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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2006

Private Money: Behind the Scenes

Get to know the two primary forms of private mortgage investment

Although many commercial brokers are familiar with the private-money industry, it can be somewhat tougher to understand the investor motivation and expectations behind it. Having knowledge of the inner workings of private money can help brokers achieve their financing goals when working with private lenders.

Private mortgage investing takes two primary forms: fractional investment and mortgage-fund investment. While the traditional fractional-investment model continues to be popular, the trend toward mortgage funds seems to be accelerating because of the benefits the funds offer to investors.

Fractional investment

This is the traditional method for investors to extend loans to borrowers. A limited number of investors secure a loan made to a borrower by placing their names on a first (or second or third) deed of trust on the borrower’s property. The monthly payments are made to a servicing agent, who then distributes the payments in proportion to the individual investors.

Fractionals offer the benefits of simplicity and transparency. Each individual investor reviews each prospective loan before making a decision to invest.

On the downside, “building” each loan investor-by-investor takes time. This detracts from one of private money’s key advantages — speed.

By its nature, this kind of investment is not diversified for individual investors. It is made entirely to a single borrower, usually on a single property. In the event that the borrower fails to make monthly interest payments, the income flow to the investors stops. If the borrower defaults, this income flow will cease completely.

Investment principal and interest will be recaptured only after the loan is renegotiated or the property securing the loan is foreclosed upon and sold. Investors must supply additional funds to prepare foreclosed-upon properties that are for sale.

Further, investors holding the larger-percentage interests in a fractionalized loan may maintain greater control than other, smaller investors.

Mortgage-fund investment

Mortgage funds, or mortgage pools, resemble equity mutual funds, made up of a wide selection of stocks. Investors deposit money in a fund managed by certified mortgage brokers or bankers. Money within the fund is lent to borrowers and is secured by first (or second or third) deeds of trust. Those deeds name the fund, not individual investors, as the actual holder.

As shares in a mortgage fund are purchased, and as interest is earned from monthly mortgage payments, the fund generates income.

There are subcategories of mortgage-fund investments:

  • Mortgage notes: Investors purchase notes from the manager for a specified period of time with a fixed rate of return. The notes are backed by a security interest in the portfolio of loans within the fund. The manager guarantees the funds itself, providing a second layer of security to investors. Returns to investors, however, are low.

  • Equity-ownership programs: In this structure, investors take direct ownership positions within new development or properties that are undergoing rehabilitation. They participate as members of LLCs created specifically for each project. This structure can be used in conjunction with loans extended to the project, so that the investor holds equity and debt interests.

How they stack up

Fractionals and mortgage funds offer different benefits and drawbacks to investors. Although investor yields are similar in both structures, the primary difference lies in diversification. With mortgage funds, risk is spread across a portfolio of loans, not centered on a single loan. Risk is also spread across the entire pool of borrowers, with different types of properties in different locations.

As a result, in the event of a late pay or default with a mortgage fund, there could be minimal — or no — impact on investors’ yield. The reserve accounts established by the fund and by its manager would compensate for any shortfall.

Mortgage funds maintain reserve accounts that also serve as sources of cash for investors seeking to liquidate their positions. Funds also retain the right to disburse funds to investors as funds become available, not when they are requested. This prevents a “run on the bank.”

At the same time, investors attracted to mortgage funds generally seek the compounded yields available through long-term investing. They don’t wish to use mortgage funds as a checking account. Another difference between the two structures is liquidity. Investors in a fractional who wish to cash in their position must be replaced with another investor or wait for the borrower to pay off the loan. Because many private-money loans are short-term bridge loans lasting less than a year, this waiting period is generally limited.

Mortgage funds, however, generally offer rapid — sometimes immediate — repayment of principal. This is possible because funds have reserve accounts in place and because funds are generally oversubscribed, with more investors wanting into the fund than wanting out.

The historical industry-wide default rate with mortgage funds is quite low. This is primarily because loan to values and underwriting standards have been stress-tested in the real world for half a century.

Reserve accounts are also established and maintained by the fund to protect against defaults. In practice, fund managers themselves generally step in to make up for shortfalls. Managers are tenacious in maintaining solid records of consistent yields and no losses.

Mortgage funds also have less paperwork. And the fact that fund participants enjoy 365-day investments, without being sidelined between loan opportunities, is of benefit. Indeed, many of the benefits of this private-money-investment structure explain its increasing popularity.

The future

Although the traditional fractional-investment model will continue, the popularity of mortgage funds continues to grow. This is because increasing property values continue to push prices and loan amounts higher, which means more investors are required for fractional transactions. This makes the process to conduct each loan more costly and time-consuming. This time lag translates into slower funding for borrowers — and more time on the sidelines for investors.

Mortgage funds’ benefits of diversification, liquidity and professional management will increasingly give them more investor appeal.



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