Other Articles in this Series:

How to monitor the collateral on your loan.

When you make a private loan, you give the borrower capital and then kick back and wait to get repaid at the end of the loan term, right? If you are in the private lending industry, you know that is never the case. At least, you should know. Without some sort of oversight, you could lose your asset on the deal.

More so than raising capital and attracting borrowers, proper collateral monitoring throughout the course of a loan is the most crucial aspect of a private lending operation. It keeps projects on track and provides early clues of a looming loan default.

Collateral monitoring serves three main purposes:

  1. It keeps construction progress on track to ensure the finished project will achieve the estimated After Repair Value (ARV.)
  2. It protects against loss of collateral by casualty.
  3. It protects the lender’s lien position on the collateral.

The Draw Process

 The first article in this series discussed estimating the ARV of the property during the underwriting process. A clearly-defined draw process that gives the borrower continued funding throughout the course of the loan allows the lender to control construction progress, ensuring that the target property value can be achieved. Once the borrower completes a portion of the construction, they submit a draw request for the completed work. This draw request includes receipts for materials and labor, an inspection to confirm the work was completed within the scope of the budget and photos of the work performed. Perhaps, most importantly, lien wavers signed by the party performing the work, when applicable, are required to avoid the imposition of a mechanic’s lien on the property.

But it also pays to be proactive—time is of paramount importance in any successful real estate investment. Rather than waiting for the borrower to submit draw requests, it’s important to monitor how many days have passed since the last draw request. Monitoring the frequency of draws and following up with borrowers who fall behind on the draw schedule will help keep construction on track. A delay in the first draw may indicate the borrower is having permitting issues, which can sometimes make or break a project. Awareness of issues the borrower may be facing at all phases of the project helps you anticipate and react to potential problems with a loan.

Both the lender and the borrower benefit by conducting an appraisal or Brokers Price Opinion (BPO) midway through construction on the project. A BPO provides an extra level of assurance that both the project is on track to reach the estimated ARV and the budget is adequate. It gives the borrower time to course correct, if necessary. Remember, if the borrower has to come out of pocket or is unlikely to make money on the project, the lender incurs a greater level of risk because the borrower may decide to abandon the project altogether.

It’s important to look ahead and monitor maturity dates for loans in your portfolio. Certain loan buyers won’t permit a loan to go past maturity without an extension in place. If a loan must be extended, the lender typically will collect extension fees or raise the interest rate on the loan to the default rate. A loan that goes past maturity and requires one or more extensions is an indicator of increased risk to the lender. Once the project is complete and the property is put on the market, it’s wise for the lender to monitor the listing price to assess how it compares to the ARV.

Cover Your Assets, Insurance

Insurance

If your asset is wiped out, you could take a major loss on the property if you don’t have insurance. Though insurance premiums are paid in advance at the time of loan closing for the term of the note, the renewal can sneak up on you and your borrower if the term of the loan must be extended. Sophisticated private lenders will stipulate that a lapse in insurance on the property equates to a default on the lender’s deed of trust. However, the lender should have a forced-placed insurance process in place to minimize the likelihood of a policy lapse.

Just as the lender monitors the borrower’s draw schedule, they should also monitor the status of the borrower’s insurance to help avoid a policy lapse. Remember, protecting borrowers from themselves also serves to protect your investments. So, send out reminders to borrowers when the deadline for renewal approaches. Doing so at intervals of, say, 30 days, 15 days and one day before expiration should give the borrower ample time to renew the policy or obtain a new one. Once the project is complete, a builders risk policy is no longer sufficient, so the borrower must change the policy from a builders risk policy to a fire dwelling policy, which also saves money on the premium while the property is being marketed.

If the borrower fails to renew the insurance policy on the property, don’t stand around fiddling while Rome burns. At that point, it is critical for the lender to force-place a policy on the property immediately. That always incurs an additional premium but, unfortunately, the borrower must shoulder that extra cost.

Taxes

It’s been said that only two things in life are certain. As with an insurance policy lapse, a tax default also should signal a loan default according to the deed of trust. It also could mean extra fees for the borrower, or even the lender. Not only that, if taxes on the property become seriously delinquent, the county can place a tax lien on the property, which is superior to any lender’s lien.

For any lender servicing a high number of loans, it’s useful to use a third-party platform to monitor the status of property taxes. They can provide monthly updates to the lender and even send out letters to borrowers who are approaching the deadline to pay taxes on the property or who are past due. Automating this process provides an added layer of security and simplifies collateral monitoring for the lender.

The Bottom Line

Properties that end up as Real Estate Owned properties (REOs) can cost lenders a great deal of time and money. And, quite frankly, they’re a pain in your portfolio. Prevention is the best remedy for the problem. To reiterate, preventing REOs starts during the underwriting process before the loan is even closed. But, the process of prevention is ongoing. Loan servicing is not just about money in and money out. Lenders should always future proof their investments with a comprehensive process to monitor project progress from start to finish. In the end, it protects your bottom line. ∞

(This is the second article in a six-part series that covers asset management and the disposition of distressed loans. Read first part: The Very Last Nail)