How To Use Lending Deals in Property Investing
My mission with this podcast and blog is to introduce you to the benefits of alternative investing, specifically. So, instead of meandering across various topics associated with wealth, I’ve decided to put the guardrails up and stick to the topic of alternative investing.
On that note, let’s get straight into it.
Overview of Lending Deals
One of the questions that I’ve received a few times over the last few weeks is about the anatomy of lending deals.
I certainly can’t claim to be a guru in this space, but I’ve learnt enough over the years to at least give you a pretty clear insight into why I think it’s one of the most exciting areas of alternative investing.
Advantages of Becoming the Bank
You may have heard me talk about all these opportunities out there where you can actually act as a bank.
The idea particularly has its roots in the United States, but it’s quickly becoming more of a trend here in Australia.
One of the most exciting things about being the bank in a transaction is that, from a security, risk and time point of view, you’re ultimately in one of the most leveraged positions at the table.
My mentor has said to me time and time again that one of the things you always want to be doing in real estate is calculating your effective cost time.
What he means by this is that, when you look at the way a deal is packed or structured (in terms of who participates in the deal), it’s the bank that has the highest rate of return and has the highest position of power in terms of the capacity to control the deal and ultimately protect their downside.
Obviously, if you don’t structure the deal properly and don’t do efficient due diligence, then lending deals, like every other kind of investment, can turn south on your pretty quickly like every other kind of investment.
But, assuming you found a stable deal, all those things I mentioned earlier about banks hold true.
When I Discovered This Concept
When I first discovered his concept of being the bank and creating lending deals as an idea, it totally blew my mind because lending and trading or using debt as an instrument have been around for decades.
It’s an incredibly established and well-understood market – especially in the United States.
So, we’re not talking about reinventing the investment wheel here, we’re talking about trying to find opportunities to participate in a market that’s already well-established.
Having said that, however, it’s generally restricted to a space for more sophisticated investors and high net worth individuals.
So, one of the things I thought would be useful to share with you, is to illustrate two or three really simple examples of how I’ve seen lending deals structured.
Using Debt as an Asset
Remember: when we’re talking about lending deals, we’re talking about owning debt as an asset.
So you’re the bank, you’ve loaned money to someone, and you’ve effectively negotiated a fixed rate of interest as a return as well as how your principal will be repaid.
One of the other facets of lending that I love is that, depending on who you are, where you are, what your aspirations are, it can go one of two ways:
Short-Term Lending Deals
I’m not necessarily looking to go into short-term lending deals myself. So, while I can share the basics of these deals, you’ll want to find a trusted advisor or deal maker that’s proficient in this space to explain how they can support you in these deals.
But, essentially, your deal maker will find a project where they personally need a short-term loan or where someone who they’re affiliated with needs a short-term loan.
Short-term is typically anything under two years.
The sorts of terms that I’ve done deals on that I’ve done over the last twelve months are pretty similar. I usually look for around 8% to 11% interest on my money and clarity around how the deal is structured.
One of the things I’m always really focused on is doing due diligence on the property itself. So, for example, if a deal maker presents you with an opportunity, go and look up the property first.
I generally look at the address and some photos and just try to understand how my funds will be applied.
You’ve got to put yourself in a bank’s shoes and think about what they would be expecting if you or I go to them to borrow money. So, you need to look at things like the kind of leverage the loan will be creating in this particular deal.
In my experience, I look for leverage below 60% to 65%. And the reason I’m looking for lending deals that don’t go beyond that figure because generally on a short-term deal, there is more risk than on a long-term deal.
Having an “Equity Cushion”
On a short-term deal, I’m looking for a low loan to value ratio because I want to know that if the market crashes or something significant happens to property prices, I have enough of an equity cushion to protect myself.
An equity cushion is an expression I like to use to describe, if something goes wrong and the wheels come off the economy, how much of a cushion I have to protect myself against any downside.
So, in the case of short-term loans, you want to look for a low level of leverage.
Another thing you want to determine is whether you’re in the first or second position as a lender. For example, if I’m coming in with a short-term loan and there’s already another bank mortgage in place, I recognise that I might be in the second position, which could help me understand what sort of risk I’m carrying – especially if I’m bringing money to the table to increase debt on a property.
