How to protect the hard money loans in your portfolio
Are national marketplaces more risky than local options? Plus top techniques for safeguarding your portfolio.
November 3, 2015 BY IAN IPPOLITO
IMPORTANT: See the "Comprehensive Guide to Hard Money Loan Investing" for detailed info on how to avoid the problems investors encountered on these loans.
In part one of this article, we discussed how Realty Mogul recently had two hard money loan investments go into bankruptcy/foreclosure. In part two, we talk about whether or not national marketplaces are riskier than local options. And we also explore the best techniques for safeguarding your hard money loan portfolio.
Is local better?
Some investors question whether national crowdfunding companies can ever do as good a job with due diligence, as a local company can.
One investor, who has a “considerable” portfolio of hard money loans on several real estate crowdfunding sites said, “Hard money loans have always been a more localized type of business and for crowdfunding portals to want to take this nationwide can be dangerous. It’s likely that it’s not cost-effective to understand their markets in a way they should. It is partly this risk that keeps me from funding more crowdfunding deals unless and until I know who their local team is in the area."
Jason Fritton, is the CEO of Patch of land, a national site that has a large number of hard money loans. His perspective is, "Real estate investors have invested in properties nationwide for decades, though before the advent of online investing, this wasn't as easy to accomplish as it is today. There are steps that all lenders must take to properly vet and underwrite risk - some do it manually, some enhance that process with data and technology. At Patch of Land, we use a hybrid model of data/tech as well as boots-on-the ground, which means we have trusted individuals in each market who work with us to provide insights and information on the local market, the property and the borrower. This information being provided by local sources, combined with the data sources that we are aggregating, enhances the overall risk profile of every loan we make, no matter where we make it.”
How to protect yourself
Ultimately, the most important question for investors is: How do I invest in hard money loans, while minimizing the chance of losses? Here are some important techniques.
Watch the loan-to-value
Loan-to-value is what percent of the value of the property is in the loan. The higher the number, the more risk for the investor. That's because if you have to foreclose, there may not be enough equity to pay you back after all the expenses, etc. also, sticking to lower loan-to-value loans protects you in case of a cycle downturn, where prices can drop dramatically.
So how much is too much risk? One experienced investors recommended “never go higher than 60% loan to value”. I personally feel comfortable going to a 65% loan to value. Whatever value you ultimately choose, it’s important to stick with it, and avoid ratcheting up your risk unnecessarily.
Only allocate long-term money
The downside protection of a hard money loan (the ability to foreclose) isn't automatic. It takes resources and time to implement, during which time the investment is not paying any money, the funds cannot be accessed to use on better alternatives, inflation is eroding the value and the ultimate outcome is in limbo.
In some states this process may take several months, and years in others. So it's important to know and understand the local foreclosure process behind every investment you make, before you pull the trigger.
You need to both understand and feel comfortable with all the risks, and ensure that it's okay to potentially allocate that money for the maximum period of lockup.
If you only have one hard money loan in your portfolio, and you happen to pick a dud, you can lose money and/or may have your funds tied up for a year or more before you get them back. If you have 50 hard money loans in your portfolio, the chances of one loan disrupting your entire real estate portfolio is remote. Click here to read more about real estate portfolio diversification.
Think twice before stretching for yield
In general, the higher the interest rate, the higher the risk of default. And often the risk increases exponential, rather than linearly, which means that stretching for that extra little bit of yield can be a very expensive decision if things go wrong. If you want to avoid defaults, consider sticking to more conservative yields in the 8 to 10% range, rather than stretching for 14%.
Consider going local or hybrid
If you feel there is an increased risk of going national, one solution is to allocate some or all of your portfolio to local sources. Another option is to mix national sources and local sources. This gives you the diversification of broader geography, along with mutliple due diligence processes.
Hard Money Loan Pro Techniques
Want more information? Check out this three-part series which talks about more information on what I avoid on risky loans, what I look for on loan-to-value and other metrics, as well as my detailed due diligence checklist for hard money loans.
See "Hard money loan roulette" for more info.
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About Ian Ippolito
Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.