Chasing Yield Can Bite You

It’s no secret there’s a lot of capital chasing yield right now. With historically low interest rates in the U.S. for a few years, many investments are seeing diminished returns.

As a small or new private lender, you may often battle it out against larger, institutional capital offering super-low interest rates to your best borrower prospects. On the other hand, keeping your reserves in a CD at a bank often yields returns well below inflation, especially with the current economic outlook in the U.S.

Given these choices, individual investors and investment managers may feel desperate. Wanting to at the very least keep up with inflation and at best find ways to keep money growing faster than increases to cost of living, many are on the hunt for high-yield investments. And, often they don’t fully consider or appreciate the risks that may accompany those higher returns, which also aren’t guaranteed!

So, where does all this leave you?

Unfortunately, it can result in chasing yield that bites you if you don’t carefully consider the risks associated with the potential reward.

Beware of These Bites

Here are some challenges small private lenders can face when they try to play against the larger, institutionally backed private lenders who can offer lower interest rates, higher loan-to-values, and more competitively structured loan products:

  • Junior lien loans with higher yields. Most lenders will not lend outside of first position, so yield chasers tend to lend in junior liens where it’s less competitive. If these aren’t underwritten carefully, you could have little equity buffer to protect your investment.
  • New or less experienced operators. It’s no surprise that the best rates are offered to seasoned and experienced borrowers, so new private lenders may work with inexperienced operators who will accept the higher rates offered due to lack of choice.
  • Complex lending scenarios outside of the lender’s comfort zone. Some of these complex and “difficult to lend” scenarios with higher interest rates—transactional funding, gap funding, or horizontal construction financing, for example—generally fall outside a new lender’s wheelhouse.
  • Opportunities that are scams or “too good to be true.” Less experienced private lenders who operate independently may lack the resources or the industry knowledge required to detect loan opportunities that appear “too good” on paper. They are unable to navigate the more subjective underwriting associated with a borrower’s character rather than other tangible qualifiers like credit or experience.

Play or Pass?

The last point, in particular, is all too common with individual private lenders seeking higher returns. Beware of deals where you have the “opportunity” to make $100,000 on a $200,000 loan in an 18-month period. Or, one in which you’re offered a 30% return for a loan period of 90 days.

Those opportunities may sound amazing. But, in both cases—which are true examples— the terms and deal structure were offered by the real estate investor, not the lender. This is red flag No. 1. Private lenders should set their own rates and terms based on the deal rather than allow the borrower to drive the negotiations. Additionally, neither deal offered a personal guaranty. Both deals however, offered significantly higher rates of returns than private lending standards—some in excess of 50% cash on cash return.

Here are some questions to consider if you are confronted with a private debt offering that just seems too good to pass up:

  • Trust your gut. If the deal feels really solid, then why might you be seeking a second opinion? What is your gut telling you?
  • Question the rate of return. In our current competitive environment, why would this investor offer you such enormous rates of return when interest rates are at all-time lows?
  • Ask “why you?” Really seasoned investors know where to go for cheap capital, so what do you offer that other private lenders don’t? And is that differentiation truly worth the extra costs to the borrower?
  • Don’t skimp on underwriting. Are you sure you know how to underwrite this deal to make sure you are protected before the loan funds?
  • Beware the Smooth Talker. Is the person presenting this offer to you just an excellent salesperson, or do they have the street credentials to back up their proposal?

Unfortunately, unbelievably attractive loan opportunities tempt some individual lenders to cut corners, sometimes with disastrous effects. The temptation to remove some barrier to entry for a borrower might seem a feasible alternative to offering a lower rate. The barriers you remove must be chosen wisely, and they often are unique to a particular property or borrower.

Be sure to follow these best practices to protect yourself against deals seemingly too good to be true:

  • Challenge the borrower to answer tough questions about why they are willing to give up a large amount of profit to have you fund the deal.
  • Always require a personal guaranty (PG) and verify the borrower(s) has enough net worth to make a PG worthwhile.
  • Ensure there is sufficient equity buffer to protect you in case the project goes sideways.
  • Engage legal counsel to advise you on usury laws. Enormous interest rates may sound great on paper, but they could be usurious and not stand up in court, if contested.
  • If you wish to move forward, retain an attorney well-versed in private lending to prepare your loan documents.

The Bottom Line

In the current economic environment with historic low interest rates and an onslaught of institutional capital chasing yield, private debt opportunities presented to small, individual private lenders with unbelievably high rates of return should be reviewed with the utmost caution.

The competitive real estate investing environment over the past several years has also impacted profit margins. So, as attractive as these proposals of extremely high double-digit returns may sound, less experienced lenders should also be hearing alarm bells.

Resist the temptation to latch on to these deals. Instead, go for more traditionally safe investments with yields that fall into the range of private lending standards within your market. Above all, ensure you stay within the usury rates defined by your state (and the state the property collateralized is in, if applicable) so you don’t find yourself in financial or legal hot water.

Published in American Association of Private Lenders’ Private Lender Magazine Q1 2022 – page 6 – Private Lender by AAPL Winter 2022 by American Association of Private Lenders

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