Great servicing teams drive loyalty and stop losses before they start.

Private lenders spend considerable effort building, fostering, and maintaining relationships. Often, this experience allows them to understand the operational risk associated with a loan, the anatomy and warning signs associated with each loan, and when it’s time to call it quits. A servicing team, particularly one that’s in-house, provides a bridge between borrower and lender and is often on the front line of making difficult decisions.

Relationship building is essential to the success of any lender. In a hypercompetitive lending space, small factors often differentiate one lender from another. Although pricing (fees and interest rate), duration, leverage, and loan structure all play a critical role in a borrower’s decision, the overall experience and ease of the transaction create repeat customers.

This especially rings true for balance sheet lenders who service their loans in-house. Understanding a borrower, educating them, and going the extra mile to restructure a deal to get it closed (with a high probability of success and mitigation of risk) is the goal of any lender.

Understanding a borrower starts from Day One, often with the initial inquiry. A simple call, email, or video chat with a prospect can yield a wealth of information. They can help a lender understand a borrower’s background, liquidity, experience, and goals—and how those factors fit into the lender’s guidelines and credit matrix.

The initial fact-finding mission often yields red flags and outright warnings. Some are subtle, and some are extreme: Is this a new borrower with little experience? Are they going too big, too soon (heavy vs. light rehab)? Are they investing in high-risk areas, which include risk related to insurability, crime, economic compression, or oversaturation? Are there geographical complexities related to distance? What are the current micro and macroeconomic climate conditions that will impact this particular investment?

Private lending, like many industries, is a function of sales. An intelligent, highly trained sales staff with a great product will drive originations and loan volume. The sales team cultivates the relationship with the customer, processing ensures proper documentation is provided, underwriting qualifies the loan, and closing/quality control ensures the loan makes it to the closing table without hiccups.

Now, any proud, experienced servicing team member will tell you this is where
the real fun (challenge) begins. The servicing team is the ultimate guardian of a company’s capital resources and must police and monitor the progress of each project, maintain a positive relationship (hopefully) with each borrower, and know how to spot warning signs in a complex, dynamic industry that can be suffused with fraud.

On the surface, one may think a servicing team member’s job is simple: collect interest, release draws, provide payoffs, and nothing more. That could not be further from the truth. Servicers are the backbone of the borrower relationship, providing guidance and education on construction budgets, while navigating simple to complex change order requests, contractor matters, and the many issues that arise between business partners. In addition, the servicing department must guide loan modifications and extensions when they are (or are not) appropriate. They must do all this while managing collection issues, monitoring property insurance and tax compliance, issuing notices of defaults, and working closely with internal and external legal counsel.

Day One: The Welcome Letter

Now that the loan has closed, the servicing department must “welcome” a borrower to the business and familiarize them with several important details related to both planning and process. Although many, if not all, these details should have been explained during the sales process, it is good practice to outline them in a “cheat-sheet” for the borrower to reference. Often, a lender sends a welcome letter that incorporates several important pieces of information.

Communication is vital, so be sure to include key contacts. Who does the borrower contact for a draw, what needs to be included, and what is the typical turnaround time from the initial request to the deposit of draw funds?

Additionally, costs related to the loan should be spelled out. These include the interest rate and how it is calculated (e.g., Dutch vs. Non-Dutch, inspection fees, wire fees, NSF fees, late fees, etc.). Be sure to note when interest is billed and subsequently due.

How fees will be paid also must be clarified. As part of the closing package, many lenders require borrowers to provide banking information that will be used for monthly direct ACH payments. This allows the lender and borrower a hassle-free payment transaction each month and minimizes the risk of missed payments and late fees.

It should provide a “refresher” of the borrower’s budget (Scope of Work) and, importantly, how best to follow it to maximize draw releases and minimize delays.

The welcome letter also should cover whether release of draw funds is dependent on each line item being 100% complete, installed (properly with acceptable workmanship), and on-site. If the lender allows for partial releases, it should specify what is required and how percentages are determined. Any additional documentation needed for specific repairs (e.g., roof warranties, septic certification and inspections, special permits and invoices) that must be submitted in conjunction with the inspection report should be noted as well.

Finally, details on the final holdback funds, when they are released, and what is required to access them (e.g., lien waivers, certificate of occupancy, clean/complete project, etc.) should be spelled out.

The servicing department will educate even experienced buyers (or remind them) about the details of their loan and the nuances of each lender, especially if they are new to the organization. This education allows the borrower to quickly and efficiently access draw funds and expedite their rehab.

Start to Finish: An Evergreen Underwrite

As the eyes and ears on every project, the servicing department is tasked with monitoring the progress of each loan. They treat every draw as a mini underwrite, examine the progress in detail, and look for red flags and warning signs. The servicing department should constantly communicate with the borrower, understanding each project’s budget and complexities.

