Evaluating a Potential Loan: My Plans

In the previous post I discussed your exit plan. If it is credible I may decide to proceed and fund your project. Even if I am skeptical about your plan I may be willing to move forward. (There are ways to structure deals which may lower the risk in your project to a level which I am willing to incur). It is now time for me to discuss my exit plan

Most of the time my exit plan is the same as yours. I loan you the funds and you pay me back (with interest) either with periodic payments, with a balloon payment at the completion of the deal or with a combination of these. Oftentimes private lenders structure equity deals where they are paid with a percentage of the profits though, to date, I have not structured a deal like this. (A deal where the borrower pays interest is a debt deal. A deal where the profit is shared is an equity deal.)

What if you don’t pay? What if you can’t? The equity in your deal is my collateral. Remember the mortgage you recorded with the County clerk when you took the loan? Did you read it? That mortgage gives the lender the right to take possession of your property if you don’t comply with the terms of the loan. Actually, the mortgage is a public declaration by you saying that the property belongs to the lender and that you may use it if you comply with all the terms of the promissory note which accompanies the mortgage. In a foreclosure the lender is simply taking back their property. It was purchased with their money. Foreclosure is one of my backup exit strategies. (There are other exit strategies. Loans can be restructured but that is up to the lender. The lender may not be in a position where they can afford to restructure the loan even if the need arises. Also, if the relationship between the borrower and lender has deteriorated the lender may not want to extend it).

I must also evaluate the real estate that secures the loan. Is it valuable? Would I want to own it? Does it complement my existing portfolio? I have made loans on property that I would not want to own under any circumstances. Why? The borrower was experienced with a record of completing several deals similar to the one I funded. She had a well thought out exit plan and a good backup plan. Also, the purchase price was so good that the loan amount was considerably less than the value of the property. I would have a reasonable chance of recovering all of the money loaned on the property if I had to foreclose and sell the property. Finally, the investor compensated me generously for the added risk.

I have also made loans on property that I would be happy to own and operate as rental property. n these cases I was willing to offer better terms for the loan. The loans required fewer or no upfront points, lower interest rates and I was willing to fund a greater amount of the value of the property (a higher loan to value ratio). In some cases I loaned the entire purchase and rehab cost. The worst case scenario for me in a deal like this is that the borrower would pay as agreed. I would actually expect to earn more if I had to foreclose and take possession of the property.

My Plans: This is the part of the equation that you can’t control. Even if you have excellent credit and a good deal I may not be in a position to fund your deal. My funds may simply be deployed elsewhere. You may be looking for a long term commitment when I am only lending on short term projects. I may have other projects to consider that are more profitable than yours. Your project may be a bit too risky for me. I may have a project of my own that I am working on.

So, how do I evaluate a deal? I consider the borrower’s credit and their deal and see if they match my plans. I don’t have fixed criteria though I do have loose target yields that I try to achieve. I evaluate each deal individually. If I have known you and we have done business before I may reach a decision to fund your deal during a 5 minute phone call. This has actually happened several times. The terms will depend upon the type of deal you are presenting, how closely it complements my situation and how risky it is. Of course, I seek to fund deals that give me the highest returns for the risks involved. I prefer to keep my money working but am much more concerned with making a secured investment than maximizing yield. I do not need to make any loans and will not unless I find a situation that meets my goals.

The ideal situation has a well thought out business plan presented clearly and thoroughly by an experienced investor (who has documented that experience and who has completed several similar deals) on a property that is located in an area I know well and that I would be happy to own if the investor cannot perform their obligations. I have not yet found an ideal situation. The threshold to convince me to fund a deal is harder to reach if we have not done a deal before but it is most definitely achievable. I have funded a bit over three dozen deals during the past three years and approximately one dozen have been first deals between the borrower and I.

I am finishing writing this the evening before I plan to post it and a few hours ago I reached an agreement on terms to fund a deal for an investor whom I have not done business with before. Maybe I’ll share some details of this deal in a future post but, honestly, if you have read some of my previous blog entries you already know a good many of the details of this deal and how it came to my attention. Find a good deal, present it honestly, allow your business partner a fair return and you will find funding.