The Art of the Deal
Author: Joel Westle
May, 2011 Issue
There’s absolutely no doubt we’re living in a brave new economy. Everything is different. To stay ahead, we need to shift our thinking and adapt quickly. Financial advisers say the trick to survival is not to panic. The wheel doesn’t need to be reinvented; just restarted. Private lending is doing just that. The adventurous world of private lending (or “hard money,” as it was once called) is the financial nexus where both borrower and lender can actually benefit from these strange economic times.
Due to banks’ restrictive lending practices, the amount of money in the economy and the velocity of circulation—meaning the average frequency with which a unit of money is spent in a specific period of time—are currently severely dampened. Statistically, the government tells us we’re coming out of a recession, but it doesn’t yet feel that way, and economic growth is still very anemic. The economy needs the velocity of circulation to increase if it’s to grow. In the 1980s, when California was in the grip of the savings and loan real estate crisis, private lending rose to the occasion and stepped in to the financial void the banks created. Now, once again, nontraditional lending can facilitate the financial transactions we so desperately need.
Perspective is king
If you consider the economic situation with a fresh outlook, you’ll see it’s not as hopeless as some might have you believe. There’s opportunity at every turn. Sellers are now more realistic about pricing and buyers are starting to get off the fence. Banks’ lending requirements are as stringent as ever, but this is precisely why there’s a huge opportunity for alternative loans to shift the economy back to health. Where banks have curtailed lending, alternative loans fill the gap to solve the tremendous surplus of unfinished project opportunities that exist due to the slow down. Finishing these projects and funding pending deals benefit both lender and borrower.
Power players: borrower
To be involved in the real estate markets, you need to ask yourself if you can quantify the risks and responsibilities. Borrowers involved in private lending deals are generally more experienced—it’s not their first time at the rodeo! Historically, real estate has always been a sound investment with great tax advantages. Between 1926 and 1996, the annual average rate of return on real estate investments was 11.1 percent. During the same time, the rate of inflation was around 3 percent, making it a much better investment to buy real estate than to bury cash in jars in your backyard or risk the stress of the volatile stock market.
Power players: lender
To be a private lender, you need to have enough knowledge, experience and willingness to evaluate unconventional real estate transactions. Are you comfortable with the borrowers’ vision of the property, what they wish to do with it and how much investment they’ll put up? When you compare the balance sheet to the loan, how much is left to facilitate completion of the project?
The stock market is near a two-year high, and 10-year treasuries are paying 3.65 percent. Where can you get a blend of good rates of return and security simultaneously? Private lending is now holding notes yielding 10 percent (8 to 12 percent) and holding first deeds of trust as security.
Here’s an example. A borrower understood the vision and potential in a property with a commercial residential apartment building. The banks only saw the subject in disrepair and, therefore, the property wouldn’t meet conventional banking standards. When the borrower was researching the property, he understood it would have higher borrowing costs during the initial acquisition period and reflected this in a lower initial bid.
The property encompassed 2.5 acres, located on top of a knoll with beautiful views of Sonoma County’s mountains. It was a seven-unit apartment building in unincorporated Sonoma County and had fallen into advanced stages of disrepair because of the owner’s personal financial problems, morphing into bankruptcy. Three of the units were inhabitable and the landlord was remiss on his obligations to the property and the tenants. Therefore, the remaining tenants stopped paying rent and instead used the money to minimally maintain the property.
This was an ideal private lending opportunity for two reasons. First, a commercial residential property not producing income will not qualify for bank (or conventional) financing. Second, because of the pending bankruptcy, quick funding was needed (14 days).
The deal included a 25 percent down payment, with mortgage loan terms at 12.5 percent interest-only (30-year amortization), three points and a 36-month term with no prepayment penalty.
After 10 months of construction, the property was available for full occupancy. Simultaneously, refinancing of the private first loan into a conventional bank mortgage was started and completed 18 months after the original close of escrow. The initial rent roll (total sum of the month rents) was $3,400, but now ranges from $7,300 to $8,600. The real estate market has gone through many unforeseen and cataclysmic changes, but the property has continued to produce income at pre-2004 levels, indicating strong demand in a declining market.
Let’s be clear: Private lending is a short tool and isn’t meant as long-term financing. It fills the void where conventional lending doesn’t work. When circumstances are corrected (construction is completed, permit violations are reversed, personal finances and a host of other issues in need of a private loan are all cleaned up), a more traditional loan can be instated. Industry after industry in the American economy has been swallowed up by big business. From the corner hardware store to Home Depot, the family farmer to multinational agribusiness, banks have continued a stance of restrictive lending that’s presented a great opportunity for those willing to take the risk to fight back and get ahead.
Joel Westle has more than 20 years’ experience in the financial world as an options floor trader, real estate investor and business owner. He now focuses exclusively on real estate acquisitions lending to apartments, mobile home parks, commercial real estate and SBA transactions. He’s the linchpin many call in to facilitate “the deal.” You can reach him at firstname.lastname@example.org or (707) 495-7152.
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