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The Three Things Private Lenders Want
The concept of private lending has grown over the years as institutional lenders have tightened their lending guidelines while more traditional investments such as stocks and bonds have proven to be a rocky road with tepid returns. Private lenders can generate greater returns compared to other types of investments when financing real estate. Not only are these returns more than respectable, they’re also secured by the asset being financed. Private loans are typically of much shorter term compared to conventional financing, most often between six and nine months for most residential properties. Higher yields, greater security and quicker turns are the hallmarks of private loans.
Yet private lenders aren’t free with their funds. The interest on private loans is higher but there is still risk involved, regardless of the inflated rate. Such lenders, be they an individual or a pool of like-minded investors, evaluate each project with care and can finance properties that banks won’t touch yet that doesn’t mean a private lender will finance anything it sees. What do private lenders look for when asked to finance a future project?
The Story
A project needs to have a credible storyline and clear path to completion. Why is the property in its current shape? Abandoned? Poor management? A foreclosure? How did the borrower come to put this property under contract and why? Knowing how a property got where it is helps a private lender get an idea if the situation can be corrected in the first place.
Assuming the cause of the problem is correctable, the real estate investor must demonstrate a plan to renovate the property or otherwise repair what’s broken, then provide a final value once the property has been acquired, renovated and ready for market. If the property will be flipped, what will be the final value based upon similar sales of real estate in the area and how long will it take to complete the sale?
The acquisition cost, cost of repairs and all selling costs are carefully reviewed and compared with the “as completed” value. The investor needs to put the entire story together providing a clear exit strategy. If the lender is convinced the plan will work as presented, it’s time to review the borrower’s financials.
The Borrower
Once a “good story” is established, the private lender typically turns his/her attention to the borrower: capital, credit, and track record. Compared to a traditional lender and depending upon the type of property and perceived risk, down payments for private loans range anywhere from 30 to 50 percent or more. The borrower will be asked to provide up-to-date bank and investment statements showing sufficient funds available for the down payment and closing fees. The lender will evaluate liquidity making sure the funds needed won’t completely drain the borrower’s accounts.
More often today than before the downturn, private lenders will pull a credit report for review to determine whether or not the borrower is creditworthy. Credit requirements will vary based upon the lender and project. Some lenders are less concerned with borrower credit and more emphasis on the equity in the project, while others require a strong credit history from the borrower.
Will the borrower be making payments during construction or will the payments be deferred until the project is complete? If the borrower will be making payments during the renovation process then copies of recent income tax returns will be reviewed and business bank statements eyed for cash flow.
Most short term projects will allow interest to accrue until the property is sold with no monthly payments required. However, if the project is not completed during the term of the note, the investor may extend the note for a fee or issue another loan.
The Asset
Once satisfied with the story and the borrower, the lender will examine the asset (collateral). A basic understanding of the current condition of the property, both in terms of physical and legal is reviewed to determine the starting point of the potential investment. The private lender will review the current legal status of the property by reviewing a title report. The title report will show a chain of ownership but more importantly any existing clouds on title that will hinder the sale. If there is a mortgage on the property the mortgage must be satisfied before the deal can take place. In the case of a distressed project it’s usually the lender that owns the property and will be listed for enough to take care of any lien the bank will have.
There are other liens the bank has no control over that must also be settled. If there are any delinquent property taxes there will most likely be a property tax lien which must be paid. So too any federal income tax liens or even back child support or alimony. Distressed real estate can often carry a lot of legal baggage and a private lender needs to know if there are any issues that need to be resolved.
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In the end, private lenders can make a loan on anything they want. Because they’re the underwriter they can make exceptions to underwriting policies as they see fit. Real estate investors leverage their acquisitions with loans and typically have an established banking relationship with a traditional lender. Real estate investors who have been in the industry for some time will also have solid relationships with private lenders. Investors need flexibility and diversification as it relates to lending—knowing how to secure private funds and where to secure them are key ingredients to any investor’s success.
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