How much should borrowers track record matter when private lending?

Question

Hi,

I was interested to see how much a borrowers track record should matter when you are thinking about lending on one of their properties.

If a borrower seems trustworthy and has a long, flawless track record would you feel comfortable loaning at almost a 100% LTV, compared to that of somebody who doesn't have as long of track record, but at 70% LTV?

Bill Gulley · Answer

There really isn't a measurable relationship to experience and LTV determinations, it's a subjective comfort level. I have loaned 100% in several areas of acquisition and repairs, or inventory needs, or carrying expenses of start-ups.  Not usual lending practice, but some can or will underwrite the deal if there is an out where others will step in if the initial party fails.

Every economic transaction action will have three of the four fundamentals of economics,  land, labor, capital and entrepreneurship, or some substitute. All four could be present but at least three will be present in lending. When there is a lack of one factor another compensating factor will need to be increased keeping the potential of the deal in balance and acceptable. If you have less capital, more entrepreneurship or management may be necessary or may be we can add more labor or may be we can add more land to entice another party. If you have less land or management you may need more capital.

The easiest way I know to explain "compensating factors" what a lender will look to in making a lending decision is what keeps the deal in balance as a good lending risk.

Borrowing money is an economic transaction, there must be some exchange made by each party and each must bring something to the table. If your father "loans" you money and there is no exchange in return, it's not a true loan but a gift even if there is an expectation for the money to be returned. For it to be an economic transaction there needs to be consideration which is also a legal requirement for the contract. The promise to pay is consideration, so is the promise to pay interest and granting collateral is additional consideration.  The lender provides cash as consideration. The transaction needs to be balanced in consideration of the risks assumed by both parties.

So, those new to business or real estate need to begin thinking from the basics to understanding transactions. Having only one aspect such as land may not be sufficient in an equitable exchange for the economic benefit for the use of money.

If someone has no management skills, no experience, no capital or income, and can't contribute anything to improve the land as labor, but has 1,000 acres and wants to borrow $1,000.00 that is not an equitable exchange. if any lender did lend in that situation it would be a predatory transaction. This is where some private lenders or hard money lenders can fall into a predatory area as the loan may be so out of balance and one sided. Most lenders won't go there.

The concept is usually referred to as "what one brings to the table". When I started I couldn't swing a loan without cash or equity to level the field. Today I can obtain 100% in certain deals based on my experience and management skills. While there is a chicken or the egg aspect, it will come in time where your track record becomes valuable.  Until then you need to rely on other factors to anchor your ability to use other's money. :)

Bryan Hancock · Answer

I don't lend money to folks, but I do borrow money all the time from a number of sources.  To me it is pretty much universal that the reputable lenders value a good track record more than anything else in the transaction.  There are obviously other concerns as well and others have already touched on them, but there is simply no replacement for someone that knows what they're doing and can prove it with evidence from past deals.

Ann Bellamy · Answer

Taylor, it's more than just track record, it is personal lending history with the borrower as well.  If I've done 15 deals with the borrower, not only do I know that they have a track record, I know exactly how they pay and I probably know whether they lost money on the deal, if I know them well enough.

If a borrower loses money on a deal (it happens even to the most experienced rehabbers) and I am still paid exactly on time and the deal doesn't drag on, then I really start to get a comfort level that I will be made whole no matter what.

Chris Martin · Answer

To borrow somewhat off of Bill Gulley's post ... some other options could be for the borrower to add collateral (additional equity via tracts added to the deed of trust) or to add other compensation (e.g. profit sharing) to get the deal more in balance. 100% of purchase price on a really good deal with good terms for the lender may be an acceptable risk.

Jeff S. · Answer

Borrowers don’t avoid a default because of late charges.  Defaults occur due to poor judgment, circumstances completely out of their control, or any of a thousand other issues.  Nonetheless, you absolutely want late charges in your note to protect yourself in extreme cases.  There will/should be an entire section entitled, “Borrowers Failure to Pay as Required, “ or something to that effect.  It will define the late charges, definition of a default, notification requirements, waivers, etc.

These are not terms you make up yourself since much of them will be governed by state statute. (In CA I believe the maximum late fee is 10% after 10 days.) It’s also a good reason not to blindly take someone else’s note and to have yours reviewed by a really good lending attorney.

Jeff

Taylor Green · Answer

Thanks again for all the response, good information.

As far as making sure the borrower has sufficient collateral, is it common practice to add a default interest penalty to the loan agreement or promissory note?

If the borrower defaults on the loan, the lender could then add (for example 4 points to the loan) in order to add incentive to the borrower to not default. Especially if a loan is at a high LTV? I'm not sure if that is normal or even if it's legal with the usury laws.

Jeff S. · Answer

The first thing we ask when we meet a potential borrower is how much experience they have, how many flips they’ve done, for how long, and if they do this full time. If they are new, or minimally experienced, we politely tell them we can’t help. It's only after we’ve established their experience that we will plan on going out to get to know them and to see their properties.

LTV is moot to us. It’s also arbitrary among all but the largest lenders.  We won’t loan less on a property because a borrower is inexperienced – we just won’t do the deal.  Period.  In our view, there’s a lot more safety in a borrowers experience (and even more in their integrity, as Ann noted) than in LTV.

I'm sure many don't have a problem loaning to newbies, even at higher rates and lower LTV's.  Nothing wrong with it if that's your niche.  There's plenty of business around from experienced rehabbers that we feel it's just not worth the chance.  To us, it boils down to the amount of experience a borrower has and how well you know him or her.

Jeff

Bill Gulley · Answer

Yes, good thoughts Chris, profits in private deals, lenders can't take profits in connection with loans, yields are unknown and usury comes into play as well as liability and security issues. That's not to say a stated amount can't be paid as profits are received, that's a different arrangement. :)

Taylor Green · Answer

Thanks again for the responses.

Sorry for the confusion, I originally meant 100% of the purchase price, not the ARV. But it's good to see experienced lenders opinions on this...

Basically, from what I am understanding is you never want to go to a 100% of even the purchase price unless you have a personal track record with the borrower or you know the area/property well enough that there is built in equity.

If the borrower agrees to a recourse loan and gives a personal guarantee does that change anything? Or should I not make a loan without those terms included anyways, no matter what the LTV % is.

How much should borrowers track record matter when private lending?

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