Every private lender is different in terms of their ability to loan, their risk tolerance and their desired outcomes. These differences carry over to their lending criteria and how they evaluate every deal. While there is no one-size-fits-all answer to how to analyze every transaction, there are some basic factors and processes that an investor will need to consider before signing on the dotted line.
Risk vs. Reward
First and foremost, private investors should never invest in anything that they don’t understand. When considering any type of private loan opportunity, make sure that your homework is done and your processes are all in line and checked off.
One of the main determining factors that will shape your loan requirements will be the kind of return that you need from your portfolio. The answer to this question will tell you how aggressive or conservative your investment strategy needs to be, as well as what types of deals to consider. For instance, if you are an investor seeking more moderate returns to build long-term wealth, then you can adopt a more conservative strategy with less risk. In short, if you want higher returns, then you will have to take on more risk.
When it comes to risk vs. reward, the term of the loan may dilute your annual rate of return. For instance, if you take on a loan deal for a six-month term where the borrower is seeking a renovation loan for a fix and flip property, the high rate of return accompanied with the higher risk investment may be diluted if you cannot find any other investments for the remainder of the year. In this case, if your interest charges are at 14% for the above-stated loan scenario, your annual rate of return would average out to 7% if your investment capital is not reinvested. Conversely, if you decided to loan the same amount at 7% interest for a one-year term, then you would achieve the same annual rate of return as the previous case, but with relatively less risk exposure. On the other hand, if you do roll those funds over again, your potential ROI can but much higher with short term lending.
Analyzing the Deal
Once an investor has determined their risk tolerance as well as the types of investments they are comfortable with, it’s time to analyze the deal to evaluate whether it is a worthwhile investment.
The amount of equity in a deal is one of the critical factors that will affect your investment decision. The equity-to-debt ratio will also fluctuate depending on the type of loan sought. In any case, an investor should obtain a current fair market value from an accredited investor in order to determine the equity ratio. It is prudent to seek at least 25% equity in each deal (but there are many instances where it can be less than 25%) to provide for a large enough safety net in case the borrower defaults on the loan.
A renovation loan may complicate the lending ratios as some lenders may lend based on the ‘after-repair value’ of the property if they have a more aggressive appetite, while other lenders will stick to the current appraised market value. The lending ratio in the first instance would be based on the future value of the property following the completion of renovations.
One of the first steps in analyzing a potential deal is to understand the value of the loan’s underlying collateral. This is where an investor will be able to mitigate risk by determining their potential risk exposure based on their potential loan amount.
If you are evaluating numerous loan opportunities and wish to conduct a quick valuation assessment prior to ordering an appraisal, a comparative market analysis (CMA) can be conducted to determine the value of the property ( a CMA can also be obtained from qualified realtors familiar with a geographic region). This involves the process of looking at recently sold properties in the same region that are similar to the subject property.
After having gathered at least several comparable properties, you will want to adjust for feature differences to come up with an estimated value for the subject property. If you are lacking in recently sold comparables, you may supplement your comparables with similar properties that are actively for sale. It should be noted that homes that haven’t actually sold are only viewed with a grain of salt and should not be used for determining the true valuation. When selecting comparable properties, pay attention to the following factors:
Property Sale Date – When available, you will want to select the most recent sales that occurred within the last few months, especially if the subject market is moving fast in terms of price.
Property Location – While you may not always be able to find similar properties in the same neighbourhood, you want to make sure that they are still within the same vicinity and in comparable neighbourhoods.
Home Characteristics – Seek out properties with the same or similar features and quantities (ie. bedrooms, bathrooms, square footage, age).
Determining the property value through a CMA approach is both an art and a science that improves over time, and the margin of error is reduced with experience.
Generally, there are two types of appraisals – desktop and full appraisals. Both models are similar in terms of their research and comparable selection, but the notable difference with a full assessment is that the appraiser visits the home and conducts an onsite inspection of the property whereas the desktop appraisal approach has no physical inspection. The desktop approach, of course, is less reliable where the appraiser is limited to multiple listing service records. Desktop appraisers generally do not have a wide margin of error and are more cost-effective. The application of each is dependent on the investor’s risk tolerance and the corresponding deal type.
The types of properties invested in should also play a role in your determining decision. A simple rule could be to not invest in a property that you wouldn’t be comfortable to own if the borrower defaults. In the event of default, what will be your exit strategy with the asset once you obtain it? For instance, if the loan were a renovation loan and the borrower decided to purchase a few tons of copper wire, then there is not much you can do with that material. Under a renovation loan, you should not advance funds for repairs until they are actually completed with an inspection. Only a portion of the allocated funds for repairs should be released following each phase of completion. This will further mitigate your risk exposure.
Another precautionary method to mitigate risk is to take immediate action when the loan goes into default. A default letter from your lawyer should be sent to the borrower if they are at least a couple of weeks overdue. The worst thing an investor can do is not take any action, indicating to the borrower that this can continue to occur in the future without any repercussions.
Consult with Experts
If you are not familiar with the loan process and the corresponding measures and documentation, consider engaging a professional company. You always want to make sure the loan is reasonable and structured correctly.
At CMI, we use our own proprietary software, developed in-house to ensure smooth closings and post-closing administration. We are responsible for all aspects of the financing vertical from mortgage origination and underwriting right through to the funding stage. Working alongside investors, we are able to be their investment partner providing for proven streamlined systems to mitigate risk and maximize return.