If the bank is in the first position and the property is already leveraged to 70% or 80%, and I’m being asked to lend more money, that would indicate that I’d be in a more precarious position.
But, there are no hard and fast rules about what kind of leverage you should be prepared to tolerate. Each market is unique.
The point I’m trying to get across is that it’s more about making sure that you understand the market that you’re going into and what threshold you’re prepared to tolerate in terms of a loan to value ratio.
long-term Lending Deals
With longer-term lending deals, you’ll also want to be working with a dealmaker who has access to a pool of vetted applications that can’t get traditional bank finance for whatever reason.
Some of those reasons are legitimate. For example, some people may have lost businesses as a result of the COVID-19 pandemic. Some people may have some black mark against their credit rate from five years ago, and it could be another two years before banks are prepared to talk to them,
Either way, it’s people who have fallen on bad luck and can’t get traditional lending from a bank because they’re looking for loans that sit outside of what a traditional bank would consider.
So, a deal maker will connect me with people looking for non-bank lending and put the entire deal together. For example, they’ll find the home that Family X wants to buy, and they’ll do the due diligence and prepare some financials for me.
Of course, however, it’s my job as the investors to layer all of that with my own due diligence. Then, I may come up with an arrangement where I loan either part or all of that home’s value.
In a traditional US real estate deal, those deals are generally sub-$100,000, and I’m looking for returns of 8% to 12% depending on the deal.
There’s a pretty good chance that sometime before the 30-year mark (or even with a five-year loan), the family will recognise that paying me a high-interest rate isn’t palatable. So, in that period, they’ll repair their credit, get some more money together and then go to a traditional lender and refinance.
So that could be another option out there.
Advantages of long-term Lending Deals
The reason I prefer longer-term lending deals because you’re essentially setting up an annuity. You’re setting up a long-term, cash flowing income stream for yourself at a very good rate of return – far superior to just having that money sit in a bank where you might get 1% or 2%.
And if it’s structured in a way to ensure that your downside is protected, it’s a really beneficial alternative investment strategy.
Let’s go back to our example of the $100,000 home. You’re only lending a certain percentage of the value of that home. So, Family X may bring $40,000 to the table as their skin in the game.
And the reality is that if someone’s putting that much skin in the game, from my perspective, it’s highly unlikely that they’re going to walk away from it. They’re putting a lot of money into the deal themselves, so I can feel good about the deal.
I would obviously still do all the proper checks and balances around in the same way a bank would. And I know that there are two ways that I’m going to roll out of this deal. Either the family will refinance with a traditional lender and pay me out. Or they fall over in a heap and they stop paying their mortgage.
In the case of the second option, there are very clear cut provisions as to how I would go in and basically take ownership of that property. And given that I’ve only got a relatively small and comfortable level of leverage – that sits well with me.
Essentially I would have created an asset either way.
One of the things that is just mind-boggling is that there is a huge market for hungry investors to come along and purchase that debt – it’s an asset. It’s an annuity.
And if you want to get out of a short-term deal and move onto longer-term deals, there are even hungry investors out there who will take those loans off your hand and carry them on their balance sheet as an asset.
I hope I’ve given you enough of an overview of lending deals as an alternative investment strategy.
There are definitely people who are world-class in their capacity to creatively play in the space of lending and owning debt as an asset.
What I understand enough at this stage of my journey is that from my perspective, it carries far lower risk than people imagine. Often, I feel like I’m at the highest position at the table in terms of time, leverage, return, and the lowest risk level. That sits really well with me.
If you speak to any sophisticated investors, they’ll tell you that real estate prices are just too high. So, they’ll hold a reasonably high percentage of their portfolio as lending deals because they’re happy to take a relatively modest return. After all, it’s predictable and sustainable.
You don’t have to think too hard, and you don’t have to deal with property maintenance or tenants – it’s just money that turns up every month with very little effort.
I’ve given you a few examples within the US market, but there are definitely lending opportunities in the Australian market.
My word of caution would just be to know exactly who you’re dealing with because, in Australia, lending deals aren’t an asset class that we trade as investors. So, the entry and exit considerations need to be really well thought through.
If you’re interested in understanding how to create wealth through alternative strategies, please check out my programs, where I help you get onto the path of generating passive income through investing or getting in touch today!
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