Yes, first and foremost, a servicer must ensure the financial liabilities for each borrower are met—including timely interest payments, sufficient and current insurance coverage, current tax liabilities—as well as monitor for any mechanics’ liens that could jeopardize a project or a lender’s first lien status.

However, the construction draws are where the rubber meets the road. The servicing department is tasked with reviewing each draw in detail. What does a draw review consist of?

Permitting and plans. Are the necessary and proper permits in place, and do the plans match the progress of the project? Look for warning signs. Differences in project scope can be subtle and less impactful, such as changing flooring materials. At other times, changes will severely impact the overall feasibility of a project, threatening the original ARV that the loan was underwritten to. For example, has an addition been added or deleted, a planned finished basement scrapped, or worse, an entire structure demolished?! Heed the warning signs and question everything.

Speed and consistency of draws. How often are draws being taken? Every borrower is unique in their plan and scope. Some borrowers take smaller, more frequent draws, while others fund the entire project and will not take a draw until the very end. Communicate with the borrower and remain involved. If regular draws are not being taken, discuss the reason with the borrower. These conversations can often unearth issues with permits, liquidity issues, contractor woes, or disagreements between partners.

Signs of fraud. Inspect every picture, every angle, and every detail of each draw. Unfortunately, fraud can be pervasive, especially in private lending. Whether you allow your borrowers to submit their pictures or rely on a third-party inspector, make sure what you are reviewing is the actual property on which the loan was made. Compare each draw report to the original appraisal and the original inspection/feasibility report (if available). Ensure there are clear, current exterior photos with proper address markings. Use online street view services to compare the surroundings. Releasing draw funds on fraudulent reports and pictures can and will cost a lender dearly.

Change orders. Exercise cautious skepticism with every change order request. Although many lenders enforce strict rules (no change orders or no change orders after the first draw), one must speak with a borrower to understand the unique circumstances for each reallocation request. A lender must use common sense, especially with smaller change requests that have little to no risk to the overall viability of the project.

Large reallocation requests often come with increased risk (and may be predicated on other underlying issues). Is the borrower attempting to “frontload” the budget, drawing more funds earlier, which will negatively impact cash flow to finish the project? Will changes impact the overall ARV of the project (for better or for worse) and require a new appraisal? Are these changes indicative of the borrower’s (or contractor’s) lack of experience and pose threats to the successful completion of the project?

Poor workmanship. Carefully examine the inspection report and read all notes in detail. Look for subpar workmanship, including poorly installed materials, evidence of “cutting corners,” and lack of experience, as well as the overall organization or cleanliness of the jobsite. Any obvious issues that impact the safety or quality of the renovation must be addressed immediately. The level of every renovation is different; for example, the cost and quality of each project’s materials reflect various factors such as location and end-use. Not every project is meant to be fit for a king or queen. However, overall construction quality, standards, and safety must be adhered to in every project.

Inspection reports and detailed draw reviews are designed to protect both the lender and the borrower. Although no inspection is perfect, the lender must trust the inspector to provide an accurate examination in order to make an informed opinion about the project’s status and, importantly, to understand the warning signs when things start to go bad.

Red Flags and Warnings

Short-term bridge, construction, and renovation loans are designed to be limited in duration. The quicker the transition to exit or refinance, the more profitable the deal is. The servicing department is tasked with understanding the borrower’s budget, timeline, and overall exit strategy. Clear, consistent communication is critical, and proactive conversations between borrower and lender can prevent issues from escalating to the point of no return. Servicing staff must provide a comprehensive resource center, handling everything from onboarding to payoff and everything in between.

But what happens when a project begins to show cracks (literally and figuratively)? What are the warning signs? Here are some common red flags:

Late or returned payments, inconsistent payment methods, and requests to net interest payments from draw funds

Lack of necessary permits (or refusal to present them), permit delays, other municipality issues

Frequent requests for budget changes, reallocation (e.g., attempts to frontload draw releases), releases of final holdback funds, advances of materials

Lack of understanding of the original scope of work and draw process

Infrequent draws or stalled projects

Questionable workmanship, frequent or inconsistent design changes, cosmetic and structural work performed outside the original scope

Issues with contractors and coordination with trades

Lapse of insurance coverage, unpaid taxes, mechanics’ liens

Lack of communication (inability to reach borrower via phone, email, text, written letters)

No project is perfect, but the servicing department is designed to work with the borrower to communicate challenges and problem-solve. The key to success is knowing what to look for and assisting with a solution amenable to both borrower and lender.

