Semi-Passive V.S. Passive Investing

article semi-passive V.S. passive

The number one investment asset held by self-directed IRA accounts at Quest IRA Inc. is real estate notes. That is, IRA holders have lent their IRA money to someone in exchange for a promise to pay it back with interest, and a lien on a property as collateral in case they don’t. In most cases, these loans are made to real estate investors that are buying a distressed property that a bank would not lend on. They will then fix the house and either sell it (flip it) or refinance it with a traditional lender and keep it as a rental property. In this situation, the borrower benefits greatly because traditional lenders won’t usually lend on a distressed asset. The IRA holder benefits because he or she can charge above average interest rates because it is considered a risky loan. In my 11 years as a real estate investor, I have borrowed over $18,000,000.00 to do this type of real estate purchase and over 60% of that was from Quest IRA account holders.

Most of these loans are set up with monthly interest-only payments to allow the IRA to receive monthly cash flow and keep the borrower from going further in debt to the lender. After the property is fixed up, usually within 4 to 12 months, the property is then sold or refinanced with a mortgage company and the IRA is paid back the principle of the loan plus any unpaid interest. While doing this type of loan in your IRA is usually considered passive investing, how passive is it really? Let’s look at the work and time involved in doing it correctly. Quest IRA provides an enormous amount of classroom and online training to help guide their clients to success if this investment method is chosen but the work still needs to be done by the IRA holder.

To do the proper due diligence to lend on a real estate investment you will need to…

1) Network to find active real estate investors.

The easiest way to do this is to attend IRA training classes and mixers or attend one of the many real estate investment groups in your town. Here you will find many people that are looking for money to buy an investment property and will be glad to pay above-average interest rates.

2) Vet the investors.

Just because someone wants to borrow money from you and pay a high rate doesn’t mean you should lend to them. You need to make sure this person or group of people have the character and honor of someone you would feel comfortable doing business with. I promise you, from experience, that most IRA holders skip this step. Most will decide to lend based on whether they like someone or not. There is no further verification of anything. Just a gut instinct. To do this step properly takes time. You have to get to know the potential borrower on a personal level and know their financial situation. The deal may be great but if they are in a financial bind on other projects or in other areas of their life, it could doom your project to failure. Another point is, no one is too big to fail. Often lenders will gravitate to the biggest players in the room, assuming they are so experienced, they couldn’t possibly fail. In my 11 years in this business, I have seen several of this type of investor go down and when they do, it makes a big splash. Vet every borrower the same. No matter how big or small they seem to be.

3) Vet the deal.

You have decided if you would lend to a particular investor. Now you have to make sure the investment that he or she is buying is one you want to lend on. Every investor makes mistakes and buys properties they later wish they hadn’t. Trust me. I have had at least a dozen of them and some of them have cost me hundreds of thousands of dollars. In the active real estate investing business, it isn’t if you will buy a dud and lose money, it’s when. When that happens, you don’t want to be the lender and if you are, you had better hope you picked an honorable borrower that will take the hit and not stick you with it. Only lend on a property you would be willing to own if the deal went sideways and you had to take the project over. Always assume when lending you could end up owning and finishing the project.

4) Vet the paperwork.

Next, you need to have paperwork prepared and reviewed. Although I am not an attorney and this should not be considered legal advice, I will list a few things you should look for. The title commitment will tell you a great deal about the property, but only if you read it. Most lenders don’t even ask to see it. They just assume the investor knows what he or she is doing and will keep them safe from later title issues. The note and deed of trust are two documents that you should have your attorney draw up. These are the agreements between you and the borrower and could be considered the controlling documents should something go wrong. Make sure everything you have agreed to be memorialized in these documents. Property insurance is a tricky business in real estate investing. There are several types of policies for properties in different stages of repair. Builders risk, vacant dwelling, homeowners and more. If the wrong type of policy is in force at the time of a claim, there may still be no coverage. Also, make sure your IRA is listed on the declaration page as mortgagee.

5) Service the loan.

Once the loan is closed you will need to track payments and make sure insurance and taxes are kept up on the property. If there is a problem, address it quickly. Most people don’t like uncomfortable conversations, so they just let things go. I had a private lender lament to me about another borrower he had lent to. He said, “he hasn’t paid me a payment in over 6 months”. I said,” I didn’t know you offered that option”. He said, “I don’t”.  In truth, he did. By doing nothing, he leads the borrower to believe he could get away with not paying his payments. The best time to discuss an issue is when the issue is small or in other words, as soon as you know there is an issue.

6) Repeat every 4-12 months.

I have had private lenders tell me that they felt like lending was a full-time job for them. This is true especially if you have a large amount of money that you are trying to work. The more you have, the more loans you will need to keep going at the same time and while the compounding of interest can be exciting, the compounding of work may not.

While I have broken the process down into 5 seemingly simple steps, there are many steps in each category that should be done and to list them all would have taken several more pages. In our lending co. Investor Loan Source, our due diligence on every single loan file fills a 3-inch 3 ring binder if it were printed out. As we do so much work on the front end before we make the loan, we have very few loans go bad and foreclose. As experienced active real estate investors, we have the ability to help coach borrowers through the rough patches when they do run into trouble to help them become better investors.

As you can see, making direct loans from your IRA to real estate investors is not really a passive investment. I think it would more accurately be described as a semi-passive investment.

If you are interested in a truly passive investment I would love to talk to you about our real estate note fund. ILS Short Term Fund 1 is a private equity fund available to accredited investors who want the advantage of working with a professional team to invest their money in the high yielding environment of real estate notes. As a fund investor, you have the advantage of our experience, systems, processes, contacts, and resources. We do the vetting, processing, servicing, and the clean up when necessary. For more information and a full PPM contact us at [email protected].