All investments carry risks, and passive growing of wealth is less about winning with decisions based on straightforward parameters than it is about optimizing one’s chances of success given a variety of determinants. Regulatory issues, the economic environment, and market trends are only a few of the factors that come into play.
Private lending is no different. Mortgage investors understandably hone in on their chosen firm’s underwriting practices, the quality of the borrower pool, and the value of the assets against which the loans are secured. However, they often overlook another critical element to successful investing: their own inclinations and investment characteristics.
While many private money investors have a more generalized approach to lending, there is value in capitalizing on one’s existing knowledge base or focusing on a subcategory of the market. A more targeted strategy also leads to deeper insights about a potential transaction and minimizes blind spots that a less specialized individual may have. Therefore, it is in the best interest of both borrower and lender to have the former’s needs and objectives match the latter’s expertise.
Personal loans
Personal loans are arguably the most troublesome among the debt types. There are countless reasons for borrowing, including medical bills, car repairs, and school fees. Private lenders who deal with these types of loans mitigate risks with shorter debt durations and underwriting practices that are tailored to their criteria.
To take some of the tedious work off their shoulders, private lenders, no matter their specialization, often work with brokers or lending institutions who study and vet each opportunity. Such entities should be able to source and originate loans specific to the lender’s profile.
Private lending is a form of investment with its own set of risks and benefits. Capitalizing on one’s experience in a particular category also optimizes returns, and an investor is better off utilizing their existing knowledge as an asset.
Refinancing
Creditors that focus on refinancing are masters at creative solutions that provide value to themselves as well as the borrower. There are many reasons borrowers might want to refinance a loan, and the private lenders with whom they choose to work must know how to navigate every scenario.
Two of the more common objectives for refinancing are debt consolidation and renovations.
Refinancing for debt consolidation requires the lender to be familiar with credit rehabilitation. Borrowers replace existing loans with new ones (by paying off the former with the latter) to improve their credit score, to stretch out the payment period, and to lower the interest payments, reducing the monthly amortizations. Those swimming in credit card debt, for example, may find a lifeline in private loans. Meanwhile, lenders need to develop an exit strategy, which often means working with the borrower to make sure payments are manageable.
If the loan is going to be used for renovations, lenders will often offer a cash-out refinance, where the homeowner borrows more than the original mortgage is worth. After paying off the first loan, the borrower can then use the surplus to fund a home improvement project that increases the value of the asset. With enough equity on the table, lenders’ risks are mitigated, though each creditor will have to set their own criteria for what constitutes “enough equity.”
Commercial vs. Residential Real Estate
Some private mortgage investors focus their competencies on property types. Commercial real estate, for example, can be a vastly different animal from residential. Numbers dictate what happens with a commercial property, and emotions weigh heavier in residential real estate. Some lenders may be better with business dealings, and others may have a natural inclination for understanding the needs and desires of families looking to make a home.
A major difference between the two is the way the properties are used, how long they tie up one’s capital, and the process of acquisition.
Residential buyers, since they are buying homes and not merely income-generating assets, look at the characteristics of the surrounding area, the quality of the property, and how it all aligns with their personal preferences. From a lender’s point of view, there is an additional layer of “sentimental security” in lending to a homebuyer since it can be assumed that the property will have both emotional and fundamental value.
On the other hand, commercial properties are meant to be liquidated via sales or rentals. These types of assets come in the form of apartment buildings, multiplexes, retail spaces, offices, warehouses, and other property types meant for income generation. Lessees and buyers of commercial properties have to conduct market research, come up with cash flow projections, and, if representing an enterprise, make their way up the organizational chain of command as part of the approval process. All this prep work factors into how financiers see their borrowing capacity. Commercial property lenders assess borrowers’ ability to pay not only by looking at their portfolio and credit history but also by analyzing their business plan.
Residential and commercial properties, since they have different purposes, affect investment strategies very differently. “Commercial investors avoid vacancy like the plague because a property is only valuable if you have a stream of income,” said property investment coach Sam Beckford in a 2018 article. By contrast, properties that are owner occupied are therefore never vacant, and the homebuyer never has to deal with stagnant and unoptimized square footage; the value lies in the residence itself, not in the income the asset provides.
Business Loans
SMEs are often called the lifeblood of a nation’s economy, and the same is true for Canada. Many independent business owners, however, find themselves with limited sources of financing because they don’t qualify for traditional bank loans. If they left their job to pursue entrepreneurship full time, for example, they would have lost a source of assured income banks typically require.
Private lenders fill this gap in the market, and many narrow down their specialization further into particular business categories. Funding tech startups, for example, is “an art form,” as described by veteran tech banker Mark Usher. Despite the technology sector’s notoriously volatile nature, financiers have been competing to take a piece of the pie. With the steep competition and the fast-moving market, that requires savvy, and venture capitalists and lenders alike are required to have some measure of adeptness in the sector if they are to invest.
Location-based specializations
Some lenders have location as their primary consideration and direct their attention to specific areas that meet their criteria.
For example, there are private creditors who focus on projects in urban areas as these are often more easily liquidated. Properties in city centres are often valued higher because proximity to convenient places of business—like shopping malls and restaurant strips—makes these areas attractive to both commercial and residential occupants. For lenders, the higher the asset’s value, the more cushion they have in a mortgage deal. Borrowers don’t like losing prime properties, which incentivizes them to prioritize their loan obligations, and even in the event of a foreclosure, a lender may end up with an easily liquidated asset.
Other private lenders have a more regional approach. They may prefer certain areas for a multitude of reasons—from the economic environment to their familiarity with the market. Understandably, investing in home soil feels safer for most lenders, so many of them lend exclusively to borrowers whose properties are near enough for a personal inspection.
Many lenders will take an approach that spreads their portfolio across various region types for the purpose of diversification as means to hedge against risk exposure from one sole strategy.
Working with the right partner
For a company like Canadian Lending (CLI) where residential real estate makes up for the vast majority of transactions, hedging risk is a primary concern when underwriting potential private loan deals for its investors. Their investors are not simply looking at the potential upside in terms of the rate of return, but also place a lot of weight and consideration on the borrower and their capacity to make payments which in turn makes up for the investor’s cashflow. The borrower also has a strong intent not to abandon the asset as it is their primary residence and not merely a place where they conduct business as in the case of commercial assets.
