When a borrower’s renovation project and loan payments stall, the knee-jerk reaction of many private lenders is to initiate foreclosure. That’s a lengthy and expensive process in most jurisdictions that ends when the lender takes back the property.

Active Forbearance offers an alternative route that can get a borrower’s renovation project back on track, get the loan reinstated and lead to a profitable resolution for all parties.

A good Active Forbearance process involves stepping in midstream on stalled renovation projects and collaborating with the borrowers to solve the problems causing delays and cost overruns.

If there’s no way resolve the problems, the lender can exercise its first lien position and take over as general contractor. The lender can then finish the project, market and sell it, and pay off the loan with the proceeds. When possible, the lender may also return a portion of the borrower’s equity. The lender pursues foreclosure only if the borrower is unwilling to agree to the forbearance agreement and terms.

WHY USE ACTIVE FORBEARANCE?

There are three reasons to use Active Forbearance to avoid foreclosure.

First, it’s smart. When your money is tied up in a project, you don’t have it to lend to someone else. Aside from that, you have obligations to pay your investors regardless of the challenges you face with the property and borrower. Vacant properties tempt vandals and thieves, and foreclosure sales typically depress values for surrounding properties. Both can harm surrounding property values.

Second, it’s moral. It may fly in the face of being a for-profit lender, but we think it’s morally right to try Active Forbearance before resorting to foreclosure. The borrowers who are new to the business have to start somewhere. They can go to a lot of seminars and read books, but nothing can replace experience because every deal is different.

Sharing experience and expertise with others grows a better client base. Keeping projects on track helps develop business people who are loyal to you and better at flipping houses, which reduces your risk next time you lend to them.

Third, it’s practical. The more quickly you get the property back on track, the sooner it gets to market and your loan is repaid. When a borrower runs into trouble and is financially stressed, they’re not going to keep making payments.

You’re not getting payments, and you’re not getting the property back to sell any time soon, especially in a judicial foreclosure state. If you can keep the project moving ahead, you avoid foreclosure.

Active Forbearance produces win-win results, as lenders can return capital to investors and borrowers as:

• They know more about successfully renovating and selling properties.
• They have equity from the original deal to fund a new project.
• The lender-borrower relationship remains intact.
• There’s no foreclosure “black mark” on the borrower’s record.

ACTIVE FORBEARANCE AT WORK

Surprisingly, it’s not poor credit that tends to cause defaults in private lending. The two most common reasons borrowers and projects run into trouble are:

1. A lack of construction experience.
2. An inability to stay on top of the many tasks involved in renovation projects.

A lender who has been in the trenches has the unique skills and insights to help rehabbers succeed. They can show borrowers how to avoid mistakes, share best strategies on vetting vendors and suppliers, and provide insight on key methods to stay on time and within budget. They have contacts, know the local players and understand who has the ultimate power to make or break a project. They’re in and out of projects overseeing construction draws, so they notice when deadlines start to slip. When that happens, they step in and begin a series of communications that clearly define what’s going wrong and what they expect the borrower to do to get the renovation back on schedule.

Here’s an example of active forbearance in action. It shows how things can go wrong, even for seasoned flippers.

An experienced and repeat renovator, who we’ll call Jim, bought a house at a substantially undermarket value in Eckington, an up-and-coming Washington, D.C., neighborhood.

Jim selected a well-known local contractor to perform the work, teamed up with a skilled architect to produce streamlined and contemporary floorplans and, ultimately, started demo.

Fairly quickly, the job fell behind schedule due to permit delays. In response, Jim decided to cut costs. He made design changes that could negatively affect the exit price.

After more weeks went by without permits, Jim was frustrated by the very slow pace of the project and went looking for solutions. They had several meetings at the property, and discussed the best course of action.

Changing contractors in the middle of a job isn’t usually smart or cost effective, but in this case, it made sense. The lender helped Jim bring in new, more seasoned contractors who pulled permits quickly. Jim also agreed to put the high-end design elements back in the plan.

The lenders created a forbearance agreement that:

• Extended the loan term and increased the loan amount to allow for cost overruns.
• Stipulated monthly payment procedures.
• Called on Jim to pay an extension fee and contribute additional money into the project.
• Amended Jim’s LLC to appoint the lender manager of the project (allowing the lender to manage the contractors, increase the construction budget, if needed, and oversee the sale of the home).

The agreement also stipulated that the division of proceeds would be disbursed in the following order upon sale of the house:

1. Transaction costs, i.e., real estate commissions.
2. Repayment of all property obligations such as loan pay off, taxes and utilities.
3. 30 percent of profits to be paid to Walnut Street Finance.
4. Remaining profits to be paid to the borrower.

The new contractors had the old work fixed and inspected, and made some positive design changes to the interior and exterior. Within six weeks, the project was finished and under contract to sell.

In this case, the market moved with the project, and the exit price was even higher than projected. After the sale, Jim had nearly as much profit as he had originally planned, there was no foreclosure, and he moved on to his next project.

Private lending provides a pathway forward for those traditionally ignored by banks. Entrepreneurs with skills and the determination to work hard can turn a profit by rehabbing old properties. As they learn the business, those dreamers are inevitably going to hit some rough patches.

When that happens, a lender has two options in the way they choose to approach the situation. The first is to immediately claim that the loan is in default and begin the foreclosure process. The second option is to work with the borrower to resolve challenges. Replacing the adversarial foreclosure process with Active Forbearance and helping people grow their construction project skill just feels a lot better.