Private Lenders: Are You Secure?
As a lender, you need to thoroughly analyze security when originating loans or evaluating leads. Taking unnecessary risks with your hard-earned money - or as a funds custodian, you’re often managing capital raised from friends, family, and acquaintances - will not lead to financial success in private lending. If you are entering into a loan you need to verify there’s sufficient collateral to be secure. There are a few factors to consider when evaluating if you are protected.
Underwriting a Loan for Security
Collateralization means securing the loan with the value of the property. If a borrower defaults on their loan, as the lender, you want to be able to recover your investment with the collateralized asset. To determine if your loan is secure, you need to estimate the value of the collateral and calculate your Loan-to-Value ratio (LTV). We covered comping and comparative market analysis last week, so check out the last blog post, Underwriting vs Comping - They're Different, for a primer if you missed it.
To calculate LTV, the loan amount is divided by the total value of the asset. However, it's not always that straightforward. As a lender, you may have additional costs to consider when calculating your LTV, such as attorney fees, holding costs, etc. Typically, lenders prefer an LTV of no more than 80% for security. You are not secure if you have a note worth $100,000 and a property valued at $100,000. Why? There are costs associated with defaults and remedies and you should be able to pay those out of the collateral, not out of your pocket if failures occur.
Additionally, while comps are important when valuing a property, you also need to understand your exit strategy. If you enter into a six-month loan in June and exit in December, the property value will be significantly less in December since it is a slower time of the year for real estate. In some cases, it may work in your favor if inventory is low and there is a perfect buyer, but that is not always the case, and you should consider underwriting conservatively.
Perform Due Diligence
When you lend your hard-earned money to borrowers, you want to ensure you properly vet the borrower and the deal. You must make your own assessment of whether the deal will be profitable. Oftentimes, asset-based lending focuses too much on the asset and not enough on the borrower. While analyzing factors like the property's value and legal documents are important, you must also evaluate to whom you lend your money. You should check their creditworthiness, solvency, and the merit of their business plan. Taking the time to do your due diligence can help save you from entering into a bad deal. Put simply, are these people who they say they are, and can they do what they claim they will do? You need to verify.
Lien Position Matters
In the event of foreclosure, the position of the liens determines the order for which creditors are settled. If you are in the first position, you generally have priority and are in a stronger position than those in the second or third. You are in trouble if you find yourself in third position because you are not secure. If you are in either the second or third position, it's important to ensure that there are sufficient alternative means to receive payment.
How We Can Help
If you are considering private lending and want to ensure you are secure, we can help. We offer services like credit and background checks, due diligence on a deal-by-deal basis, and consulting for auditing current systems and processes. Reach out to us today to see how we can assist you.
Sources:
Collateral Value: Definition, How It's Used, and LTV Ratios (investopedia.com)
A Guide to Lien Position and Priority for Private Lenders (garnaco.net)
Comments