When the Equity Is There but the Financing Isn't, What Are the Options?

Question

I keep seeing a particular problem with otherwise viable real estate deals, and I'm interested in how other investors are solving it.

The property has substantial equity, sometimes hundreds of thousands of dollars, but the owner can't access it.

The bank says no. DSCR doesn't work. A hard-money lender declines it. Another private lender isn't comfortable with the property, borrower, location, construction status or exit.

Then there are the underwriting requirements themselves.

Many investor and rehab financing programs look at some combination of:

• Credit score• Cash reserves• Liquidity• Prior investment experience• Completed flips or rehab projects• Debt service• Construction experience• Existing leverage• Exit strategy

Some programs also want to see a documented track record of completed investment properties or flips. An investor with limited experience, damaged credit or depleted reserves can therefore have difficulty qualifying even when substantial equity remains in the property.

That's where I think this problem becomes particularly interesting.

Consider this example:

Current property value: $1.5MExisting debt/liens: $650KRemaining rehab: $225KEstimated stabilized value: $1.9M

There appears to be substantial underlying equity.

But suppose the investor has already deployed most of their available cash into the project.

The construction budget runs short.

Work slows down.

Then it stops.

The owner approaches another lender, but now the lender wants reserves the investor no longer has, a credit profile that may have deteriorated, or a stronger track record than the investor can demonstrate.

The investor becomes caught in a difficult cycle:

The property needs capital to reach its value, but the problems created by running short of capital make obtaining additional financing increasingly difficult.

Meanwhile, the underlying asset doesn't stop deteriorating just because financing stopped.

Contractors and tradespeople may still be owed money.

Potential mechanic's liens can become another problem.

Taxes, insurance, utilities and existing debt continue.

And if the existing hard-money or private loan goes into payment default, the economics can deteriorate even faster.

Depending upon the loan documents, a default can trigger a substantially higher default interest rate, late charges, legal expenses, servicing costs and other contractual remedies. In some transactions, the default rate can be dramatically higher than the original contract rate and can continue accruing until the default is cured or the obligation is otherwise resolved.

That creates another serious problem:

The investor isn't simply unable to access the equity. The cost of the existing capital may now be actively consuming it.

For example, an investor may have originally underwritten the project assuming a certain interest expense and completion timeline. Once the project stalls and the loan defaults, those assumptions can become obsolete.

Every additional month can potentially mean:

• Higher interest accrual• Default interest• Late charges• Legal or collection expenses• Additional carrying costs• Unpaid contractor obligations• Potential liens• Taxes and insurance• Property deterioration• Permit and approval deadlines• Lost rental income• Delayed stabilization• Delayed sale or refinance

What originally looked like a temporary $100K or $200K capital shortfall can therefore become a much larger problem.

And the money required to resolve those accumulating obligations ultimately comes from somewhere.

In many cases, it comes directly out of the property's anticipated equity.

An unfinished property can also suffer weather exposure, vandalism or deferred maintenance.

Permits and approvals can approach expiration.

Contractors move to other jobs.

Materials can sit unfinished.

The projected completion date gets pushed further out.

And every additional month can consume more of the equity the investor is trying to protect.

At some point this becomes more than a financing problem.

It becomes a time problem and an equity-preservation problem.

There's also a human side to it that I don't think gets discussed enough.

An investor who originally believed they had a viable project can become increasingly discouraged as lender after lender declines the deal while expenses continue accumulating.

They're sitting on substantial property equity but can't convert that equity into the capital necessary to solve the problem.

Pressure from lenders, contractors, tradespeople, taxes, carrying costs and unfinished construction continues building.

If the existing loan is also accruing default interest and additional charges, the investor can literally watch anticipated equity disappear month after month while still owning an asset that may have substantial underlying value.

Eventually the owner may start making decisions based on immediate pressure rather than the property's underlying economics.

That can lead to the worst possible outcome:

Selling a fundamentally viable property in an unfinished or distressed condition simply because the owner has run out of time and alternatives.

A property with substantial potential equity can then be sold at a major discount, transferring much of that upside from the distressed owner to the next investor.

So here's the question I've been thinking about:

What do you do when the equity is clearly there, but the investor can't satisfy the conventional prerequisites required to access it?

Do you keep searching for another lender?

Bring in private capital?

Structure a JV?

Bring in an experienced operating partner?

Sell an equity interest?

Recapitalize the project?

Restructure ownership?

Or sell before the situation deteriorates further?

I'm particularly interested in hearing from investors who have dealt with:

• Stalled rehabs• Incomplete construction• Budget overruns• Depleted reserves• Below-market multifamily rents• Poor current DSCR• Maturing or defaulted hard-money debt• Default interest and accumulating lender charges• Limited investment track record• Credit deterioration during a project• Contractor or tradesperson obligations• Properties needing additional capital before becoming conventionally financeable

At what point do you stop treating this as a lending problem and start treating it as an equity and capital-structure problem?

And if you were considering bringing capital or expertise into a situation like this:

What minimum equity cushion, project completion percentage and exit margin would you want before taking on the execution risk?

Javi Talamantes · Answer

Erik, I appreciate the perspective, especially coming from someone on the lending side.

I agree that selling and taking the remaining equity should absolutely be considered, and a traditional JV can make sense when the economics support it.

The specific gap I'm looking at is a little narrower. I'm interested in situations where the underlying project still has sufficient equity and a viable completion/exit strategy, but the investor has reached a point where traditional financing, DSCR, hard money or additional leverage either isn't available or doesn't solve the problem.

Instead of automatically forcing an as-is sale, the question we're exploring is whether a properly structured capital partner can step in, provide the capital and controls necessary to complete the project, and allow the existing investor an opportunity to participate in the remaining upside.

Given your lending background, I'd actually be interested in your perspective: where do you see the line where a deal stops being financeable but still remains economically viable?

That's really the gap we're trying to identify.

Dan H. · Answer

>I'm interested in situations where the underlying project still has sufficient equity and a viable completion/exit strategy, but the investor has reached a point where traditional financing, DSCR, hard money or additional leverage either isn't available or doesn't solve the problem.

I question if the analysis of sufficient equity and viable completion/exit strategy is accurate.   The reality is somehow the project got into this state.   This likely indicates that the effort has not performed to underwriting?   Why would anyone think the underwriting going forward would be accurate.

About a month ago I was asked to consult on a project gone bad that likely was the result of fraud by one of the partners (there is a BP thread on this Sacramento effort, D St).    I question if the effort was ever viable.   The initial rehab quote was not realistic.   There were multiple investors who still believed this could be saved and some of those still believed the initial underwriting (even though their subsequent quotes showed the rebab cost to be about double the initial, bogus rehab estimate.   My point is investors often see what they want to see.   It is not unusual for the. Investors to believe a project is still viable or works financially when it likely does not.

Please do careful and conservative underwriting.   Do not put yourself in the position of being out of money with no viable solution except exiting at a discount (often a loss).   Do not work for free.   Do not pay to work.

Good luck

Dominic Mazzarella · Answer

I think the big question is whether the equity is still real after default interest, liens, carry costs, and a realistic completion budget. If someone is bringing in new capital at that point, they probably need real control over the budget, contractors, timeline, and exit, because the margin for another mistake is usually pretty thin.

Erik Estrada · Answer

These scenarios come from to time and it is usually the same story..

The owner over leveraged and underestimated the cost of the rehab. It is very common for first time investors to go through this difficult learning curve.

I think the easiest path forward is selling and capturing the "equity" and taking it as a learning lesson or presenting it to a JV partner and sharing the upside if the deal actually makes sense.