If my tenants suffer an uninsured loss that may have a knock on effect on their ability and/or willingness to pay rent and of course my property may suffer collateral damage from their loss. 

You could secure the lien with another real property or personal asset with a substitution of collateral agreement in place. 

He suggests I buy lot outright and use this as collateral for demo and construction loan. 

Now he just needs to cash a check each month when the payment is due - no need to wait for the mail man.Write in an early payment discount in the event you sell the building and pay off the seller financingUse a stutter clauses - allows you to miss one payment a year.Build in a substitution of collateral clause - that means you can move the security of the mortgage to another property with equal or greater equity when you sell without having to pay off the existing mortgage - therefore not having to pay off the mortgage gives you more cash at settlement.DON'T ask for seller financing - it is SO easy for the seller to say NO Way - BUT write it in to the offer - it will be much easier for the seller to understand.If the seller resist seller financing - build in a short term balloon 6 - 12 monthsLet the seller know he can make more money (in interest) if he helps you will financingGive the seller some great references (financial and testimonials) sellers like to deal with people they trust and like.

Indeed, here is some research done by Collateral Analytics (that sells data/etc to the mortgage industry) that just came out in July where they find that the "FSBO Discount" is typically greater than what the real estate agent commissions would have been, had the property sold for fair retail price.As a buyer, either can be viable.

@Jordan Bochner, Young Chap or no, loans are all about collateral, credit, character, and capacity to repay the loan.

What does the collateral for the loan consist of? 

@John Thedford  Excellent thread to advance this thought process.I would caution anyone doing this though that being a 100% collateral based lender can certainly lead to many problems regardless of LTV. you want to make sure the folks your lending to are known to you and have great character you don't have to run credit on them.. but you do need to know they know what they are doing.. and are not shyster's... or worse totally inexperienced newbies.

The plan was to use my current house as collateral and have the lien be on the duplex.  

It worked sometimes because the banks didn't want the collateral back.Balloons are but one commercial loan product offered, you can also get fixed typically either 10 or 15 year, along with regular adjustable mortgages.