In Part 1 of our series, we introduced private money lending and in Part 2 of our series, we saw how hard money lending works. Let’s continue by taking a look at the underwriting aspect of hard money loans.
Underwriting includes all the analysis necessary to confirm valuation, income, property condition and the borrower’s capacity to execute on its repayment strategy. This might sound similar to the underwriting process of a bank for a bank loan but in reality, underwriting private money loans is a completely different process than underwriting traditional loans.
In the private money world – neither two transactions, nor two investors are alike. Most hard money mortgages are made by private, non-institutional investors, predominantly “individuals” whom retain the loan and service the note. Each individual lender sets economic, demographic, and geographic criteria (generally lending in their local areas). The loans private individuals are willing to invest in will vary based on what they are comfortable with. Because each investor and each trust deed transaction is different, the underwriting process for trust deeds is highly individualized.
Perhaps the most unique trait of private money lending is the methodology of underwriting: manual vs. automated. Mainstream plain vanilla loans can be easily processed in an assembly line fashion because institutional and conventional lenders utilize a fixed procedure and a cookie cutter method – an automated underwriting system, thus shifting a lot of the responsibility for lending decisions to the secondary marketing agencies. Private money lending on the other hand, is person oriented, not process oriented and requires a manual approach to underwriting, a “human touch” that cannot be easily automated.
Unlike the conventional mortgage industry, there is no formalized private mortgage marketplace, no secondary market, no securitization, and there are no government organizations (FHLMC/FNMA/FHA/VA/USDA) that establish uniform guidelines. In essence, private lending–or “hard-money” lending as it has come to be known—lacks uniform underwriting guidelines.
Because there is no government or other entity to establish guidelines for each lender to follow within the private lending market, there is much more flexibility in the process. But that doesn’t mean there aren’t certain core factors that each lender looks to satisfy when underwriting a loan.
Central to the human element intrinsic of private money underwriting are the following core factors lenders evaluate when considering a loan:
- Collateral (security – property)
- Capacity (ability to pay) – the borrower’s ability to repay the loan
- Character (willingness to repay)
- Credit (credit score and credit history)
- Story (The story that gave rise to the need for the loan.)
- Exit Strategy (A realistic detail of how the loan will be paid off at maturity.)
Private money investors consider the underlying collateral securing the loan as the primary and most important factor for each loan. All other criteria (creditworthiness, exit strategy, etc.) are secondary to this primary factor. Albeit, there was a time when the property was the sole consideration to securing a loan and though there remain a few “pure equity” players (lenders who’s underwriting & lending decisions are solely based upon the strength of the collateral), in today’s economy the property you present to the trust deed investor is the primary source of collateral in the loan.
In reviewing the collateral, the lender will evaluate:
- Protective Equity – In any investment, intrinsic hedges help to reduce risk. Protective equity is a hedge within a trust deed investment that provides the cushion for the risk taken in extending a loan. The amount of protective equity in the property provides protection to the investor against payment defaults, market fluctuations and property devaluation and ensures that sufficient protective equity remains to pay the total amount owed to the investor, including all fees, costs, and expenses incurred in processing the foreclosure and/or in responding to a federal bankruptcy petition or state court action (e.g., legal fees, costs, and expenses). Protective equity is calculated by taking the liquidated value of the property a.k.a quick sale value (the price at which the property could be sold quickly, usually ninety days), and then subtracting any outstanding debt related to the property in the form of existing loans or tax liens on the property. Since the amount of protective equity directly relates to the security of the Trust Deed, it is fair to say that the primary risk to the investor relies on the amount of protective equity remaining in the property.
- Loan to Value (“LTV”) ratio. The ratio, established by the lender, is expressed as a percentage of the appraised value of the property or quick sale value. It represents the maximum loan amount that the lender will consider and determines how risky it makes the loan. Obviously, the lower the loan amount is to the value of the property, the more equity there is to protect the lender in the event of default. This can result in a favorable loan determination. Each lender has its own loan to value limit.
- Marketability – The likelihood that something will sell; Lenders also review the property to find out how marketable it is. This helps determine how probable it is that the property can sell based on its location, size upkeep and more.
- Salability. The probability of selling property at a specific time, price, and terms.
- Condition (Physical)
- New/Unused – Property which is in new condition or unused condition and can be used immediately without modifications or repairs.
- Usable – Property which shows some wear, but is habitable without significant repair.
- Repairable – Property which is unusable in its current condition but can be economically repaired.
- Salvage – Property which has value in excess of its basic material content, but repair or rehabilitation is impractical and/or uneconomical.
