With all the recent turbulence in the private lending world, we thought we’d offer some insights into essentials to consider before lending your hard earned money to a potential borrower, providing a Private Lending Checklist to ensure a secure investment.
You might be looking for dependable monthly income in your retirement account or diversifying your investment portfolio. Whatever your reasons for becoming a lender, there are three fundamental elements to every investment: the borrower, the real estate, and paperwork (promissory note and lien).
1. Know Your Borrower
I’m putting this first because – in my opinion and experience it’s the most important element of private lending.
If you’re going to lose money in this game, then it will most likely be because your borrower screws up.
The instances in which I have seen people (myself included) lose money as a private lender, has been as a result of either incompetence, dishonesty or plain bad luck on the part of the borrower.
You might think; credit score, background check or job history might be among the most important things to check out first?
Well, those things are important, but in the world of private lending, there are other more important things to consider.
Here’s 3 things to look out for in a potential Borrower.
a. Working Relationship & Communication
Many people make their first loan to someone they already know. For example; a family member, friend or business colleague.
But to find the best deals and the best Borrowers to work with, you will most likely have to look outside of your existing circle of contacts.
If they are serious real estate investor, chances are that your investment with your Borrower won’t be a ‘one-off”. They will want to maximize the potential of your relationship as much as you do.
With this in mind, it is important to have a good working relationship and an open line of communication. This becomes especially important if things don’t go to plan!
You need to know that your Borrower is prepared to pick up the phone and communicate the good, bad and ugly as the project progresses. In fact, have something in your agreement in regards to frequency of communication.
There is nothing worse than receiving bad news out of the blue!
b. Real Estate Investing Experience
There really is no substitute for experience.
Establishing the operational credibility of your Borrower is extremely important for both parties. After all, they’re doing the dirty work, whilst you are just the bank.
An investment that looks great on paper can run into all sorts of problems along the way. That could seriously impact your Borrower’s ability to repay, or sink the project entirely.
Their experience will often be the thing that pulls them through.
At the end of the day, you want your borrower to be experienced and agile enough to adapt to, and overcome, the practical problems one encounters in the day to day course of real estate investing
c. Financial and General Stability
As a responsible private lender, you want to get a handle on the general and financial stability of your Borrower.
Just like with real estate note investing, asset-based lending of this nature relies heavily on the value and/or income of the underlying real estate as security. But you also want to be sure that your Borrower treats credit with respect, keeps to their commitments, isn’t overrun with debt, and isn’t harbouring any other issues that might impact your investment.
A Credit Score is a good place to start, but it certainly isn’t the be all and end all. I know plenty of lenders that do not pull credit scores in their private lending decisions.
Also another useful tool is often a background check. If someone has a litany of DUI’s, anti-social behaviour offences, theft or fraud on their record, they could have issues that might well turn up to impact your investment!
2. Understanding The Real Estate Investment
As a private lender, the real estate acts as sole security for your investment. You are relying on the value of the asset to repay the debt, regardless of whether it is to be sold or refinanced.
There are few things you need to know that will be helpful in making your decision to lend or not:
Purchase Metrics
This includes; purchase price, closing costs and incidentals, and includes any liens being settled as part of the purchase such as mechanics liens or tax liens.
Some of this you will find in your initial review of the purchase contract, but a copy of the land titles statement tells you everything you need to know, so make sure you get a copy before closing.
Title Insurance
The last thing you need as a Lender is to end up entangled in title issues.
Make sure there is appropriate title insurance in place at the point of acquisition/funding to protect your investment.
Also check that the property is conveyed properly with clean title through an appropriate closing company or attorney.
Current As Is Value
Whether it’s a fix and flip, long term rental or whatever, you need to know the current disposition value of the property before any after renovation work takes place.
If for some reason the project does not get off the ground and you have to foreclose early on (or midway through construction), then you might well be relying on the proceeds of a sale of the property in its current condition to recoup your money.
A brokers price opinion (BPO) or appraisal will tell you what you need to know, but so will conversation with a friendly local Realtor or two. Do not rely on online listing platforms like realtor.ca, Zillow or Trulia.
