Do you place significant value on your relationships with your best borrowers?
If you do, you’re not alone. And because you value those seasoned, well-qualified investors so highly, you—like many institutional private lenders—likely offer tiered rates and terms to accommodate them.
For private lenders just starting out, this strategy could prove troublesome.
Let’s take a look at some considerations private lenders, especially novices, often overlook when working with a borrower they already “know.”
Although it’s true that past behavior is a strong predictor of future behavior, in some circumstances, you should set aside your subjective opinions of an individual’s experience and capabilities in favor of hard facts.
Many of the “gotchas” that occur when relationships are favored over facts are rooted in common misconceptions. Here are a few of them:
- Only lending to people you know. Perhaps the person is a young family member and you want to support their investing journey. Or, maybe a close friend or colleague tells you their amazing fix-and-flip stories over lunch. Whatever the relationship, the tendency is to trust these people implicitly because you know them on a personal level. But you may not know much at all about their professional reputation, spending habits, or business experience.
- Only lending to people with experience. Although experience should be a strong consideration, even the most seasoned investors can fall victim to a market correction, general contractor gone M.I.A., or global pandemic shutdown. Experience may help some recover faster, but no one is completely immune from market fluctuations, including you.
- You know the borrower is “good for it.” You see the flashy cars, the social media posts flaunting recent project wins, the fancy watches, and designer wardrobe. Their appearance wreaks of success, right? It’s common for novice private lenders to get carried away with the public fanfare of investors rather than verifying their background and experience.
- The borrower came highly recommended. Referrals in the real estate industry are critically important to success. Relying solely on another’s opinion or recommendation, however, should not override your own due diligence. As Ronald Reagan said, “Trust, but verify.”
Make Data-Driven Lending Decisions
Verifying facts about the borrower is important to be a successful private lender. Even if you already know the borrower as a friend, family member, or colleague, how often do you conduct background checks, pull credit, or ask about their annual income?
The process for underwriting a borrower should be similar to how landlords conduct tenant screenings. A few things to fact check would be:
- The Character. A background check can give you insight into legal matters the person hasn’t freely shared.
- Although credit scores usually are not provided on free credit reports, you can still see the borrower’s open credit lines and payment history. This can typically provide a true assessment of their current liabilities.
- Past experience. Ask for a schedule of real estate and past projects and verify the person’s project experience through the tax assessor’s records. Make sure to verify the borrower was an actual equity partner vested on the title on past projects.
- Financial health. Request personal financial documents that will substantiate liquidity and sources of income and prove the borrower can cover project expenses and monthly carrying costs.
Paint the Bigger Picture
After completing due diligence on the borrower, consider outside forces not within the borrower’s control but that could impact their ability to pay you back.
Execute your due diligence on the borrower’s intended use of loan proceeds by collecting relevant documentation and asking some simple questions to ensure you are comfortable proceeding.
Here are a few important questions you should answer before funding a deal:
- Does the borrower have relevant, verifiable experience?
- Are the borrower’s project plan and budget realistic?
- What are the market conditions where this project is located?
- Is the general contractor reputable, licensed, bonded, and insured?
- Does the borrower have multiple and reasonable exit strategies?
- Does the property have sufficient equity to cover you in a worst-case scenario?
- Are you willing and able to lend more money on the project if it exceeds budget?
- Do you have enough experience and knowledge to underwrite this type of project?
This last question is one of the most important and self-reflective to answer. No matter what information you gather about (and from) your borrower, if you cannot distill or verify this data because of lack of experience or little understanding of the current real estate market, you might be in over your head. Whether lending your hard-earned savings or through your self-directed retirement plan, the primary goal for new private lenders should be return of principal, not return on investment.
Here are some ways you can overcome this obstacle and ensure your private loan investments are safe and secure:
- Stick to what you know. If you only know about flips, then stick to fix-and-flip loans and turn away requests for complex construction loans or asset classes outside of single-family residences.
- Consult with real estate experts. Reach out to people who can help vet your borrower’s general contractor proposal. Contact a local real estate agent (or pay for an appraisal) to find out more about market conditions and property values. Review with a real estate attorney.
- Join an investor club or association. Attending local real estate meetups can greatly improve your network and the knowledge base you’ll need to assess a loan request. You may even find investors who have experience in private lending, both as the borrower and as the lender.
- Lend through a trusted private lender. Established private lenders can help you source, underwrite and fund your first few loans. Find a local lender who facilitates direct placement of trust deed investment as opposed to investing in a pooled mortgage fund where your participation is more hands-off. Eventually, you may feel confident to proceed independently.
Give Yourself Time
Private lending can be attractive as a passive investment if you are seeking ways to earn money on your money. However, you must take responsibility upfront to protect your investments.
Although your intuition is important, knowing someone socially is not a good enough reason to avoid the hard work of fact finding. In many ways, lending to someone you have an existing relationship with can be even more difficult, because you are starting out with preconceived notions about this person rather than a clean slate.
So, if you value and want to preserve your personal relationships (and your principal investment), focus on the critical thinking required to properly underwrite a business loan. The information you need to make a sound financial decision often doesn’t come through in everyday social conversations.
Published in American Association of Private Lenders’ Private Lender Magazine Q3 2021 – page 56: Private Lender by AAPL by American Association of Private Lenders