How to minimize defaults on your investment.
When you invest your money, in most cases, you relinquish a certain amount of control over what happens to it. If you’re invested in the stock market, for example, you are at the mercy of innumerable economic factors and capricious faceless investors. But, what if you could maintain control over the outcome of your investment, or at least trust that the steward of that investment is doing it for you?
If all investments involve risk, the risk in private lending for real estate investment is borrower default. Default results in costly real-estate-owned properties, or REOs. Anyone who has ended up with this kind of distressed asset can attest that they are nothing but a headache—a very expensive headache. Not only are REO properties nonperforming, they incur significant carrying costs.
If you’re a private lender, how do you minimize the likelihood of REOs? The easy answer is you must control the process from start to finish. Here are some tips for doing that.
Underwriting the Loan
The process really starts during loan underwriting, before the first penny is even disbursed. You should have a thorough understanding of the scope of work for any project—right down to the very last nail. A solid underwriting process considers a number of different factors to ensure the proper scope of any project. If the lender doesn’t get this right, the loan is in danger before it even begins.
Every aspect of loan underwriting takes direct aim at the value of the finished property, whether it is a renovation or a new construction home. Your due diligence as a lender is crucial at this stage. Determining the market value or the after-repair value (ARV) of a home is really about whether your borrower can realistically achieve his or her target sale price.
In a perfect world, studying comparable homes in the neighborhood that have recently been sold should begin to give you an estimation of what the property will be worth, but that isn’t where it ends.
Does the borrower’s scope of work achieve a result similar to the other homes in the area you are comparing to? If your comps all have exotic hardwood floors and marble counter tops, but the scope of work for your property states that it will have Pergo and laminate countertops, then you’ll miss the mark by a wide margin. Assuming the borrower’s plan does fit the target home value, does the budget for the project fit the bill? If the borrower finds during the project that they didn’t budget the right amount to afford 30-year shingles and has to downgrade to a lower-quality alternative, they just erased some of the home’s estimated value.
You also have to ensure the borrower is building the right home for the neighborhood. The project has to align with the character of other homes in the immediate vicinity. If it doesn’t, it might prove difficult to sell once it hits the market. In most cases, whether the home is a new construction or a renovation project, you want it to be more attractive to buyers than other homes in the neighborhood. But, if it is so different that it’s out of place, the borrower might struggle to find a buyer.
Knowing the market conditions for a home’s geographical area is also crucial to estimating the after-repair value or the market value of the home. That data can tell you how difficult it might be to sell even an ideal home. The average number of days a home spends on the market, the months of available inventory and the average median home price will all affect the selling price of the home once the project is completed. Since you are essentially forecasting the market a year or more out, you should also be familiar with the trends in these market conditions over time.
Once the loan is made, the lender is committed, so you better have already done your due diligence to the best of your ability. What you can control at this point is the construction process. Your construction control must be on point throughout every step of the development phase. The main objectives of the asset management department are to make sure the project is progressing according to the stated scope of work and to ensure the quality of work that is being done.
Time is money, so the timeline of a construction or renovation project is central to the success of the borrower and, correspondingly, to the lender. In fact, the lack of construction progress is often an early indicator of a looming loan default, so asset management needs to make sure that the project stays on the rails.
Just getting the work done isn’t the only objective. And, usually good enough isn’t good enough. Asset management has a responsibility to hold the borrower accountable for the quality of work and materials laid out in the underwriting process, so the project stays on track to hit the target market value when all is said and done.
There is a stringent and methodical process by which an asset management division controls the construction costs and the progress of any given project. The draw process essentially incentivizes the project operator to produce high-quality work and to adhere to the plan. Once the borrower completes a specific phase of the construction, they’re required to submit a draw request along with their original budget, receipts and lien wavers as proof of completion and to verify that any contractors doing the work were compensated. The latter is to ensure there is no danger of mechanic’s liens being filed on the property. Once the request is submitted, the actual work needs to be verified by a third-party inspector.
Following these steps, the borrower can be reimbursed for the work completed. The construction or renovation of any project should proceed in this fashion to help the lender maintain visibility and to hold the borrower accountable throughout the development phase to avoid any surprises.
Exiting the Loan
It’s important for the borrower to “bake in” the time necessary to market and sell the property. If they followed the plan and budget laid out during the underwriting process, the borrower should be able to come within range of their target profit—assuming they can sell the property relatively quickly. This is where having a thorough understanding of local market conditions is crucial. Since most of the work is done at the beginning of the project, hopefully the borrower will be able to sell the home in the time anticipated and won’t encounter any setbacks. But that’s never guaranteed.
Many things can derail a real estate investment, but there are certain things you can control, which is why you need a firm grasp over what’s involved and clear insight into even the smallest detail of any real estate project. ∞
This is the first in a six-part series of articles that will cover asset management and the disposition of distressed loans. In part two of this series, we will discuss in greater detail collateral monitoring during the loan, the draw process, insurance and taxes.