Communication and advanced planning between both borrower and lender are critical to the financial success of any rehab project.

Every rehabber aims to complete a project on time and within budget. Success can be measured in many ways, but it ultimately comes down to the old saying: Time is money. This could not be more true when it comes to rehab loans. Rehab lenders provide short-term financing, with most loan terms being 12 months or fewer. The key for the borrower is to complete the project within those terms to avoid accruing additional interest and costly extension fees.

Communicate, Communicate, Communicate

The borrower has identified a new project, set a detailed budget with a clear timeline, and has closed on the loan. Now what? Communication with both borrower and lender does not stop when the loan closes, nor should it be a one-way street. It is both the borrower’s and the lender’s responsibility to maintain constant communication throughout the life of a loan.

The lender must review every draw and only release funds on budget line items that are 100% complete and done in a satisfactory manner. The job of the lender and loan servicer is more than just collecting interest payments on time. The lender should know the borrower, understand the project, and monitor draw progress. If a budget is designed with phases, the borrower must ensure each phase is being completed in the specified timeframe, with as few deviations as possible.

The lender should be looking for any red flags both early and often. For example, if a borrower takes no draws, it should automatically trigger a response. The lender must contact the borrower and determine the reason why. Are they funding the work out-of-pocket and plan to take all draw funds at the end? Have they run into permit issues that have impacted the start of work? Are they having issues with their general contractor or finding labor in general? Are there personal issues that will impact the borrower’s ability to pay their interest and complete the project?

Try to understand the borrower on a personal level without being too personal. The lender and borrower must understand that communication is vital in any relationship and is the only clear way for shared success.

Once a project is underway, the lender should be updating the borrower on key maturity dates as well as reminding them of the original terms of the mortgage note. When the note is coming close to maturity, the lender should be making contact at 90, 60, and 30 days before maturity. A simple email, letter, or phone call usually does the trick.

The lender should ask the borrower about the progress of the project and whether they think they will be able to complete it on time. Has the original exit strategy changed? If so, what does the new one (if any) look like? Have the circumstances at the onset of the loan changed? The lender should assess several factors that can impact a project. Has the borrower’s employment, income, credit, or liquidity changed? Is the borrower currently working on other projects? Remind the borrower that loan extensions can and will be costly.

What Can Go Wrong

At the beginning of a project, the borrower will have a good sense of the work that needs to be completed, how much it will cost, and how long the renovations will take. A thorough and detailed inspection by a trusted third party will yield a budget that is both complete and realistic. This is critical to any project’s success. However, like anything in life, unforeseen circumstances can and often will delay a project’s completion and impact overall profitability. Some common issues that can impact a project include:

Permits/Inspections. Borrowers thought they had all permits in place, but now additional permits/inspections need to be performed. Borrowers are often at the mercy of cities and municipalities and can face heavy delays.

Poorly Executed Rehab Budgets. Initial budgets are light or highly unrealistic, leaving borrowers scrambling for additional funds to complete the project. Such a development puts both borrower and lender in jeopardy.

Unforeseen Construction Circumstances. No budget is perfect, and construction and rehabs often encounter issues that were not planned for in the original budget. Structural issues, septic issues, and a host of other items can often delay and sabotage the success of a project.

Unforeseen Personal Issues. Life happens. Unfortunately, it can impact a rehab project. A borrower, family member, or close friend becomes ill. A spat occurs between business partners. A borrower loses a major source of income. These are all items that can delay the completion of a rehab project.

Not Knowing Your Market. The borrower overimproved the property, spending too much money, which leads to listing the property at an unrealistic price. You may have the nicest house on the block, but that does not mean it will sell at a premium. The property will sit for sale for an extended period of time, incurring additional carrying costs.

Change in Real Estate Market. The project is complete and ready for sale or rent, but changing market conditions make the exit strategy difficult or impossible.

The Extension Agreement

The borrower and lender have been in constant communication during the life of the project and the loan is due to mature. Now what?

It’s time to discuss loan extension options. No matter the circumstance, once a loan has matured, it must be extended, which necessitates a signed loan modification. This is a legal document that alters the original note.

