The most critical component of a real estate investment is a trustworthy private lender. Residential real estate investors need flexible loan terms specific to their objectives. An investor turns to a private lender for need and purpose in today’s market.
Because of the abandonment of lending to the value-add opportunities within the residential asset class by conventional lenders, there has been a slew of private lenders entering the market to compete in this space.
But how can an investor know of the viability of these lenders when the time comes to fund? What is the process of due diligence investors should perform to vet private lenders?
Before delving into these interesting and pertinent questions, this article will explain the workings and focus of a private lender in the value-add space.
Key takeaways
- Private money lenders look to invest in value-add opportunities over the short term.
- Loans funded with private money are the alternatives to conventional loans for fix-and-flip, value-add, and single-family rental homes.
- Private lenders will work with a borrower to determine a loan program specific to the deal.
- Private lenders underwrite a deal from the after-repair value.
- Private lenders should be vetted by investors asking for referrals, creating a pitch deck for the deal, and reviewing past transactions the lender has closed.
The Private Money Lender
Private investors fund a private money lender to lend on value-add opportunities in the residential space over the short term.
A private lender is funded with private capital, even including institutional money like banks, credit unions, and life insurance companies of late.
Because of more lenient regulations and rules imposed on private lending than bank lenders, a private lender can be flexible in its terms, close quickly, and underwrite to a future value.
A private lender generates its returns like a conventional lender. Profits and ROI are created from the interest rate and the fees applied to the loan.
The lender wants to work directly with the borrower from application through closing, even with a preferred broker program in place.
The approval process will be faster, and the borrower’s creditworthiness will be evaluated by considering many factors holistically.
In other words, the loan terms will be based on the combination of both the borrower’s and property’s profiles. For example, if the borrower’s credit is low but liquidity and experience are excellent, the deficient item can be offset with other strong compensating factors.
By the same token, the property’s high enough profitability emanating from the after-repair value can be also helpful in overcoming some weaknesses. This is the quintessential common-sense, flexible underwriting.
The trade-off is the higher interest rate and fees than what would have been quoted by a conventional lender had it been willing to fund.
A private lender is willing to assume the risk of relaxed qualification standards and the after-repair value; hence, the higher rate and fees.
The Need for a Private Money Lender
The use of private money by investors with the fix-and-flip or rental objective has become the best option to access capital. The reasons for investors to seek private money include the:
- Easier qualification process
- Faster closing schedule with less paperwork
- Next-best alternative to a cash deal, and
- Willingness to close multiple deals simultaneously
The Trustworthy Private Lender
Business is based upon relationships. The relationship built between a private lender and a borrower who proves its capability of creating value and satisfying the loan according to the terms will make for an easier path to future deals.
A private lender that is reliable and trustworthy can be hard to find because of the lack of name recognition and branding. Although private lenders are now making a more significant effort to market their brand, these lenders still significantly depend upon referrals and the luck of an internet search.
Time will strengthen the position and the perception of private lenders in the investment sector. For now, investors seeking private capital will need to perform their due diligence. Below are actions an investor can take when seeking a trustworthy private lender.
1. Understand the Private Loan
The due diligence process will be more straightforward if the investor views their deal through the eyes of a private lender. Unlike conventional lenders that must adhere to federally-mandated standards, a private lender underwrites deals on their criteria.
Through the process, a private lender will want to know:
- The property’s present and future value
- The predicted rewards against the risk of the value-add component
- If the potential returns will outweigh the risks of creating value
- If the market can support the end value, and
- If it will receive the returns of and on its investment under the loan terms
2. Create Your Network Around Private Lenders
The network of real estate investing is a relatively closed loop. While there are many opportunities, the number of those participating successfully in this sector is small. This includes private lenders.
A good reputation and the proven ability to fund and close are everything to a lender’s reputation.
An investor needs to use its network of other investors and contacts like:
- Insurance brokers
- Mortgage brokers
- Appraisers
- Title companies
- Real estate agents who represent investors, and
- Conventional lenders who could not place the value-add opportunity but want to save the banking relationship
Word-of-mouth is a powerful marketing tool that either solidifies or destroys the credibility of a private lender.
3. Create a Pitch Deck for Your Deal
A private lender has an objective the same as a conventional lender—an understanding of what the deal is, how it works, and when the returns of and on the investment will be realized.
The investor can answer these questions and give the private lender comfort with the deal by creating a pitch deck or a deal book.
The information to present needs to include:
A. Transaction Summary
The summary needs to include the purchase price, scope and costs of the renovation work, after-repair value, market comps to support the future value, and the projected return on the investment.
B. Resumes of the Investment Team
The investor’s team members are its business partners, general contractor, insurance agent, and the title company or the law firm handling the closing.
C. Purchase Contract
Any lender will want confirmation that the property is under contract with its potential borrower. A summary of the pertinent terms of the contract is better than attaching the entire contract without any explanation. The pitch deck’s pertinent terms must include the end date of any contingency periods, deposit amount, property location and address, and the intended closing date.
D. Visuals
Photos, videos, floor plans, site plans, and any other visuals to aid the private lender in understanding the collateral.
The lender will appreciate the thoroughness of a pitch deck. This will solidify the professionalism
of the investor and evidence of their understanding of the lender’s view.
4. Narrowing the List
Establishing a relationship works both ways. The investor and the private lender want comfort with each other and the deal. The professional presentation of the pitch deck at the initial meeting will set the tone by which any future relationship will proceed.
Each party’s comfort and professional handling will create the willingness to move forward. The tone and the interactions during the initial meeting will lead to a term sheet for the potential loan structure.
Then, it will be a matter of evaluating the term sheets for acceptance.
How to Vet a Private Lender
An investor needs to know that the private lender has the capital to fund and be the best choice to bring the deal to a closing. The lender needs to be suitable for both the investor and the deal.
Below is a checklist of the fundamentals for vetting a private lender. The ultimate goal should be to find a relational lender, not a transactional one.
- Request references
- Ask about past transactions that have closed
- Verify licensure if applicable
- Understand how the private lender is funded
- Understand how the funds will be released, and
- Study and take the time to run the numbers of each term sheet to know the required equity amount and the cash-on-cash return
- Most importantly, focus on whether the lender genuinely cares to get to know you, your investment goals, and needs so the right lending option can be tailored to your situation
Conclusion
It is the responsibility of the investor to perform due diligence on private lenders, as the lenders perform their due diligence on the investor.
Even though private lenders underwrite the merits of the transaction, the comfort in a potential borrower’s professionalism and credibility are factors in the measurement of risk.
The time and effort taken to vet a private lender will prove the worthiest of investments made in the deal.