- Scrap – Property which has no value except for its basic material content.
a. Local to investor – Some investors like to physically inspect the properties they’re lending against and will typically lend in the areas they are personally familiar with.
b. Major Markets, Metropolitan Statistical Areas (MSA), Infill, Urban locations are preferred to rural or remote locations.
c. Prime Locations-Waterfront, Resort, in the middle of a major city, in a high end development/neighborhood.
- Quality Control: Collateral located within an area that has been designated as a significantly blighted area or located within an area that is considered to be a high crime area, where the likelihood of vandalism to the collateral would be significantly magnified as compared to a more predictable, lower crime area or on any collateral which has current or past environmental issues or structural integrity issues.
- Risk Factors like market price stagnation or other unexpected market factors.
There is no formula for determining creditworthiness. While traditional bank lenders refer to the “Four Cs” of lending (Credit, Capacity, Collateral, and Character) hard money lenders reduce credit worthiness to “Three Cs” of private money lending: Capacity, Character and Credit. Hard Money lending uses the same rigorous credit assessment principles, but applies them to situations in which the lender must rely on borrower character and capacity.
The first step in underwriting is for the borrower to be vetted by an independent intermediary known as a Trust Deed Investment Company (TDIC). The loan application and the first meeting with the borrower are the first screen of whether a borrower is a potential candidate for a hard money loan. The TDIC must assemble and evaluate information and then determine what the entire picture looks like. Beginning with the first meeting, the lender must evaluate the quality of the deal, the fit with the borrower’s experience and capacity, and whether the financing amount and structure is appropriate. First, the TDIC will look at the borrower’s income history and assets to make sure he or she is capable of meeting the terms of the loan and making payments.
Next, the borrower’s debts and credit report will be reviewed. Although hard money underwriters and lenders place a higher risk-hedging value on the equity in the property than they do the fiscal resources of the borrower but that doesn’t mean you can get out of this without proving that you have an income that could be reasonably expected to pay the loan. Remember, in some cases it is not legal to loan money for a real estate transaction to someone who does not demonstrate an ability to pay it back – such as primary residences where it is actually illegal to make a loan to someone who does not demonstrate the ability or capacity to make payments.
Chances are there is a reason why a borrower is seeking financing through a private, hard money lender rather than a conventional lending institution. In trying to figure out the reasons for the loan, what the borrower is trying to accomplish as well as the intent for repayment, the lender will take a look at the full picture – the story behind why conventional lending doesn’t work.
Behind-the-scenes ‘Story’ board:
- Basics on the Principal(s) in the transaction.
- Life events that have led to both successes and failure.
- What led to the borrower’s current situation?
- Location and Character of the underlying property.
- Current Status of the Real Estate and/or Project.
- How long does the borrower need the money?
- How quickly does the transaction need to be closed?
- Are there issues with credit, bankruptcies, cash flow of the property, title, etc.?
- Are there liens that need to be taken care of?
- What is the exit strategy?
The ‘story’ behind the scenes may uncover information that benefits a loan request, such as more equity, income, assets, collateral and/or financial viability – making for a stronger loan case. Conversely, the story may reveal another situation exposing investors to financial loss, delay or interfere with your ability to return to and/or sustain timely payments, or may result in other adverse consequences.
It’s important to invest your time and make the effort to clearly think out and present the full ‘story’ about your loan. Doing so may bare you are more qualified than you think.
Your exit strategy is the key to whether or not your property is seen as a viable investment option. For many lenders, the exit strategy is just as important as the collateral itself. But it’s one thing to say you have a plan for exiting the loan, and another to be able to show the viability of your plan as well as your back up plans if something should fall through. In short, your exit strategy must be realistic, viable, verifiable and multi-faceted.
You have to have a plan for getting out of the loan in order to get into it. Since it is more difficult to refinance now than it once was, each borrower needs to present a well thought out plan for exiting the loan. Most lenders want to stay in the loan from six months to two years, so an exit strategy that proves the borrower has a sound plan for paying off the loan is extremely important.
As you can see, there may be a wider range of people who get approved for hard money loans than traditional bank loans, but that doesn’t mean they are actually easier to get. Most lending standards start with equity in a property. They are also tempered with the quality of the collateral, borrower’s ability to repay, the overall viability of a project, the reputation of the borrower and the exit strategy that is required to repay the loan such as resale or refinance of a property. With this information in hand a real estate borrower can learn where to improve and increase the odds of securing loan approval— but not guarantee them.
If you are refinancing or buying property, whether commercial or residential it is important to prepare yourself for financing. Access to capital is a very important part of anyone’s financial stability as well as the success of any business, especially that of a real estate investor. Hard Money Loans will help you have a very profitable business.