Often, the reason for extension is clear, and the borrower simply needs extra time to complete the project and exit. The property is currently listed with active showings (or under contract) and shouldsell shortly. Construction took longer than expected, but completion is near, and the project is moving along. These circumstances may require a simple three- to six-month extension, which can be negotiated on a month-by-month basis or for an upfront fee for a set period.

If the borrower and lender have communicated well, an extension can often be foreseen and pre-negotiated. This best-case scenario allows for ample planning, providing a comfort level for the lender. Ensure that all guarantors on the loan are aware of the situation. An extension agreement must be signed by all parties to the loan, including guarantors. A lender must remind all guarantors they are financially responsible. More important, the borrower must continue with the rehab to complete and pay off the loan within the extended timeframe.

Both borrower and lender want to avoid a multiple extension situation at all costs. Not only do these additional fees eat into project profitability, but the lender will also incur significant costs of carrying the loan, especially in a high cost of capital environment.

In some circumstances, a lender may consider foregoing all extensions on a project for many reasons. Lack of experience or mismanagement has left the borrower with little to no remaining budget, with a significant amount of work remaining to finish the project. The original budget may have grossly underestimated the rehab needed and the borrower will not be able to complete the project, even with additional time. The original scope of the project changed significantly due to unforeseen construction issues. Or perhaps the loan has been outstanding much too long with multiple extensions, and the lender will not, or cannot, carry the loan in an economically feasible manner.

The lender must carefully analyze the current deal structure and communicate, educate, and guide the borrower through alternative exit strategies. If the project is complete, can it be refinanced? Is there enough equity in the project to consider additional short-term bridge financing? Has the borrower evaluated current market conditions and judiciously priced the property to sell? As the lender, it is often difficult to inform a borrower that a loan will not be extended. Still, with careful, consistent communication, a mutually beneficial alternative is often within reach.

Preventing a Default

The lender has given an extension, or multiple extensions, and now the project is at a crossroads. The borrower’s original exit strategy has failed, or the project is still incomplete. The lender must do everything they can to educate the borrower and help create a new exit strategy to avoid as much financial pain as possible and, more important, a default, which can ultimately lead to a foreclosure.

What can a lender do to help a borrower mitigate losses? Some options may include:

Cut Losses. Often the best option is to know when to cut their losses and move on. The lender can educate the borrower on their options, which often include selling the property as-is (often to another investor) and exiting the project. Even the most experienced rehabber can encounter problems. Like any endeavor in life, every setback should be viewed as a learning experience.

Consider Rental and Refinance Options Until Things Improve. Market conditions may have made it difficult to sell a property. The lender can advise the borrower on several refinance options, which include refinance and debt-service coverage ratio loans (DSCR).

Each situation is unique and depends on the current state of the project. Is it complete, or is it rented? Does the borrower have good enough credit and liquidity to qualify? It is the lender’s duty to help guide and navigate the borrower in these situations.

Wholesale Options. The borrower may be able to sell to a wholesaler/investor that specializes in acquiring properties in these situations. The lender can educate the borrower on this process, but not necessarily refer them.

Assist with Contractor Issues. If a borrower has been adversely affected by a less than stellar contractor, the lender can reach into their vast network and refer (without direct endorsement) to a reputable contractor who can move the project over the finish line. The difference between success and less favorable outcomes is often as simple as working with someone who is experienced, trustworthy, and willing to help.

New Rehab Loan. The borrower’s original budget was inadequate, or unforeseen construction circumstances have vastly increased the funds needed to complete the project. If the borrower is qualified and there is sufficient equity in the property, it often makes sense for the lender to write a new loan with additional rehab funds that allow the project to be completed. This loan must be carefully underwritten to avoid another situation in which the project cannot be completed.

Collaboration for Success

The relationship between the borrower and the lender in any rehab project is critical for success. For various reasons, a loan extension may become necessary during any project. These circumstances for a loan extension can be many, but it often does not mean the borrower is a “bad” rehabber.

The key to success is managing the timeline and completing and exiting the rehab in the timeframe given. As a lender, your goal is to ensure the borrower is educated, supported, and able to complete the project in a manner that is successful and profitable. Providing support and consistent communication can help the borrower maintain a proper exit strategy, even when things do not go as planned. The goal is to create customers for life, and this symbiotic relationship between borrower and lender is crucial for continued mutual success.