Every successful real estate investor must rely on access to capital with an efficient underwriting process. Since the abandonment by conventional lenders (banks) of financing the value-add opportunities sought by investors, private lenders have stepped in to fill this funding gap.
The streamlined underwriting process of private lenders enables investors to buy and sell their projects at competitive prices to maximize profit. For the investor, it is all about timing. There is no room for delays in closing the acquisition loan and offering the project to the market for sale at the optimum price.
Time is not a friend to the real estate investor.
Key Takeaways
- The business plan of a private lender matches that of an investor with a fix-and-flip objective
- A private lender will lend on the renovation costs
- A private lender factors the after-repair value (“ARV”) into underwriting
- The cash-on-cash return to the investor is higher with a private loan over the short term
- There is a time and place for private and conventional lenders in the investment sector
What is Private Lending?
A private lender extends loans to investment opportunities that would be hard to meet the requirements of a bank. These loans are typically referred to in the lending industry as “hard money” loans. Please see our blog on Hard Money Lender vs Private Lender for a detailed comparison.
A loan funded with private money is for the short term with real estate property pledged as collateral. The business plan of a private lender fits well with the plan of an investor with the fix-and-flip objective—getting into and out of projects for a profit over the short term. The average hold period is 9 months.
Private lenders understand the investors’ need for flexible requirements, and these terms can be offered without adherence to federally mandated standards and ratios. These flexible requirements can include:
- Higher leverage
- Relaxed credit minimum
- Relaxed income requirement (cash liquidity considered), and
- Interest-only payments during the term (also interest payment on disbursed amounts only)
The loan-to-value ratios of a private lender will depend upon the lender’s ability to gain comfort and understanding of how the investor intends to create the future value.
A private lender will apply the after-repair value to a potential loan, as would an investor when identifying an opportunity. Both parties look to the future value in conjunction with the as-is present value.
What is Conventional Lending?
Conventional loans are offered by banks, credit unions, and mortgage companies, with stringent requirements that must be met to adhere to federally mandated standards. These loans will have a lower interest rate, but the income and credit requirements can disqualify many investors.
The qualifications of conventional lenders are stellar credit, high W-2 earnings, and collateral that is stable with the value in place. These lenders look to the financial position and the credibility of a potential borrower before even underwriting the collateral.
Under this structure, an investor would need not only to qualify but self-fund the costs of renovation and the equity needed on a lower LTV ratio.
Aside from the qualifications and leverage, investors do not have the luxury of time when a property is under contract. Investors cannot afford the red-tape, slow-paced approval process of a conventional lender.
Misconceptions of Private Lenders
Unfortunately, there is a misconception of private lending at higher rates to predatory lending. While the interest rates offered by a private lender will be higher, investors and critics cannot overlook the benefits of the:
- Quick access to capital
- Flexible loan terms, and
- Higher leverage ratio on future value.
1. Quick Access to Capital
In the sector of real estate investment, one cannot place a value on time. In private lending, the time between application, approval, and closing can be within 7-10 days. This benefit is priceless in a competitive market. Private lenders are the next best alternative to an all-cash offer.
2. Flexible Loan Terms
Simply put, a private money loan is a collateral loan based upon a property’s value potential to generate a higher profit in the future. The approach taken by a private lender in its measurement of risk is entrepreneurial and holistic. A private lender is willing to work with an investor to create a loan structure to make the investment work.
3. Lending on Future Value
The term used by private lenders when underwriting a fix-and-flip deal is the “after-repair” value. The loan ratio is based upon the value created at the completion of the renovation scope as opposed to the purchase price only.
The cost of the property is adjusted upward when improvements are considered. These improvements can be the addition of square footage, modernizing a floor plan, or upgrading the systems and appliances. This approach gives the investor a distinct advantage over the standards of a conventional loan.
The Cost-Benefit Analysis
So, let’s now put the loan terms of a private loan against those of a conventional loan to compare the net profits and the cash-on-cash returns to the investor.
The example below will compare a bank loan at 6% at a 70% Loan-to-Cost/Value against that of a private loan at 12% at an 75% Loan-to-Cost/Value (the determinant of Initial Loan Amount) and 65% Loan-to-ARV (i.e. the determinant of Total Loan Amount) with the inclusion of the renovation costs.
As an example: An investor locates a property in an older, but stable, area for $600,000. The investor knows that, with the investment of $200,000 for upgrades, the property will sell for $1,000,000 over a 6-month hold.
An investor seeks a conventional loan, assuming a bank will approve the collateral, because of the lower interest rate and carrying costs. However, the investor decides to seek a term sheet from a private lender for comparison purposes.
Below is the side-by-side comparison with the variables given above.
| Conventional Loan | Private Loan | ||
| Initial Loan Amount | $420,000 | $450,000 | |
| Investor Equity (Down payment) | 180,000 | 150,000 | |
| Total Stack | $600,000 | $600,000 | |
| Renovation Costs (Out of Pocket) | $200,000 | ||
| Renovation Costs (Loan Draws) | $200,000 | renovation costs in loan | |
| Debt Service | $12,600 | $39,000* | interest only; 6 months |
| Total Investor Cash | $392,600 | $189,000 | equity, renovation, debt service |
| Sale Price | $1,000,000 | $1,000,000 | |
| Closing Costs | (20,000) | (20,000) | 2% |
| Satisfaction of Loan | (420,000) | (650,000) | |
| Net Proceeds | $ 560,000 | $ 330,000 | |
| Debt Service | (12,600) | (39,000)* | |
| Recoup of Equity | (392,600) | (189,000) | |
| Net Profit | $ 154,800 | $ 102,000 | |
| Cash-On-Cash Return | 39% | 54% | Net Profit/Equity |
* Debt service is calculated based on the full loan amount for the ease of the demonstration
From this simple comparison, even with the higher rate and carrying costs, the investor’s cash-on-cash return is higher with nearly 50% less cash in under the terms offered by the private lender.
Also Read; How to Find the Trustworthy Private Lenders in Today’s Market
The Bottom Line
A conventional loan will work better for investors with the objective of a long-term hold for cash flow. Under this objective, an investor would acquire the property and perform the renovation work with private money.
The private loan would then be refinanced with a conventional loan at a lower rate and carrying costs over a longer hold period.
In the sector of real estate investment, there is a time and place for both private and conventional lenders. Investors need to take the time for a side-by-side comparison of both loan structures through the renovation period without the sole focus on the higher rate quoted by private lenders.