After Repair Value & Rents
This is crucial. You need to know what the property will be worth once rehab is complete.
This is a key metric is ascertaining risk. It tells you your loan-to-value and investment-to-value once the Borrower has completed any physical rehab work.
If the plan is to rent the property, you also want to know what market rent is, ensuring that the asset is capable of generating sufficient income to service interest payments on your loan. Don’t base it off the borrowers opinion, actually research what the market rent is in that area.
This is called a debt service coverage ratio.
Detailed Scope of Work
This will tell you exactly what will be done to the property to force up its value to meet its after-repair value.
Ideally, your Borrower will provide an itemized and costed quote from the contractor that will be doing the work.
This is another key piece of information you can use in assessing the overall risk of providing a private money loan.
Exit Strategy
It’s important to know that your Borrower has a plan.
Will this be a fix and flip, a long term rental or something else?
How and when does the Borrower plan to exit the investment and pay you out?
This could be via a sale of the home on the retail market, or refinance of your loan with a traditional mortgage.
Either way, you need to feel confident that it is realistic for the Borrower to repay the loan in full at maturity by one means or another.
Loss Payee Cover
Make sure you are named as Loss Payee on the Borrower’s buildings insurance policy. That means you are paid out first in the case of a total loss of the property.
3. The Promissory Note
Now into the technical part of your private lending investment, and the first thing to look at is the promissory note.
The note is the contract between you and your Borrower. There are a ton of templates online, but you really should speak to a real estate attorney and have specific terms drawn up that suit you.
Here’s what every note should contain as a bare minimum:
- Details of the Borrower and Lender
- Loan Amount
- Interest Rate
- Payment Terms
- Dollar amount of monthly payments
- Term in months
- Maturity Date
- Late Charges
- Details of the Associated Mortgage or Loan Registration
- Reference to the Security/Collateral
- What Happens if the Borrower Defaults
- Governing Law (e.g. Ontario)
Obviously this list is not exhaustive. But, for the most part your note should be clear, concise, and contain the relevant legal language that will lay out the terms of the loan and the responsibilities & liabilities of both Borrower and Lender.
Again, do not rely on a template for this. Have a lawyer review your loan paperwork for you. You can always reuse and repurpose the same documents for the next deal with any amendments that might be necessary.
4. The Lien
The last piece in our private lending puzzle – for the purposes of this checklist at least – is your lien.
There are a number of things to consider here. All liens are not created equal, and as this instrument acts as the security for your investment you need to make sure you understand it.
You will have either a mortgage lien, or deed of trust depending on which country/Province or State the property is located in.
There are broadly two things to consider; the position, and the priority of your lien. These might sound like they are the same thing, but they are not.
You may have a 1st position lien, but there are other liens that can be recorded before or after funding your loan that can still take priority over you in the case of a sale or foreclosure.
I have seen this type of thing sink more than one real estate project, taking down the private lender with it!
Lien Position
You will have either1st position or 2nd position lien recorded against the title of the property in the city records.
A first position lien will usually take priority over all other liens in the case of a foreclosure. As a private lender you always want to be in 1st position as 2nd position liens carry much more risk.
Lien Priority
This can be tricky. There are certain types of lien; such as a property tax lien, or some types of contractor’s (mechanic’s) liens, that would take priority over your 1st position lien in a foreclosure, even if they were recorded after your lien.
Again, working with an experienced and competent borrower is key. If they don’t keep up their property taxes for example, that could end up coming out of your pocket.
Also, making sure you close your loan through an notary or attorney who completes full title work is essential.
Conclusion
As I mentioned right at the start of this post, private lending can be a great way to invest in real estate. But, there is a lot to consider, and we have seen plenty of people lose money because they skipped some of the fundamental basics that I have included here in this private lending checklist.
If you want add passive monthly income to your portfolio, make sure that – over and above anything else – you do your due diligence on the borrower and their project.
While real estate and the plan certainly matter, you are reliant upon the borrower to execute their game plan, choose the right property, carry out the rehab, and market the property for sale or rent, or obtain a refinance loan to get you paid out in full and on time.
