Different Loan Term Possibilities in Private Lending

[Alex Breshears]

As someone who knows a lot of private lenders, I routinely get to see what the discussions are about and how things may be changing as markets move or regulation changes occur. Recently, I've seen more of a move to the loan to cost (LTC) model for many private lenders.  But what does that mean for borrowers? Let's take a look at the different ways a loan could possibly be structured.

First, many active investors are likely familiar with the loan to value (LTV) model. The loan amounts are generally based off a percentage of what the loan will be valued at after repairs. Some lenders will also lend on a percentage of what the value is currently, if there are not significant renovations or deferred maintenance on a particular property. Generally, this LTV model means that if an active investor's purchase price was significantly below the after repair value (ARV), they could possibly get the entire purchase price and renovation budget from a private lender because those total costs would be less than 70% to 75% of the after repair value. This model was very popular in the raging bull market we have seen in most of the US from 2010 onwards because the properties were likely appreciating steadily each year, so if a property went into the foreclosure pipeline, there was a willing buyer at the value of the loan or more because the property had increased in value.

Now, with market softening being seen in many markets in the US, this straight LTV model is losing ground to a more loan to cost (LTC) model. The loan to cost model can be calculated in a variety of ways, and the terms widely different, but I'll share the most common options I have seen recently from other private lenders.

The first LTC option is by far the simplest - and the one I see most frequently right now. This option takes a certain percentage of the purchase price and then funds the rest of the renovation budget up to a certain total percentage of the property's value after renovations.  As an example, if a borrower has a home under contract for $100,000, a private lender may have a 90% loan to cost model, funding 100% of renovations up to 75% of the after repair value.  That means the borrower will be responsible for 10% of the purchase price ($10,000) plus closing costs at the time of closing. If the property is expected to appraise for $190,000, then 75% of that would be $142,500.  Depending on what the renovation budget is and how comfortable the lender feels about the project and investor, that money for renovations could be given at the closing table, or held in escrow until renovations have been completed and the active investor is refunded for costs after proper documentation has been submitted. Obviously this can be a very different scenario than a straight loan to value model, which with these same numbers wouldn't require a borrower to bring anything to the closing table, and would actually be leaving with a hefty check!  This version of the loan to cost model does two things for the transaction. The first, the borrower is forced to have some skin in the game. They are responsible for some downpayment and closing costs to be paid at the time of acquisition. Secondly, it reduces the amount of money a lender has held up in a particular property, so if "the nuclear option" happens and the property much go through the foreclosure process, not as much capital is at risk. Again, depending on the numbers of the deal, there may be a huge difference in the capital required to close and renovate a property, so a borrower needs to know these details early to make sure they have the capital needed to close.

Another twist on this loan to cost model is when a private lender figures in the renovation costs as part of the total cost of the project. For example, if a borrower has the same $100,000 property under contract, and it needs $45,000 of renovations to then sell at $190,000, the lender may choose to fund a certain percentage of the $145,000 it would take to get the property into a certain condition to be sold. In a straight loan to value model - this borrower may only need a few thousand down plus closing costs, but the lender is funding all the way up to 75% of the after repair value.  If the lender uses a total cost option, They may choose to fund 90% of the total cost ($145,000 in this case) and have a loan of $130,500, or roughly 69% of the after repair value.  In the first example, the borrower needed just a few thousand down and pay for closing costs (essentially), and then in the second example, the borrower needs a lot more of their own capital to close the loan and finish renovations.

What is sparking this change? Lenders are always trying to establish the risk of a particular situation. We don't want to own property, we want the loan and cash flow. When you have an increase in uncertainty, that is going to be initially perceived as an increase in risk. Right now...we have a lot of uncertainty. With the Fed raising rates in an attempt to slow inflation, supply chain shortages affecting prices for everything from construction materials to fuel, and some buyers pulling back from the marketplace as a whole, there are a lot of dynamic forces at play here. The first thing a lender is going to do is lower what they are willing to lend on a particular property, and there are a variety of ways to standardize that process, with lowering the LTV being the most common, and changing loan terms such as this loan to cost model, being prevalent.

So what are you seeing in your market for lending terms? Have things changed recently? If you are a lender, what guidelines are you currently using that may not have been used a year or more ago?