Brokers Moving From Direct Sales to Mortgage Pools

November 30, 2017 by Kevin S. Kim, Esq.

Private-money lenders have been chasing direct sales for years, providing niche, mezzanine, and hard-money financing with direct investor capital. When the market is good, the business is profitable for both the broker and the investor. Though more recently, there seems to be an increase in the amount of brokers looking to transition from direct investment into mortgage pools. With the stock market stagnant or wildly fluctuating, investors are becoming more open to mortgage funds as a way to offer stability and year-round consistent returns. If the idea of not having to sort through stacks of loan documents each month is not appealing enough, investors also like the idea of having their capital invested in a diversified portfolio of loans, rather than placing all their eggs in the one proverbial basket.

So, with so much interest being generated with this emerging opportunity, is starting a mortgage pool the right choice for your business? As a broker, you have a fiduciary duty to your investors to ensure your paperwork is bulletproof, to protect their capital as best as possible. What they probably like most about you is the fact that you consistently earn them money. What if you could earn them more money with better security and less paperwork? A mortgage fund offers them a great investment opportunity with better than average returns, while providing peace of mind that comes with a diverse pool of loans, and about a 95% reduction in paperwork.

Now that we understand what makes mortgage funds appealing to investors, we can take a look at them from a broker’s point of view. There is a reason why more and more dealers are attending seminars on how to become a pool manager and structure mortgage funds. Mortgage funds provide brokers with several benefits over direct investment lending. For one, the paperwork duties just got a whole lot easier. Under a direct private loan, dealers are required to send a loan package to every contributing investor for each loan the broker books. With a mortgage fund, the pool manager issues a Private Placement Memorandum and Subscription Agreement to each participating investor only once. After the agreement is signed, the pool manager may allocate funds for new loans as they are approved. For the investor, this process is far more convenient than sorting through stacks of new loan packages every 90 days.

Mortgage pools also provide the manager with the ability to fund multiple deals without as much liability if one fails. The diversity of the fund portfolio will protect investors if one loan sours, but also takes the onus off of the broker who may otherwise face litigation from unhappy investors who lost money on a direct investment. The average performance of the fund is taken into consideration rather than a single loan, and it is much easier to explain a failed deal to investors while they are still receiving their monthly disbursement check. Not only is this good for the reputation of the broker, but it also helps avoid costly litigation that may originate from disgruntled investors. If the fund has obtained a credit facility, it can quickly replace a loan that may not be performing.

A mortgage fund also makes for good marketing. Running to investors to seek approval for single-investor deals can be frustrating and time-consuming. With mortgage pooling, a pool manager can leverage his capital by obtaining a low-rate credit line, thereby reducing the cost of funds, and effectively offering more competitive financing options to his clients. The credit line can then be paid down over time using investor funds. The process allows brokers to be more selective with whom they lend funds, with the ability to offer attractive terms, and reducing the likelihood of a non-performing loan. Considering that the fund manager has the right to collect an asset management fee as a percentage of the entire fund, he will continue to receive payments even if new private money deals are not landing on his desk.

Another reason more brokers are attracted to mortgage pools is the licensing change. Private-money lenders are required to operate under a broker license from the Bureau of Real Estate. This BRE licensing requirement makes a creditor liable for loan disclosures, ATR qualifiers, reporting requirements, and a myriad of other rules that go along with being a broker. By creating a mortgage fund, a firm can now register as a direct lender and qualify for a California Finance Lender’s license.

The CFL license provides a direct lender with the ability to set up a corporate account that allows them to conduct all of their lending operations, including taking in payments, issuing disbursements to investors, and rolling over money for future opportunities. As long as the rules outlined in the Subscription Agreement are followed, the fund manager now has all the tools necessary to become a full-service direct finance company.

While the benefits are plenty, there are some hurdles you will need to address before entering the space. You will have to spend some capital to establish your presence. Bring in legal counsel to help you set up your fund and create your disclosures and subscription agreement, expenses that can be paid back from the pool at a later date. Utilizing a third-party servicer is a good option for who seeks to delegate the collection of their mortgage payments and manage investor distributions. However, by delegation you give up control of the funds and the accounting. For those who seek more control and complete management, there are powerful software options that will allow you bring your servicing and investor distributions in-house. You will need to hire an competent accountant; a person that will manage your accounts, protect your cash flow, and ensure you have access to capital when you need it. If possible, you will most likely want to secure a credit facility. If you have a sustainable cash flow and are well capitalized, it should not be an obstacle. After obtaining a credit facility, you will have some breathing room to lock up more deals, stabilize your reserve account, and give comfort to investors who are considering contributing more funds.

So how will your direct sales investors feel about your move to a direct lender? Some may be confused, but most will follow you after they get a grasp the concept and benefits. Once you have made the move and have your fund established, you can start the marketing process to bring more investors on board. As your borrowers satisfy their direct investment loans, you can fund their future deals out of the mortgage pool. As additional loans are paid back and you continue to build up your fund, you will be closer to completing the transition to direct lender. The pool manager can then devote the majority of his time to filling up the mortgage pool with solid deals. During this period, your team can then work on your existing investor base to offer assurances about your change of direction. Many brokers complete the full transition to a mortgage fund within two years’ time.

Mortgage funds are not for everyone, but for brokers who want to free up time, reduce the amount of paperwork, limit liability, reduce risk, and build a bigger and more sustainable private lending business, then starting a mortgage fund is a no brainer. Once your fund is well established, you can work on strengthening the fund or creating new pools. Data shows that more brokers are now moving away from direct investor sales and making the jump to mortgage pools. There is plenty of investor capital just waiting on the sidelines for a sound investment. While demand for mortgage pools is high, the time is right to begin the process of taking your organization to the next level.

Taking the next step is not always easy, but thankfully you have people who have been there before and can help guide you through the setup process. Geraci Law Firm has an experienced team that is ready to help you establish your mortgage fund and get you off and running quickly and effectively.