How to structure Private loan for rehab cost

Question

Hi,I'm planning on lending to an investor that needs money for rehab costs. He already has a short term loan that he used to purchase the property.He needs extra money to over the rehab cost.How to should I structure this loan?

Dion DePaoli · Answer

Well this just got messy. So there are two subject properties? So they need to be capitalized separately or together. Probably wise to keep them separate unless you take equity in the company.So interest is being converted into equity - mezzanine financing. This approach begs the question is treating this capital as debt capital to be converted the best way or should you just buy shares of the company which owns the project and be in the operating agreement?There are different ways to structure this. Buying into the LLC which owns the projects. That comes with its own set of ownership interests, voting rights, etc. Might be a way of gaining good control over the project. Then again, that may not be of interest to the other party.Additionally, you can be a stand alone partner on title and take a carved out split of equity through Tenants In Common title. The current lender would have to approve you joining title, which they shouldn't mind if you are bring more capital to the table. So TIC would be he gets X% and you get Y% of net proceeds as two separate owners of the same property. Well properties in this case. Or you can set up mezz debt, as the original idea in the thread. Originate a loan which accrues interest and then that interest is converted into equity upon sale at some conversion rate which is considered your payback. The key here is keep it simple. You want controls in place to manage your capital exposure. You also want remedies upon project default, if that were to ever happen. You are going to want to get legal counsel involved in this to protect your interests. Bare in mind, the broker has an incentive to want you to do the deal as they probably get paid when it originates. You don't get paid until it completes. Those two ideas are not exactly aligned.

Dion DePaoli · Answer

Well how long until he finishes the project and how do you plan on distributing the funds to him?If the loan amount is large you may want to have draw downs at certain construction milestones upon inspection. This limits your exposure to a default and flight on the project. There are title companies and inspection companies who can help conduct the draws and inspections. The loan will be in second position since he already has a first position. It would be wise to review the current security instrument from the other lender. Attaching another loan to the property, assuming that is your plan opposed to making an unsecured loan, is important. The first lien may have clauses which require permission to be granted. The loan could carry a deferred interest which means what is actually due on the note will be greater than the loan amount due to interest being paid upon sale or completion.How will you be handling the interest accrual of your loan? Is the borrower to make monthly payments. Will you set up an interest reserve? Will you defer interest payments? The answers to these are what you negotiate and what the project is and how it will be managed. The obvious question is why is the project already over budget? Chances are the first lien wanted to see a financial plan and capacity to ensure the project could be completed and they get paid back. So it seems likely there is a cost over-run which now requires the borrower to seek more money. I would dig into that to understand the risk of putting good money on top of bad money. These are just some ideas that can go into your inquiry. Really what you should do is describe the deal a bit more. Loan terms are relative to the risk and you didn't really describe enough of the deal or risk to understand what may or may not be warranted.

Harjot Gill · Answer

@Dion DePaoliWow thats great information. I appreciate it very much.I do plan on consulting a lawyer. What type of lawyer would you recommend? Real estate lawyer?

Harjot Gill · Answer

@Dion DePaoliThank you for your help!The loan amount is large. One property is going to require $70K and the other property $300K. The ARV is going to be over $400K and $1.9million respectively. I think construction milestones are a great idea.I will not be collecting interest, instead I will be receiving a percentage of the profits upon sale. The purchase to sale estimate(escrow to escrow) is about 6 months.The broker that I am going through speaks very highly of this borrower. They did a deal in the past where after rehab, the property sold for above market value. (Although I just met this broker, and will meet this rehabber soon).Since I will be receiving a percentage of the profits, can I structure the agreement in a way where I have own that percentage of equity in this property?