,200 loan, last year’s payment was $1,115 less than this week’s payment of $4,396.

What I see: Locally, well-qualified borrowers can get the following fixed-rate mortgages with one point: A 30-year FHA at 4.875%, a 15-year conventional at 4.5%, a 30-year conventional at 5.25%, a 15-year conventional high balance at 4.99% ($726,201 to $1,089,300), a 30-year high balance conventional at 5.625% and a jumbo 30-year fixed at 6.125%.

Note: The 30-year FHA conforming loan is limited to loans of $644,000 in the Inland Empire and $726,200 in LA and Orange counties.

Eye catcher loan program of the week: A 30-year VA fixed rate at 4.875% with 1 point cost.

Jeff Lazerson is a mortgage broker. He can be reached at 949-334-2424 or jlazerson@mortgagegrader.com. His website is www.mortgagegrader.com.

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* Specific loan program availability and requirements may vary. Please get in touch with your mortgage advisor for more information.

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Jeff Lazerson - Mortgage Columnist since 2011