When you are considering an investment, don’t make the mistake of relying solely on opinions and experience rather than on data.
Relationship building and networking are paramount to success for the small, independent private lender. These low-key lenders tend to fly under the radar. They don’t publicly advertise and typically do not have a brand that sets them apart in the real estate community.
Additionally, these truly private equity lenders likely have less capital to deploy, and they are more risk adverse than institutionally backed lenders with more experience, resources, and deal flow.
What Are Relationships Really Worth?
Most will tell you relationships are of high importance, especially when lending money, because the borrower is responsible for executing the project—and a house flip cannot complete itself. To these lenders, the experience of the operator(s) involved are critically important in determining whether the loan will be repaid.
Be aware, however, that a lender can place a disproportionate amount of value on borrower “feels.” Yes, it is true you should trust your instinct, but placing too much value on your gut without backing up your feelings with quantitative underwriting can be disastrous.
Just because you know someone personally does not mean you should forego collecting and verifying proof of past relevant performance—both financially and professionally. Both can be good indicators of future behavior. (See “Don’t Let Relationships Fool You,” Private Lender, Summer 2021).
Although previous experience can provide some insights into a deal’s merit, no investor or deal is immune from risks outside the borrower’s control, such as market corrections or dishonest contractors.
Given these factors, can an argument really be made that a borrower is the most important aspect of the deal—more so than the actual property and project itself?
Other Factors to Consider
When evaluating a prospective deal, considering person, project, and property to categorize and evaluate the deal’s merits and risks is a good strategy. The importance of each will vary greatly, however. Every private lender, even a new one, relies on a unique point of view or set of priorities to govern their lending guidelines and processes. Personal bias in private lending is based on both experience and on values or in other words, risk tolerance—especially when there isn’t much real estate lending experience to lean on yet. For every lender who tells you the person (borrower) is the most important factor, you can find another who pushes the asset as the primary consideration. So, which is it?
No other lender can tell you how to define your own guardrails in private investing. Even the most seasoned investors can fall prey to bad projects, market corrections, and setbacks outside their control. For example, you’d be hard pressed to identify a single real estate investor that was not affected in some way from the COVID-19 pandemic. Experience may save an investor from greater loss, but experience alone cannot provide you, as the creditor, with full protection of your principal.
Even if you prefer to place greater weight on the borrower, you should still choose a combination of both qualitative and quantitative data to underwrite borrower experience, character, and creditworthiness. To get a better sense of the borrower, meet in person and discuss past projects and goals. Back up your borrower “feels” by verifying critical data through documentation. For example, have the borrower complete a project experience spreadsheet with details about each deal, including addresses, purchase prices, rehab costs, and final sale prices.
Go one step further and validate the borrower was on title as a vested owner. You can do so through online public records from the tax assessor’s office. You may be surprised that prospective borrowers sometimes inflate their involvement on a project on which they were a mere capital partner or acted only as the general contractor, but did not actually own the property.
Finally, ask for a list of three professional references from people the borrower has worked with on past projects. This will provide several lenses through which to assess your borrower—the information they provided themselves, online data validation, and third-party feedback. You simply will not get the entire profile of a borrower through one approach alone.
You can apply this same three-pronged approach to both property and project, which go hand in hand. Physically tour the subject property with the borrower, noting the neighborhood characteristics, the current property condition, and proximity to amenities such as restaurants, shopping, and mass transportation.
Take it one step further and ask the general contractor to be present as well so you can hear directly about the scope of work and estimated costs. Then go home and conduct your own online data research. Do a neighborhood review, identify recently sold comparable property, and study MSA demographics such as population growth (or decline), key industries, and major employers.
Finally, verify your own research by obtaining a third-party appraisal or BPO (broker’s price opinion) for the value of the property after it’s completed.
Be sure to evaluate outside factors such as economic stability (both nationally and locally) and potential shifts in the real estate market or interest rate hikes, which could adversely affect real estate sales and property valuations in the short term.
Private lenders just starting often miss some of these steps because of the overwhelming tasks of underwriting the borrower and property. Be sure you are not a private lender who makes the mistake of overlooking any of them. Local real estate associations and meet ups as well as national real estate education groups like BiggerPockets.com often host industry or market “State of the Union”-type events that can provide insight into trends and potential impacts to real estate investing. Several news outlets such as HousingWire.com can keep you up to date online as well.
These considerations are just the tip of the iceberg regarding what a private lender must evaluate with respect to the borrower, the project, and the property—as well as other potential economic impacts. Hopefully, you can see there are choices about how to effectively underwrite a potential loan opportunity that are not necessarily a “good, better, or best” option but rather a multifaceted approach to uncover every reason to say “no” to a deal, if necessary.
To get the most accurate picture of risk as a lender, you must employ a combination of verbal communications with the borrower, request written documentation from the borrower, do your own offline and online research, and request third-party objective commentary from key experts. Your goal is to combine your “feels” with empirical datapoints that help you make the best decision possible with the limited information available to you.