Equity buffers are one of the most important ways to protect your private money investment from speeding out of control.

The first article in our Back to Basics series stressed that not making data-driven decisions about who to lend to and what to lend on can leave you in a tough position—and put your principal investment at risk.

The second article in the series addresses one of the most important ways to secure a private loan through safe equity buffers. Especially for new borrowers who are unknown entities, high-equity buffers (represented as low loan-to-value or LTV ratios) are critical until borrowers can prove themselves. Many seasoned private lenders will tell you experience and relationships can often justify higher LTVs based on their proven track record; however, relying on those two factors can still lead to challenging situations if you aren’t prepared or lack experience.

Cover Your Ass(ets)

If you have a sense of humor, you might quip “What could possibly go wrong?” when discussing complex loan requests. You can find yourself ratholed on deals trying to make sense of the gray areas rather than pushing them out due to risk factors. It takes discipline to temper the need to deploy funds with the need to protect your principal investments as well as those of your capital partners.

Many things could go wrong:  market fluctuations, project mismanagement, budget overruns, etc. All these factors further erode what little protective equity buffer is in place.

First, you have back interest and default interest as well as any late fees identified in the promissory note. And, before you can be paid out, other parties could get paid out before you, and you’ll need to protect against that. Here are some examples.

• Senior lien position loans // If you are a junior lienholder, the first lender will be paid out before you, including any default interest and penalties, which can rack up quickly with private money lenders.
• Delinquent real estate taxes // These would come into play if your borrower failed to stay current.
• Mechanic liens // These come from contractors who’ve placed claims against the property for money owed to them based on services provided before the date your loan recorded.
• Attorney fees // The foreclosing lender almost always pays upfront for legal fees associated with a default or foreclosure proceeding.

Take Extra Care

Here are several situations in which you will want to exercise extra caution:

If you are new(ish) to private lending, you may want to be extra cautious with equity buffers while you learn steps to evaluate and underwrite a prospective loan.

• Low-volume lenders originating loans a few times a year need to get reacquainted with market conditions, which can be challenging. A conservative approach is prudent.
• If you’re encountering a complex project or loan scenario, do your homework. For example, if you’ve only done vanilla fix-and-flip loans and your client requests a new construction loan or to purchase a commercial building, you will need to learn how to vet the deal since project financials and exit strategies vary greatly by asset class.
• If you are unfamiliar with the market, you will be lending in or you are lending out of state, lower LTV loans are a good idea until you better understand market dynamics.

Widening the Gap

There are many aspiring lenders with “smaller” amounts of capital who are eager to get their funds deployed and earn passive income. Many do not yet qualify as accredited investors and are unable to participate in pooled mortgage funds or syndications. These limitations make “do-it-yourself” private lending investments one of the few available options. As a result, lenders with limited capital end up in a few scenarios that pose greater risk of principal loss.

One such scenario is to provide gap fund loans. Put simply, these are the funds needed for down payment assistance and/or rehab costs while another primary lender funds the majority of project costs in first position. In Seattle, for example, median home prices exceed a half million. Although $50,000 to $100,000 can be a large chunk of change to some, it won’t stretch far on a standard fix-and-flip deal. This leaves private lenders with limited capital to take on riskier gap funding loans, often in second position or unsecured, to fill the gap between total project costs, what’s financed by another primary lender, and borrower capital contributions, if any.

Why is this risky? For starters, you’re at nearly 100% LTV right out of the gate. For example, if the borrower obtains an 85% LTV loan from a private lender for their project and asks you to gap fund the remaining 15%, there is zero equity buffer to protect you.

Lack of borrower capital contributions means the borrower could walk away with little skin in the game. It also could mean the borrower has little capital to cover unforeseen expenses. And if the first position loan defaults, high default interest rates and possibly steep balloon payment penalties could be imposed, leaving you at risk of your principal loan amount being shorted.

When Cash(flow) Isn’t King

Lenders with limited capital sometimes lend out of their home state in smaller markets where property values are less expensive. These markets generally are more inland or rural compared to coastal metropolitan markets that can often be saved through appreciation.

While this may sound like an easy way to get started in private lending, these “cash flow” markets tend to have home values that remain relatively flat by comparison to larger metropolitan markets. If you choose to lend to investors buying in these states, you’ll need to pay particular attention to home prices and market appreciation trends, average days on market, and other demographic-related factors that could adversely affect your principal loan amount.

It may sound great to buy a single-family house in the Midwest for $60,000 with rental income of $700 a month, but if your LTVs start out too high and the project goes overbudget or the market dips, you may find yourself underwater and unable to offload the loan or property without a significant principal loss.

Additionally, many financial institutions won’t lend below $100,000, so be sure to have your borrower prequalify their take-out financing if they plan to BRRRR.

Other Preventative Measures

What are reasonable equity buffers? That all depends on the project and loan type as well as your own risk tolerance. Every lender needs to figure out the sweet spot that allows them to be comfortable with the loan and sleep well at night. For example, if you personally prefer to remain within a 30% equity buffer or greater (70% LTV), there are other loan terms you can rely on to provide further protection in the event of default. Here are a few to consider:

• Cross-collateralization // Adding other properties already owned by the borrower can help provide additional equity protection as well as an added incentive for the borrower to perform. After all, nobody wants to lose a property, let alone two or three.
• Rehab or construction holdbacks // If you are funding rehab or construction costs, keeping a portion of those monies back until certain milestones in the project are reached can help ensure the project starts off on the right foot.
• Formal property valuations // A lot of private lenders do “in-house” valuations rather than pay for a third party to complete an appraisal or a BPO (broker’s opinion of value). Having one of these done for the as-is values as well as the after repair value (ARV) can be helpful in shoring up your LTVs and ensuring equity buffers are solid.

If no other collateral exists or you can’t hold back funds for key milestone check-ins, and LTVs are still too high for your taste, strongly consider walking away from the deal. With private money investments, the primary goal should always be return of principal rather than return on investment or ROI. Does it really matter what interest rate you are receiving if the principal amount you lend out could be shorted due to low-equity buffers?

Hopefully, you feel more confident now with the reasons why protective equity buffers are one of the most important ways to protect your private money investment. The goal isn’t to scare you off but to instead give you the full picture of the potential risks you could encounter when you don’t safeguard against the unforeseen.