Earning Returns While Managing Risk: Participating in Real Estate as a Debt Investor

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Guest author, real estate investor, debt investor, and wholesaler Mark Huffman offers his experience on participating in the real estate market as a debt investor.
 
As the real estate bubble of 2007 demonstrated, real estate can be risky, but there are ways to participate while minimizing that risk as a debt investor.  As a debt investor, I have lent my retirement funds to a fix & flipper. 
 
As always, due diligence is absolutely essential before participating in any investment. The best practices for a debt investor are to receive a promissory note, mortgage, and personal guaranty. 
  • The promissory note is a promise to pay a certain amount by a certain time.
  • The promissory note sets the terms and conditions, and is unique to what the two parties agree to.
    • In my case, I receive 12 percent (per annum) on the money lent with the interest and principal payable with the sale of the property.
    • While some may want monthly interest payments, I prefer a balloon payment at the end to simplify the process for the rehabber and myself.
  • The mortgage is a financial instrument that pledges the property as collateral to guarantee repayment of the loan. 
To manage and help mitigate unnecessary risk:
  • The loan amount should be only 65-70 percent of the After Repair Value (ARV).
  • Have the mortgage recorded by the County Recorder to hold a 1st lien position
  • In addition to the mortgage securing the loan with the property as collateral, a personal guaranty has the borrower pledge any and all assets as collateral.  When a renovation project proceeds as expected the personal guaranty may be unnecessary; however, the purpose of the personal guaranty is for the times when a project doesn’t go according to plan.  The personal guaranty fully secures the investment.
  • Collateralization of the property and personal assets minimize the margin for error for the debt investor.  When multiple investors are necessary to accumulate enough funding, 1st lien position can be achieved by joining the investors together with a joint venture agreement and recording the mortgage for the joint venture group in 1st position.
Investing in real estate as a debt investor offers the features of:
  • Safety – you have the house as collateral purchased at 65-70 percent of market value.
  • Security – promissory note, insurance, mortgage, 1st lien position, personal guaranty.
  • Predictability – no more roller-coaster stock market or 3 percent CD.
  • Tax Advantage – tax-deferred or tax free when completed within your IRA.
  • No Costs or Hassles – the borrower pays all the costs and handles all the details.
  • High Return – earning 10-15 percent from fix & flippers
Why I Chose a Self-Directed IRA
Between October, 2007, and February, 2009, the Dow Jones Index (DJI) declined 49 percent (13,930 down to 7,063) due to the Great Recession and took another four years to recover its lost value.  My specific mutual fund declined 40 percent and took nearly four years to recover my lost value.  I was approaching 55 when the decline started and over 60 before I was made whole.  In essence, the result was that the value of my retirement funds stood still for five years.  Since I am getting too old to continuously need to recover from market fluctuations, I set out to explore other investment options and found Equity Trust with their self-directed IRA and the ability to invest in real estate.
 
I recently initiated my fifth promissory note investment since moving to Equity Trust Company 25 months ago.  The three investments completed to-date has been executed without the slightest problem.  While the Dow Jones Industrial was declining more than 2 percent during 2015, I was earning 12 percent on my retirement funds.
 
*Mark Huffman is not affiliated with Equity Trust Company or its affiliates.  The information provided in this article is for educational purposes only and should not be construed as tax, legal, or investment advice.  Whenever making an investment decision, please consult with legal, tax, and financial professionals.

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