Private Lending (19) – Finale

This is the finale episode for this series and I will try to sum up the due diligence checklist for private lending so you can even do it yourself if interested. 

Private lending involves borrowers uses their real estate as collateral. Generally, the return on private lending falls in the high single-digit to low double-digit range, depending on each deal.

The lending duration typically ranges within 12 months, with some shorter options like 3, 6, or 9 months, but mostly 12 months. There are also occasional deals where a one-year term is renewed for another year. Renewals usually come with additional fees for increased returns, and another due diligence process based on the updated appraisal report.

Interest is often paid automatically on a monthly basis, but there are cases where annual interest is prepaid upfront or at the back end.

The principal amount is repaid by the borrower to the lender upon maturity. Typically, at the end of each deal, borrowers either refinance with a bank or find new private lenders to replace the current lender.

For the interest payment earned by lenders, it counts as income, but whether it’s categorized as corporate income, interest income, or other types of income depends on your own accountant’s assessment, as everyone’s situation varies.

Loan-to-Value Ratio (LTV):

For residential properties in stable markets in core areas, it’s advisable to keep the LTV below 75%, or even lower. However, this entirely depends on factors such as the market, interest rate fluctuations, policy changes, location, and other variables.

A lower LTV implies more of homeowner’ equity in the property, a higher safety margin for the lender, and consequently, lower risk. But does this mean lower LTV deals are always better? Not necessarily; all key points must be considered comprehensively.

Location:

Properties in core areas are generally safer. As a side note, each province in Canada has different regulations. Ontario, for instance, offers significant protection for private lenders. Auctions in Ontario follow the “Power of Sale” rather than foreclosure rules, which differs greatly from other provinces and U.S. in terms of legal and procedural aspects.

Properties in Toronto and Vancouver are typically more readily accepted as collateral due to factors such as urbanization and legal considerations. If you’re doing this independently, focusing on these two cities in Canada should suffice.

Mortgage Position:

Are you the first mortgage holder, or second, third etc? Remember, the higher the risk, also the higher the return. Risk and return are always positively correlated, so you must be sure that the price is worth the risk when taking it.

Sometimes, the first and second mortgages are arranged by the same person or institution, referred to as “One Charge.” This is done to align risk and price adjustments, although the source of funds may be the same. In such cases, the risk for creditors in later positions is slightly reduced, but it still depends on the specific circumstances.

Generally, being the first or second poses less risk under similar conditions.

Population:

Consider cities with populations above 500,000

Property Condition:

The better maintained, the safer.

Community:

Avoid areas with high crime rates.

Property Appraiser License:

A must.

Is the appraisal company on the industry-recognized bank approval list?

A must.

Points to note in the appraisal report:

It’s recommended to only accept appraisal reports issued within 30 days or less.

Check for signs of water damage or potential foundation issues.

Ensure that the report hasn’t been altered to reflect the lender’s or your management company’s name

Credit Report:

Double-check the borrower’s name, date of birth, and ID.

It’s best not to see any outstanding debts, and if there are, they shouldn’t exceed 90 days.

Bankruptcy records are best avoided.

A higher credit score is preferable, but it could also be due to insufficient transaction history. Always assess the entire project from multiple perspectives.

Borrower:

Age is a factor to consider.

The borrower’s occupation should correspond to their age and income.

Check for any unexplainable or counterintuitive factors in their income.

Loan Purpose:

They may claim the loan is for starting a new business or purchasing property. In such cases, insist on evidence like registration documents for the new company or property transaction documents.

Closing:

Always engage an attorney experienced in private lending, not just a real estate attorney, as the points to check are different. Attorneys must ensure good standing in all six aspects: title, taxes, existing property mortgage/other debts, title insurance, home insurance, and title registration 

Existing Mortgage Statement:

Never skip this step! Always review it! Countless times, discrepancies like outstanding balance and penalties stated on the mortgage statements issued by banks weren’t be found out elsewhere. Many times, differences between the numbers on the Mortgage Statement and what the borrower/broker reported have led to recalculations of LTV, interest rates, risks, and prices, making deals we thought were feasible into deals that couldn’t be closed.

If changes in the Mortgage Statement amount cause LTV or the overall deal to look risky, just walk away!

Title Check:

Is the title clean and clear? Are there any unexpected items on the title? Are there creditors not disclosed by the broker or borrower? Are there notices of securities registered by heating companies on the property title? Generally, all of these have to be made known, and must be postponed temporarily to maintain the LTV. Does any information affect the actual LTV?

Government Debts to be Repaid:

Various taxes – property tax, personal income tax, etc., must be taken into consideration. Government taxes usually take precedence over lenders and banks! So, once there’s tax liens, it’s essential to carefully recalculate the LTV.

Title Insurance:

If title insurance company is refusing to insure this file, DO NOT LEND! That means the deal might be suspected of fraud.

Home Insurance:

Ensure that there’s a “guaranteed replacement clause” or equivalent clause for rebuilding the property within the insurance terms, and ensure that you or your trustee company (with a service agreement) are named as beneficiaries on the home insurance policy.

Title Registration:

Countless times, lawyers have misspelled the name of the lender or their company during property registration (especially when the name isn’t commonly used in English systems, like Chinese pinyin). So, you must carefully review the documents to confirm, and remember, don’t disburse the loan until title registration is properly completed.

Okay, the deal is done, the money’s out, and the interest is received on time. But what if something happens? Like a bounced check?

Our advice (of course, always execute based on the market and property price conditions at the time) is to provide a standard 30-day period for the borrower to catch up on the payment. As for whether to charge an NSF fee and when to do so, it can be decided based on the original contract. If there’s trouble with a bounced check or if the amount due isn’t received for various reasons by the maturity date, review the entire deal  based on the following points:

Principal

Interest

Reasons for NSF

Communication process and results

Most recent valuation

Then, calculate the current LTV on the current valuation.

If the current LTV is still sufficient, you can contact the lawyer to consider power of sale/foreclosure process. If the safety margin isn’t enough, you’ll have to negotiate with the borrower for an extension.

The power of sale/foreclosure processes has strict timing and steps to follow. In most cases, between issuing a demand letter and the next step (several months), the principal, interest, and fines are returned, and the deal is successfully discharged (99%). For those rare cases that reach the final step (1%), there’s little left to recover, so as the lender, you can only hope to minimize losses.

Let’s take a look at a real case to understand this process:

On July 10, 2016, we received a second mortgage deal for $80,000.

After reviewing the location, appraisal report, LTV, credit report, application materials, and ID, we issued a commitment letter with an LTV of 75%, an interest rate of 10%, and a term of one year.

Between July 15 and 25, the borrower signed, the bank issued statements, the lawyer processed all documents, title was clear without issues, and on the 25th, the deal was closed, and the fund was disbursed.

Monthly interest of $666.66 was automatically deducted from the bank, and there were no bounced checks. 60 days before maturity in 2017, we reminded the borrower of the maturity date. 30 days before maturity in 2017, we received a proposal from the borrower to list the property for sale themselves and a request to extend the loan by six months to sell the property. After reviewing the current market valuation, new documents including the credit report and mortgage statement, and obtaining agreement from fellow lenders in the community, we agreed to the extension from August 1, 2017, to February 1, 2018, with a monthly payment. Considering the market conditions at the time, the interest rate was adjusted to 12%, with an additional 1% extension fee.

On January 6, 2018, the borrower’s lawyer sent a request to pay off the debt (discharge request). Our lawyer began all document work. The $80,000 principal was fully repaid, and during the 18-month period, interest income amounted to $12,902, with an average annual return rate of 10.75%.

This series is finally completed. Next time I will start a new series!