If you look out for the best interest of your investor and do your due diligence, these loans can provide a great return.

As the COVID-19 crisis has ravaged many parts of the real estate market, one of the standout sectors has been homebuilding. Interest rates are at record lows. Many families are migrating to the suburbs and other low-density areas seeking more room for home offices and schooling, or they’re just trying to avoid the worst effects of the pandemic.

Now that housing has snapped back, there is a severe shortage of inventory in many areas of the country, driven both by consumer demand and by COVID-induced shortages in raw materials. This has created an opportunity for lenders able to provide funding for new housing starts.

Now may be an excellent time for you to explore funding private-money construction loans. As housing starts continue to be strong in the COVID economy, not all builders can easily obtain traditional bank financing. They need the specialized services private money lenders provide. If executed properly, these types of loans can be very lucrative for your portfolio.

Reviewing the Deal

The first thing you need to worry about is the speculative aspect of the deal. A construction loan is different from most loans, in that you must understand the market to know what the property will be worth after it is finished. Unlike fix-and-flip loans, where a property is already built and just being renovated, ground-up construction projects present a wide range of potential outcomes. The finished value will ebb and flow with the economy and market conditions.

In addition, on construction deals you won’t have a lender-borrower relationship like you have with most standard loans. You’ll be dealing more with third parties, such as the appraiser (who values the property), builders, designers, architect, and others who make the project happen and help determine the future value of the property.

It’s helpful to establish strong relationships with these parties so you can benefit from their expertise in aspects of the transaction that are crucial to success, but where you are not an expert. These pieces of the puzzle that you do not typically see in other loans are vital in making an informed decision about the estimated value of the finished property.

Mitigating Risk

Any time so many parties are involved in a process, it creates additional risk factors. For one thing, it is far from guaranteed they will all do their job properly. When just one party fails to perform, it can affect the jobs of other participants and could even jeopardize the entire project. It is important to monitor all parts of the project carefully to ensure the various pieces come together smoothly and all the contributors are meeting expectations. This extra scrutiny can help ensure the project is done right and moving forward on schedule.

So, unlike a typical loan where it closes and then you just need to service it, a construction loan requires the lender to monitor the project to ensure its progress during the term of the loan. Construction loans typically involve much larger holdbacks than fix-and-flip loans, and the post-closing disbursement process is far more involved.

Typically, advances will be made as the contractor meets certain milestones. Each disbursement is a chance for the lender to evaluate the progress of the project. It is also important to know how far the project has progressed and what still needs to be completed in case there is a possibility of foreclosure. If the loan ends up defaulting, this knowledge will help determine whether you want to step in to finish the project or just foreclose.

Effective Underwriting

The underwriting process is one of the best ways to protect yourself when making a construction loan. During underwriting, you can learn more about your borrower beyond what is on the application (e.g., their background, track record, how many properties they’ve built over the past year or two). Get a list of properties the borrower has completed and check the selling price.

It is also essential to find out how long it took the borrower to complete the projects. Be sure to acquire documentation of the completion schedule of the borrower’s past work. Also ask the borrower to provide before-and-after photographs of previous projects. This will give you insight, not only about the quality of their work, but about how well they can drive a project from beginning to end.

A construction loan needs to be evaluated not only on the borrower but also on the project itself. It is essential to list all the jobs that will be involved in the project and have the borrower produce names for each one. This list will help you dig deeper into the probability of the project being completed and your loan getting repaid.

Protecting Your Investor

The key to funding any construction loan is looking out for the best interest of your investor. If done correctly, these loans can provide a great return. But not properly doing due diligence and vetting of the project could lead to complicated problems. The additional risk that a ground-up construction project presents can be mitigated by properly underwriting the project, adequately collateralizing the loan, and making sure you have the proper insurance coverage in place.

Adhering to these principles will improve your chances of success and significantly enhance your ability see the project through to completion. Utilize all the resources at your disposal, and if you are still unsure, employ the help of a third party experienced with construction projects to evaluate and advise on the likelihood of achieving success.