Even with the Federal Reserve’s recent interest rate increase, interest rates continue to remain lower than historical averages. As a result, private real estate lending continues to be an attractive alternative investment opportunity, because it allows exposure to the real estate market without the necessity of becoming a landlord or a flipper. This often takes the form of short-term, high interest rate loans focused on the value of the real estate securing the loan rather the borrower’s credit worthiness. These loans are typically paid when the project is flipped or refinanced after the project is complete.
Properly documenting the loan and the lender’s security interest is essential to a successful investment. Failing to require written loan agreement could result in the borrower asserting that no loan existed, and borrower has no obligation to the lender because the parties were joint venturers. Failing to properly perfect the lender’s security interest in the property could result in all proceeds from the sale of the property being distributed to other creditors of the borrower at closing. The following is a discussion of certain high-level items that someone contemplating becoming a lender should address to help mitigate the risk associated with this type of loan. Each deal is different, and a potential lender should address any specific concerns with their accounting or legal advisors.
COMPLETE A DUE DILIGENCE PROCEDURE FOR EACH LOAN
While private loans are typically associated with an expedited loan approval and funding process, in my opinion, establishing and completing a due diligence procedure for each loan should be a primary concern. It is particularly important to understand how the borrower intends to structure the deal and how the value of the property, both in its initial state and after it has been rehabbed, relates to the amount of the loan requested. Key questions include, without limitation, (1) the feasibility of the borrower’s project and the borrower’s budget, (2) whether other loans are or will be secured by the property and if so, what position will those loans be in, (3) the amount of funds the borrower is contributing to the project, and (4) the borrower’s previous experience and record with this type of project. While a lender should consider whether they will be able to recover their funds through foreclosure, if necessary, attention should also be paid to whether the borrower will be able to complete the project and repay the loan on schedule. Lenders should be cautious of borrowers with full time jobs that intend to undertake substantial DIY improvements to properties. Lenders should also be cautious if the borrower is proposing an unsecured loan, regardless of amount of the loan compared to the borrower’s anticipated profit from the deal.
BE SPECIFIC IN THE LOAN AGREEMENT
After due diligence has been completed and the lender has determined to move forward, the terms of the loan are the next consideration. Beyond the amount of the loan and the applicable interest rate, the loan agreement should clearly specify when the balance of the loan is due and whether periodic payments are required. Dependent upon the size of the loan and scope of the project, the lender should also determine whether the loan funds will be advanced at one time or through a series of draws. If there is more than one lender, attention must be given to how repayment will be structured and priority of the lenders’ security interest in the property. The lender should also take into consideration whether or not requesting a personal guarantee from the owner (or owners) of the borrower is advisable.
FOLLOW UP TO ENSURE FOLLOW THROUGH
Follow through by the lender is paramount to a successful investment. Funds should not be advanced until the loan agreement and the mortgage or deed of trust are executed. The deed of trust must be promptly recorded to preserve the lender’s priority. Once the loan is funded, the lender should intend to monitor the project and keep in contact with the borrower to ensure the project remains on budget and on schedule.
Private real estate lending creates unique opportunities but is certainly not risk free. However, by creating and following a due diligence process and documenting the parties’ obligations with a written loan agreement, potential lenders can better manage that risk.
Louis Spiker is a business attorney with Johnson May in Boise.