Just don’t forget that moving one lever impacts the entire project you’re funding.

As a private lender, there are a lot of levers you can pull to mitigate risk, including changing terms to offset the risk of a loan.

Remember, risk tolerance is less about a number and more about how you feel sleeping at night knowing the loan is out there. But remember, when you change loan parameters, you need to consider how doing so might affect other areas of the project. Pulling one lever impacts other places. The trick is to figure out those second- and third-order effects and whether those effects are intended.

For example, adding a co-borrower requirement to a loan may help add more capital on paper for the loan, but you may have introduced a risk of partners not getting along and finishing the project on time or on budget. If the original borrower and co-borrower haven’t discussed roles, responsibilities, and injection of capital into the project, the risk of default could actually be higher than if the borrower took on the project independently.

Another thing to consider is whether you are accurately assessing the risk level. One lender, still viewing their local market as red-hot, may continue to push LTV amounts, thinking their equity buffer only gets bigger with forced appreciation. Another lender may perceive the red-hot market as getting “too bubbly” and back off. If both lenders are in the same market, how do you assess which one may be right? That is the million-dollar question!

Here are six levers you can push or pull to mitigate the risk of a loan, depending on the loan situation and your risk tolerance with the loan.

1. Loan to Value

Loan to Value is the first lever many lenders pull back when uncertainty arises. Lowering the LTV means you have less capital at risk if the borrower fails to perform on the loan, whether that’s due to their own project miscalculations or a market correction.

Some lenders may assess lowering the LTV is safer because it builds the equity buffer. If 2008 taught us anything, we learned exactly how fast that buffer can disappear. The risk with moving this lever on borrowers who are currently in the pipeline for underwriting but haven’t closed yet is the the project then risks being underfunded, making it difficult to exit the loan.

If the property requires significant renovation and the borrower runs out of capital when the place is taken down to the studs, the value of that property is automatically going to be worth a lot less. Again, if the project stalls out here, that equity buffer is likely negatively impacted. Lowering the LTV isn’t the failsafe many new lenders believe it to be, but assessing the impact the lower LTV makes to the loan scenario can help avoid potential pitfalls.

2. Narrowing Criteria for Property

Some small private lenders may spend a significant amount of time underwriting the borrower but take only a cursory look at the property details. These lenders believe the borrower is the person making decisions on behalf of the property. This belief may give lenders a false sense of security, causing them to fund atypical properties because of their faith in the borrower. Think tiny homes, container homes, or some other structure that is out of character with the surrounding area or made from unique building materials. Narrowing criteria for property could also look like avoiding rural properties, luxury residential housing, and second home properties and markets. These types of properties don’t tend to fair well in an economic downturn.

With the longer-term real estate market largely up in the air amid the hysteria of early 2020, some small lenders might have opted to fund projects needing minimal rehab so they could be placed back on the market and sold amid an epic housing shortage. In addition, major rehabs required laborers to be at the property, sometimes multiple teams at the same time, which meant social distancing requirements would significantly delay project timelines. As delays wore on, raw material prices rose quickly as supply and demand worked against each other. A borrower doing just a light rehab on a smaller home will be less affected by material prices than a major rehab project on a 4,000-square-foot property.

3. Capital Reserves

During the pandemic, investors with sizable portfolios of rental properties lost income on those units because tenants were out of work and programs for rent relief or direct payments to individuals were not up and running yet. As a result, many lenders—conventional and alternative lenders alike—started requiring capital reserves (proof of funds) to cover a specified number of mortgage payments, typically six months to a full year. Capital reserves could keep many investors afloat when rehab draws were halted or tenants stopped paying and, therefore, reduced overall risk for the lender.

Small lenders can use this lever if they feel the borrower needs a larger capital buffer, is inexperienced, or the project takes longer (and usually goes overbudget). Liquid capital means the borrower has more options to make the payments, fix overruns in rehab, and qualify for conventional financing if they are trying to refinance out into a longer-term loan.

Just as in the conventional lending space, a new capital reserves requirement may put a borrower out of the running for a loan. Rarely will you hear of a lender who regretted not funding a loan. There are plenty of opportunities out there, and smaller lenders may feel they need to compete with larger institutional lenders and offer more lenient terms. The opposite is true! Smaller lenders doing balance sheet loans often have flexibility larger companies lack. That doesn’t mean you should offer more lenient terms, but you can move the levers you want according to each lending opportunity.

4. Personal Guarantees

To be competitive, some lenders may not require a personal guarantee from a borrower. During the Great Resignation, some borrowers chose to live off reserves while looking for better employment opportunities.

If the loan requires a personal guarantee from a borrower, there need to be assets to back up that guarantee. The personal guarantee helps reduce the risk of not being made whole at the end of the loan. A personal guarantee with a borrower who has next to no assets is basically worth about as much as the paper they signed on. Pulling this lever can also involve bringing on a co-borrower who will also sign a personal guarantee with assets to back up the ink on the page.

5. Length of Loan Changes

Early in the pandemic, some smaller lenders changed the length of the loan. For example, many lenders offered longer loans, some 18-24 months in length, to allow for more time to deal with material shortages and social distancing for laborers and technicians. The idea was to allow the right amount of time for the project and borrower needs.

Lenders who chose projects with fewer renovation requirements may have had a shorter length of loan time, perhaps eight months with an ability to extend. Again, keep in mind that changing one metric has a ripple effect on other parts of the loan. Funding a loan for a project requiring significant renovations, but then requiring the borrower to complete the work in eight months is likely setting the borrower up for failure.

The other side to this discussion are the lenders who wanted that longer loan term for consistent cash flow from solid borrowers while the world established how to operate in this new normal. The downside of longer terms for loans is that a lender may not be able to spot a borrower who has a project running behind due to mismanagement.

6. Lowering Property Valuations

Markets may vary greatly, but if you think it’s a hot market how can you safeguard yourself? Getting a formalized opinion through a comparative market analysis, broker price opinion, or appraisal can offer an unbiased second opinion on value and takes the guesswork out of valuations.

A lender that chooses to perform self-valuations can limit comparable properties sale dates to the last 90 days only to get a better idea of more recent values. In cash flow markets, appreciation tends to be less, so having more conservative valuations in these markets specifically can help with maintaining an equity buffer.

Other things to avoid would be cashflow markets and focus on appreciation markets, which fair better in a down economy. Choosing to fund residential property near the median home price of your market can offer a quicker and easier exit typically. Condos also tend to slump as borrowers become hesitant to take on large fees that many condo associations charge owners.

Remember, these six levers don’t exist in a vacuum. Pulling one can cause unintended consequences downstream, introducing more risk to the lending opportunity than the original loan parameters. When you consider a potential change, ask yourself, “Why?” What specifically are you trying to mitigate? Does the contemplated change truly address that risk?

Sometimes talking through the situation with another private lender can help you decide whether your solution is sound or could cause more problems than it is worth. There isn’t always a right answer. Sometimes there’s just the “best choice” given the information you have available combined with some educated guesses about the future.