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Unusual Way to Earn High Yields in Real Estate

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Private mortgage loans can be tempting for investors seeking higher yields, but lending money to a contractor or developer requires industry contacts and real estate due diligence skills that many investors lack. Assembling a diversified portfolio of loans requires deep pockets, as well.

Crowdsourcing is eliminating those obstacles. Rule 506(c) in Title II of the JOBS Act, passed in 2012, allows investment sponsors to publicly seek accredited investors for their deals. It’s no longer a matter of being in with the in-crowd. Although sponsors must verify investors’ financial status, once that hurdle is met they can work with an unlimited number of investors.

Real estate lending marketplace Patch of Land in Los Angeles demonstrates crowdfunding’s potential. The firm made its first loan in the fall of 2013 and by the end of that year had a cumulative loan total of $459,000. The firm is now receiving $600 million worth of applications each month from potential borrowers, and the amount has been growing significantly, according to CEO and co-founder Jason Fritton.

Over 17,000 retail investors have signed up through the company’s website and the firm is in negotiations with 14 large institutions, reports Fritton. As of Aug. 27, 2015, Patch of Land had funded 144 loans with a value of just over $47 million, and it returned almost $8 million to investors. Single-family residential (58%) and multifamily residential (37%) properties accounted for most of the loans.

How It Works

Prospective investors register online at the site; no accreditation status verification is required. They can view properties and projects that Patch of Land has agreed to fund, including photos and property detail, rehab plans, a description of the borrower and the investment risk. The site also discloses each property’s anticipated annual percentage rate (APR) return and expected investment holding period. Most of the listed anticipated returns were in the 10% to 12% APR range and loan terms range from 30 days to 18 months.

After selecting the properties in which they wish to invest and the amount of each investment ($5,000 minimum), participants must document their accredited status. This process typically involves income verification such as Form W-2 or tax returns, net worth statements, or third-party confirmation from a CPA or other source.

Investors must have a minimum annual income of $200,000 for single filers or $300,000 for couples for the previous two years or a net worth of $1 million or more excluding a primary residence and any liabilities. Funds can be transmitted via ACH or a third- party secure escrow service. It’s not quite Amazon.com, but the process is certainly more efficient than most real estate investments.

Investors receive a note identifying their participation as lenders. “That note is associated with the mortgage and the first lien position on the property underneath it,” Fritton explains. “We then take that underlying note, we move it to a trustee and a custodian and then we have a blanket UCC [universal commercial code security agreement] that secures all interest and principal back to that underlying asset. So we can go out and we can tell the investors, whether they’re a retail investor or an institution, that they are directly secured by the property.”

Investors receive monthly interest payments for the loan’s duration. At “the maturity date of the loan or upon full repayment from the borrower, whichever is sooner, you will receive a balloon payment of the remaining principal and interest,” according to the website. Patch of Land earns most of its income in the form of upfront origination fees that range from 1% to 5%; it does not participate in the loans. Investments are illiquid—investors cannot cash out before a loan matures or is paid off.

Loan Coverage

“Investors rely on Patch of Land’s evaluation of the borrower’s creditworthiness,” according to the firm’s website. In almost two years of operation, Patch of Land investors have not experienced any losses of interest or principal, Fritton says. He attributes that record to the company’s due diligence and relatively conservative lending practices that maintain an adequate buffer between a loan and a property’s projected after-rehabilitation value.

“Because we write the loans at a discount to the value of the property itself, there’s always some float there,” he says. “If we need to, we can provide a workout, so we can provide an extension or help to find a new contractor to finish the job. Or, if we absolutely need to and we’re not throwing good money after bad, we can write a second mortgage to take care of additional issues that popped up. … Then, in a worst-case scenario where the developer does become nonresponsive and doesn’t work with us whatsoever, we are able to liquidate.

“We do write our loans with the expectation that if [in a] worst-case scenario we have to liquidate, we can do so and cover all fees associated with that and still be able to return most or all of our clients’ money to them.”

Investors are also protected in the event that Patch of Land goes bust via legal structures that would be used to hold the loans and an indenture trustee that would continue distributions and asset management.

But the illiquid nature of the investments gives some observers pause.

Marty Morua, a former consultant to financial advisors who is now a real estate agent with Corcoran, cautions that crowdfunded real estate loans aren’t appropriate for many investors, even if “accredited” ones.

“Just because these are wealthy investors doesn’t mean they have sharper investment acumen,” he said in an email message. He suggested investors would be better off seeking diversification through “certain real estate mutual funds, REITs, homebuilding stocks, or even real estate itself.”

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