Let’s go to a whiteboard and discuss:
How do Mortgage Pools and Mortgage Funds work?
Many of my clients like me to work out their vision of their new Mortgage Pool entity on the whiteboard in my conference room. There we can brainstorm and fine tune a mortgage fund for their unique business operation. We visually sketch out their personalized financial model and the structures before actually creating the mortgage pool.
A Mortgage Pool is set up as a stand-alone legal entity. The Mortgage Pool Entity is typically set up as either a Limited Partnership (LP) or a Limited Liability Company (LLC). Typically it will be structured as a Limited Liability Company. Let’s call our example company Pacific Mortgage, LLC. For illustration purposes, our fictitious Limited Liability Company has two classes of membership. The normal “members” are your investors, and then the other member is you –the manager– who we will call “YourCo.” Your function (YourCo) is to run the mortgage pool, take care of the investors and make the underwriting decisions. At the same time, your existing mortgage or private lending company is on its own and acts as a traffic cop. Loan applications come in to your existing company and you act as the policeman to determine whether they go to the Mortgage Pool Fund, whether they go to a private individual, or whether they go to an institutional source that we will call the bank.
How You Are Compensated
You, as the manager of the Mortgage Pool Fund (Pacific Mortgage, LLC), typically get compensated in two (2) ways.
First source of your income: Points and Fees – The first major source of income is generated by Points and Fees. You are earning Points and Fees whether or not you are brokering the loan to the bank, to the private individual, or to the Mortgage Pool Fund. Points and Fees are paid directly out of your closings; they are not income that runs through your Mortgage Pool Fund itself.
Second source of your income: Servicing and Management – Your second major source of income is servicing and management. This would include some spread — usually 1% to 3% — of the interest rate spread, and ancillary service fee income such as late charges, default interest, prepayment penalties, and the like.
You should budget if you’re turning your money over every two years that you’ll probably make — and you’re not making high-cost mortgages — that you’ll probably be making 3% of the total assets managed. So, if that is a $100 million, that would be $3 million dollars income to the manager on this side of the operation of loan origination. And then you should figure that you will make anywhere around 3% on the Servicing and Management aspect of your Mortgage Pool Fund on the other side.
Like I indicated earlier, the members, or investors, have a choice of cash flow, or automatic reinvestment, or both. This gives your investors options. One of the features you’ll see in Doss Law Mortgage Pool Funds is what I call “parking lots”. This is either the money in an account or subscription agreements for people who want to come into the fund to give you good liquidity.
Other features of the Mortgage Pool Fund
This fund has the ability to leverage its mortgage assets. Typically, today, we can put you in contact with vendors who will, with your $1 dollar worth of mortgage loan give you a $5 dollar line of credit secured by good quality mortgage loans. Other features of the Mortgage Fund is the annual CPA audit. Lastly, most Mortgage Funds have very little expense within the fund itself. The manager, because the managers collecting the Points and Fees and taking the Servicing and Management Fees, bears nearly all the expenses of the Fund with a few exceptions. The possible exceptions would be any type of Limited Liability tax, the cost of the annual CPA audit, the cost of tax return preparation, or the tax return for this stand-alone entity (Pacific Mortgage, LLC).
We also want to encourage you to create a Loan Loss Reserve. This is kind of a shave off the income otherwise payable to the investor to set aside for potential losses down the road. The objective of the Mortgage Fund and your objective in running one is to gain some momentum. That momentum will pick up after your annual CPA audit. Once you have the CPA-audited results which you can show to your potential investors. And from that point, it picks up steam!
What you are also trying to do as you manage the first year of your Mortgage Pool Fund — or even the second year — is gear it toward, what I call the “President’s Letter”. This is the letter that goes out with the CPA audit typically in February or March, well before the investor’s tax returns are due, and in the President’s Letter, you will describe what the Mortgage Pool Fund has done during the prior calendar year. For example: it’s weighted loan-to-value ratios, its default rates, its rate of return, the number of people who requested money and got the money out, the number of people that came into the fund, the average loan size; all these interesting statistics that give your investors a lot of comfort. That’s what your trying to gear your mortgage fund to accomplish.
Addressing Investors’ Needs for Cash Withdrawals
It is possible within the fund for investors to get some Capital out. It’s usually done on a first, best efforts basis, it is not the fire drill; we’re not going to shut the Mortgage Fund down in order to to take care of one investor, but it’s done in a measured pace as cash flow allows.
There are a lot more moving parts and complexity to an actual Mortgage Pool, but this discussion presents an accurate, but simple “BIG PICTURE OVERVIEW” of how a Mortgage Fund is created.
Let’s Review – We set up a separate Legal Entity — in this case, Pacific Mortgage, LLC. Your existing mortgage lending / hard money lending company runs that new Mortgage Pool / Fund entity: your existing company, in essence, wears two hats. Your members (investors) have options, flexibility, and safety.