Extend, Modify

Residential Transition Loans (RTLs) are for business purposes, short-term, and anywhere between six and 36 months. Typically, these loans are interest-only with a balloon payment of principal due at maturity. Due to the nature and scope of construction and rehabilitation projects, it is often necessary to extend a note past maturity and offer the borrower a loan modification. The terms of the extension (if offered at all) are at the sole discretion of the lender. The servicing department must weigh in heavily and evaluate the risks of extending a loan. Generally a lender must consider the following when offering a loan modification.

The borrower’s payment history. Have payments been timely and consistent with no issues? Non-sufficient funds, late payments, and/or constant chasing of the borrower indicate liquidity issues.

Status of the construction project. This includes the number of draws taken, rehab funds remaining, and how much is needed to complete the project.

The reason behind the delay. Were there permitting issues in the beginning that stalled the project? Were there contractor issues, including subpar work that had to be redone (or worse, a contractor that absconded with funds)? Have business partners had a falling out that has impacted the project’s ability to be completed?

Scope changes. Did changes in the project’s scope significantly delay construction progress?

Insurance. Is the property properly insured, are all taxes paid and up to date, and are there any outstanding liens that may impact your interest in the property? Use a third party to do a deep analysis, if necessary.

Price. If construction is complete, and the house is listed for sale, is it listed at a reasonable price that aligns with the original ARV? Often, a borrower’s desire for outsize returns can sabotage an exit plan and lead to lender losses while looking for “pie-in-the-sky” returns.

Appraisal. If the plan is to refinance and hold, has the process been slow or stalled due to appraisal issues (either in obtaining, ARV, or both)? Take another look at the location and determine whether there have been economic changes to the MSA.

The nature of the borrower. Has the borrower been difficult, combative, and frustrating to deal with? Is this someone you want to do business with and allocate time, resources, and capital to?

Modifying or extending a loan can be complex, and the lender must understand the many reasons that necessitate one. In a capital-restricted environment, a loan modification can often be costly to both the borrower and the lender. The fees associated with it (which usually include an increase to prevailing market interest rates) must be sufficient for the lender to cover the costs associated with tying up capital that can be deployed elsewhere.

Loans past maturity may also have implications on a lender’s borrowing base with their lending institution. In addition, the terms must not be excessive enough to hamper a borrower’s ability to complete the project and successfully exit. The servicing department’s history with a borrower and general insight is paramount when determining the terms of a loan modification.

It’s Too Late

The servicing department drafts the interest payment per usual, except this one is different. The payment is returned as insufficient funds. Maybe there is a good reason—a bank account was closed or compromised, funds were not transferred in time, or a borrower provided a wrong account or routing number. Whatever the reason, the servicing department is responsible for remedying the issue promptly.

Often, payment issues are the precursor to larger issues. The lender issues a notice of default, giving the borrower a set time to cure the default. But the window expired without a response from the borrower.

A loan has matured, but little to no work has been done. Or worse, the project’s scope has changed so dramatically there is no conceivable way to finish with the remaining funds to be allocated. The borrower has been difficult, demanding, and appears to lack the experience, knowledge or willingness to listen. The servicing department has heard several stories, often inconsistent, as to why the project cannot be completed. Or maybe this is the second, third, or fourth loan modification. The lender has worked with the borrower several times, providing guidance and fair terms to all parties to facilitate the completion of the project.

At this point, the servicing department must sound an alarm and work with internal and external parties to devise a plan to mitigate losses. The goal is to avoid foreclosure. At this stage, loss mitigation may include:

Collateral management. This includes forced place insurance, monitoring for tax and other liens, and using a third-party property management firm to monitor, protect, and secure the asset.

Reviewing the note. Work with legal to understand the lender’s rights, including the ability to inspect the property and call the note.

Explore alternative methods. What kind of loan workouts are possible (e.g., repayment plans and deed-in-lieu)?

Explore your current borrower/investor network. Often, a failing loan can be saved by a more experienced borrower in the network who is willing to take on the project.

Evaluate each situation carefully through risk analysis, and consider selling a nonperforming asset to a specialty firm.

Foreclosure. Understand the options and the variations in the legal systems of each jurisdiction where loans are made. Build relationships with external counsel and reach out to the network for advice and recommendations. Foreclosure puts an extreme strain on both the borrower and the lender, costing time, capital, and resources.

Finally, if the collateral is returned to the lender through a sheriff’s sale, the lender must do a cost analysis to determine whether to sell the asset as-is or complete the renovation prior to sale.

Strong Relationships Build Repeat Business

Private lending is an incredibly competitive space. Everything being equal, customer service often sets one lender apart from another. The servicing department, particularly for lenders that service in-house, builds strong relationships with borrowers through clear, consistent communication. Strong servicing departments understand each borrower and project and the warning signs to look for. Engaging often and early, along with deep conviction and experience, allows a servicing team to solve complex problems. Customer experience is usually the most significant factor in determining whether a borrower returns. Despite all of this, loans do go bad. When they do, the servicing department is the first line of defense.