How Does a Private Money Lender Evaluate Your Real Estate Deal for Funding?
Many real estate investors wonder how a private money lender decides whether to fund a deal. Why would a private lender pass on one deal and fund another? Contrary to popular belief, lenders are not looking solely at a borrower’s credit score as a reason to approve or to decline a loan request.
Depending on the type of property being purchased, a lender may look at different things when evaluating a deal for funding. For example, is the property being purchased to flip quickly, or is it a rental property purchase that is being held long-term?
A private money lender looks at very specific criteria when deciding whether to lend on an investment property. A lender uses a slightly different approach than a real estate investor who is evaluating an investment property for acquisition. Let’s take a look at what private money lenders consider as they evaluate deals.
Assumptions About Value
The property’s value is one of the most important things for any lender, but when it comes to a fix-and-flip property, the “after repair” value is what a lender is trying to determine.
A private money lender reviews sold comparables and active listings when trying to determine the property’s future value after necessary improvements and repairs are made.
When looking at the comparables for value and comparing them with the subject property, a lender observes the distance of the comparables from the subject property. Your lender may dismiss any comparables located more than a mile from the subject property as not being true comparables.
Besides distance, a private money lender observes the neighborhood characteristics of the comparables. Are the comparables all located on quiet, side streets, but the subject property is on a busy, main street?
Does the Repair Budget Make Sense?
A private money lender will ensure the estimated repair budget is in line with the type of finishes the comparables have.
A borrower must plan to use the same level of finishes in the subject property that are used in the comparables.
For example, if all the comparables boast $500-per-square-foot finishes, and the borrower plans to use light fixtures from a major home improvement store to achieve $175-per-square-foot finishes, the lender may question the target resale price.
In addition, a private money lender evaluates whether the repair budget is adequate for the size and scope of the project. If a house is 5,000 square feet and the borrower has a budget of only $15,000 for a complete rehab, a lender may question whether the borrower has accurately determined the cost of the repairs.
And, just like a real estate investor who is doing due diligence on a property to purchase, a lender reviews the status of the property’s major systems to make sure they are in good repair or working order. The private money lender wants to make sure plumbing, electrical, sewer, foundation and roof are in good condition—or the borrower has planned for any replacement or repairs as part of the rehab budget. If the lender observes the roof is looking rough and may need replacing, but the borrower says that the roof is fine, the lender may need to question the borrower.
Experience of Borrower with Similar Projects
A private money lender always looks at the borrower’s level of experience with investment property rehabs. Particularly if the rehab project is large and costly, a lender wants to know the borrower has completed similar projects of approximately the same size and cost.
For example, let’s say the borrower has done only smaller projects with total project costs of under $250,000. If the borrower is wanting to take on a larger project with an estimated project cost of $750,000 or higher, a lender may question the borrower’s ability to successfully carry out the larger project.
Does the borrower have a good team in place and a solid plan for undertaking the larger rehab project? If not, a private money lender may hesitate to fund the deal.
Borrower Liquidity
Lenders are always concerned with the overall liquidity of the borrower on any type of investment property purchase. Liquidity is defined by how much cash the borrower has on hand.
- Is the property ready to be rented, or will the borrower need to invest money into repairs before it can be leased?
- Does the borrower have any additional cash set aside for repairs to the rental property after purchase?
A private money lender may lend a borrower funds for the repairs, but the lender still wants to know the borrower has enough liquidity to make a down payment, pay for insurance and make the loan payments.
Valuing Rental Properties
For buy-and-hold loans on income-producing investment properties, a private money lender may look at other factors when approving the loan.
On rental property loans, a lender places less emphasis on comparables and far more emphasis on the current and projected income of the property.
Comparables for three-plexes in the area may be scarce, for example, so a lender will want to determine the value of the property based on rental income.
- If the property is vacant or underrented, what are the projected, future rents once the property is leased?
- What is a good cap rate for the area where the property is located?
By taking the net operating income after expenses and using a reliable cap rate, a lender can easily determine the property’s value based on present and future rental income.
If the purchase price is a lot higher than the value the lender comes up with based on rental income, a lender may think a borrower is paying too much for a property and could ask for a larger down payment from the borrower.
Exit Strategy
Finally, what is the exit strategy? In other words, what is the borrower’s plan for paying the loan back? A private money lender always wants to understand the borrower’s plan for repaying the loan before funding the loan. Private money loans tend to be short-term and are not typically a source of permanent financing.
For example, does the borrower plan to resell or flip the property to pay back the loan? Or, does the borrower plan to repay the private money loan with a bank loan to hold the property long-term?
If a lender has doubts about a borrower’s ability to pay the loan back by the end of the loan term, a lender may not fund the loan.
In summary, each private money lender evaluates a deal for funding slightly different from the next private money lender. For this reason, it is wise to request a detailed list of the specific requirements for loan approval before applying for the loan.
This list of lender requirements could save the borrower from wasting time in the application process that may just end in a loan decline. For example, if the lender requires a minimum down payment or a minimum credit score and a borrower cannot comply, then there’s no need for the borrower to even apply with that private money lender.
With the knowledge of how a private money lender evaluates a deal for financing, a borrower can present new deals in a more effective way to the lender. Further, by anticipating the lender’s questions in advance of applying for a loan, a borrower has a better chance of getting funded faster and with fewer hassles.
Corey Dutton
Corey Dutton is a private money lender and the founder of Private Money Utah, a Salt Lake City-based lending company. She provides non-bank loans to real estate investors for real estate acquisitions, development, rehab and construction. Corey is also a member of the Educational Advisory Committee for the American Association of Private Lenders. (privatemoneyutah.com/about)
