Private Lenders and Note Investors: 3 Tips from an Industry Radical

Written by: Doug Smith, Portfolio Manager – Castle Rock Capital Management

For more than 25 years, I’ve had the pleasure of working with some of the best credit minds in the country. I’ve also had the painful experience of watching scores of private lenders and note buyers with no formal credit background whatsoever make fatal mistakes when underwriting private loans and notes for purchase. Making private loans or buying performing and non-performing loans can be a very fruitful and worthwhile proposition, but many lenders and investors don’t follow sound underwriting principals when making a decision about purchasing or originating a loan.

Many lenders make a decision and hope for the best, but hope is not a strategy. You’ve got to set up sound, concrete underwriting policies if you are going to be successful in either business. In all fairness, we tend to be quite radical in some of our approaches, but we’ve found, through great experience, that many private investors and lenders are missing the boat when it comes to making sound credit decisions. Although there are too many pitfalls out there to count, here are three radical concepts that could help keep your loan portfolio secure and spinning off the types of returns you desire:

MISSING BACK TAXES: Understanding a borrower’s delinquency status with respect to real estate taxes is critical for a private lender. It’s even more of an issue with note buyers. Most lenders and investors rely on on-line data and title reports to determine the real estate tax delinquency status of a collateral property. Simply looking at the title report or pulling up the local tax assessor’s web site isn’t as reliable as one might think. Even calling the tax assessor’s office sometimes will give a lender/investor a false sense of security. Why is that you might ask? Well, many tax assessors report taxes as being paid when, in fact, a tax certificate has been sold on the property.

What is a tax certificate? When real estate taxes in most jurisdictions get past due by a certain point, the county will sell the delinquent tax bill off to an investor. The county gets their money and the investor gets the right to collect on your taxes. Since the county has been paid, they often report the delinquency as paid with no mention that the tax certificate has been sold. At a certain point, the investor that has purchased the tax certificate can exercise their rights against the property by taking the collateral property. Although notices might supposedly be sent to you as the lender, often they slip through the cracks or they were slyly sent so you don’t notice them. The tax certificate investor usually wants the deed, so they normally act as quickly as they are allowed to legally steal the collateral property out from under you and the borrower.

Always, always, always call the local tax assessor and don’t just ask what taxes are due, but make sure to inquire if a tax certificate has been sold. It’s a critical part of the due diligence phase whether you are a lender or you are purchasing a note.

TRUSTING THIRD-PARTY VALUATIONS:  Whether you purchase notes or you are a hard equity lender, understanding the value of your collateral is critical to creating a good loan for your portfolio. Banks and GSE lenders use the good, old-fashioned appraisal to determine value. I’ve found that approach to be filled with pitfalls. Namely, an appraiser typically does not have expertise in construction, so all you are getting is a comparison to other properties that have recently sold, or in the case of commercial income producing property, an analysis of the net operating income vs a capitalization rate. The future value of a property is also contingent upon its condition.

Many residential investors, particularly those who purchase notes for their portfolio, use the Broker’s Price Opinion, or BPO, in order to determine value. It’s much less expensive than an appraisal, but the BPO is prepared by a realtor rather than a licensed real estate appraiser. Now, I’m also a licensed real estate agent, so I’m sure I am going to stir up a ton a venom for this statement…a BPO isn’t worth the paper it’s printed on. Realtors get paid very little for performing a BPO, therefore companies that provide BPOs tend to get the less experienced or poorly performing realtors to do them. Many don’t even actually stop at the property. They use their MLS to do a Comparative Marketing Analysis without paying attention to condition.

No one I know does what I am going to suggest, but we actually don’t use appraisals or BPOs to determine value. We’ve found that our internal staff does just as good of a job at determining value by using readily available comparative sales data, but it’s the condition that we need help with. Many property preservation companies offer a service where they send a contractor out to the property to provide a Property Condition Report. They give us an idea of remaining roof life, the quality of the foundation, and point out any issues that are readily apparent. This report costs us less than $100 and, from it, our internal team can get a pretty good idea of the property’s as-is value and what repairs are required to bring it up to snuff. It’s saved our bacon more than once, but I can’t name a time where our team has materially missed on a value that a BPO would have provided us. It’s true that most note buyers will require a BPO to be in file if they purchase the note from you, but if you have no intention of selling the note, a BPO might not be of help to you.

 

DON’T DO A DEAL JUST BECAUSE YOUR LOAN-TO-VALUE IS GOOD: You’ve probably heard of the three C’s of credit; Character (Credit), Capacity, and Collateral (Capital). You also might be aware that most private lenders and note buyers ignore sound underwriting principals in order to get money out the door. They get so excited about a deal that they think from the heart and not with their head.

Character, sometimes referred to as credit, is a good example of “past predicts future.” Will the borrower forego eating and buying nice shiny things in lieu of paying their obligation to you? Obviously, there are exceptions to this rule, but if you see that borrowers have not paid their bills in the past, it’s a pretty good bet that they won’t pay you when the chips are down.

Most lenders simply focus on Collateral/Capital. They feel that if they are at the right loan-to-value that they can’t get hurt. Unfortunately, there are many ways that a borrower can hang you out to dry even though you are properly secured. Ignoring the character and capacity of a borrower can get your burned.

One radical take of our underwriting process is how we weigh the three C’s. A wise lender early in my career told me that the three most important things in lending are Ability, Ability, and Ability! In other words, Capacity. If a borrower doesn’t have the disposable, stable income to pay you back, you are sure to face problems. A borrower can overcome past credit issues and they can even pay when the lender goes over the appropriate LTV, but it’s really hard for them to pay their bill to you if they don’t have the income coming in to cover it.

Most lenders ignore the three C’s when underwriting a deal. Make it a practice to look at all phases of a deal before acting.

I hope I haven’t scared you away from entering or deepening your commitment to private lending or note buying. We’ve enjoyed tremendous success in the industry and we hope that you do as well. I simply implore you to truly think with your head and not your heart when making a deal. Take the time for follow sound underwriting principals. Develop relationships with successful, knowledgeable lending professionals and don’t be afraid to pick their brains about their best practices. If you simply hone your skills and adhere to a solid due diligence process, you too will be successful. Best of luck!

 

About the Author:

doug smithDoug Smith spent 25 years in Private and Commercial banking and serves as the Chief Operating Officer for Castle Rock Capital Management, a Tampa-based investment management company specializing in distressed real estate and real estate-backed debt (both commercial and single-family residential).

Mr. Smith manages several private funds that purchase real estate-backed loans and real estate for investors. He also mentors other investors on the business.

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