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Overview
A note is an extension of credit from one or more individuals or entities (lender(s)) to another individual(s)or entity(ies)(borrowers). An IRA is able to extend credit to any party (including corporations) as long as the party is not considered a “disqualified person”. Such notes can be either secured or unsecured. If they are secured, it means that in the event the borrower defaults on the loan from the lender, the borrower agrees to supply the lender with the “collateral” or “security” in lieu of the principal balance of the loan.
The most common example of a secured loan is the mortgage you may have on your primary residence. In this case, you get a loan from your bank, after supplying an agreed upon amount of equity or down payment. The bank will extend the loan only if you pledge the deed to your property as “collateral”. Thus, if you fail to make your mortgage payments to them, they have the right to “foreclose” and take the property from you. And to make matters worse, you will lose your equity or the amount you originally invested and any appreciation since buying the property.
In many states, these loans are called mortgages. In some states, they are called “”trust deeds” or “deeds of trust”. In any case, they are secured loans (notes), usually with property as collateral. The collateral can be real estate (of any kind), gems, mineral rights, a car, plane or virtually anything else of value as agreed upon between the borrower and lender.
Many investors have invested in “trust deeds” over the years, and have experienced steady returns in the range of 9-15%, depending upon market conditions and the creditworthiness of the borrower(s). These investments generally result in monthly income (principal and/or interest payments against the loan), which makes them suitable for someone who requires a steady income (distribution) from their IRA. One of the keys to the success of these investments is the quality of the “underwriting”. This entails, briefly, evaluating the creditworthiness of the borrower, and the value and the condition of the property itself (so that the lender or IRA owner can be assured in the event of default, that his or her IRA will be able to receive at least the amount of his or her investment in the event of foreclosure). If the note is secured by a deed (hence “trust deed”) to a property with a low loan to value (e.g., amount of debt/value of property), there is a good chance, if a default occurs, that the lender will not only get their entire investment back, but also a good part of the equity buildup, including the borrower’s down payment.
However, the objective of most of these loans (sometimes referred to as “hard-money loans” because of their generally higher rates of interest) is not to have the borrower default. Most of these loans are given to people in the midst of some financial crisis, such as the loss of their job, or a medical crisis, where they need short time financing that would otherwise not be available through traditional lenders such as banks. Banks, who are not in the business of foreclosing and taking physical possession of properties when their debtors default, will generally require a borrower to have a regular source of income before they will lend to him or her. Hard money lenders, who specialize in these so-called “B” or “C” paper loans, will usually not lend more than 70% of the value of the property, to be sure that their risk of loss is mitigated. In addition, the more equity a borrower has in their property, the more likely they will do everything they can to ensure that they don’t go into default, thus, losing their equity investment in the property. The balance between the needs of the supplier (lender), and the demander (borrower), is usually determined by a mortgage broker that specializes in “hard-money loans”. The broker generally finds borrowers and then “brokers” or sells the loans to investors (the lenders, including self-directed IRAs). The broker charges 1-2% and the balance of the yield on the loan goes to the investor. Most of these brokers also offer to “service” these loans, for an additional fee, which can range from $10/month to .5-1% of the loan value per year. Servicing means collecting the loan payments and processing them, as well as going after delinquent borrowers. Some states will have licensing and regulatory requirements for such firms. California, for example, one of the top hard-money mortgage lending states, has supervision over all such “hard-money” lending firms through its Department of Real Estate. It is important to understand the rules in your state regarding these type of loans and the brokers who provide them, to be sure that you enter into a sound and legal investment. But, done correctly, with good underwriting, these loans can be a good source of consistent and above-market-rate returns. Of course, when these compound tax-deferred in an IRA over many years, the results can be dramatic.
Investing in real estate for your retirement may serve as a means to diversify your retirement portfolio to hedge against the cyclical changes in the stock market, economy and bank and government-based investments. For many who are experienced with real estate investing, real estate investments hold the potential to protect against the loss of principal while generating better than market rate returns through income production and capital gains. When real estate investments are not leveraged, both income and capital gains can flow back to IRAs tax-deferred (or tax-free if the IRA is a Roth IRA). |
