Search Google for information on private lending in real estate. You’ll get 127 million results. Wow!
Thanks to the digital age, real estate entrepreneurs have access to a wealth of information for free. That’s a wonderful thing.
As a private lender, I place a heavy emphasis on educating our real estate investor clients. Part of this education includes painting a picture of how lenders analyze borrowers and structure loans. After all, though the industry has more uniformity than before, lenders still vary in how they structure key attributes of a loan. This can confuse borrowers. It can make it hard for them to compare one lender’s offer with another and get maximum leverage and the best rates and terms.
So, let’s sift through that confusion and add some clarity to exactly what you need to know: how lenders analyze borrowers and how they structure loans. If you grasp those two things, you’ll know how to get the best loan for your real estate operation.
How Lenders Analyze Borrowers
Because there’s no governing body like our residential mortgage counterparts, there’s no standardized approach to analyzing borrowers or deals. For instance, residential mortgages through Fannie Mae and Freddie Mac must adhere to certain guidelines and criteria.
With many variables in private lending, it can be difficult to understand what you need to do to get the right loan. But for the most part, all lenders look at these three factors, with varying levels of importance, in a borrower’s profile:
- Experience
- Credit
- Liquidity
When you apply for an investment loan, lenders will adjust or decrease the loan amount based on your qualifications, risks, and mitigants. Private lenders in real estate generally analyze these three factors related to the borrower:
Experience: For most private lenders, experience is the most heavily weighted factor. Experience shows proof of execution and that you know how to navigate deals. In general, private lenders want to see how many real estate transactions you’ve completed over the last few years, how you’ve executed your business plan in the past, and if your previous deals were profitable. Based on your experience, lenders may have “tiers” for borrowers that provide different leverage or rate structures. Some lenders use a binary analysis of “experienced” or “not experienced” too. Typically, you can expect max leverage if you’ve completed two to six deals per year, over the last few years.
Credit: Most nationwide lenders use credit scores as a big factor in determining how responsible you are with repaying debt. If you have a good score, you can get better rates and terms and more leverage (a “good” credit score is 670 or above, according to Experian). Most lenders’ minimums are approximately 600-620. Note that more regionalized hard money lenders may focus more on your experience and liquidity, and might be willing to disregard your credit altogether.
Liquidity: Liquidity, or how much money you have access to in your personal or business accounts, demonstrates your ability to contribute to the acquisition of a property and ensure that your project is properly capitalized. For example, if you get a bridge loan through a private lender, they will likely want to see proof that you have the capital for all the monies due at closing, as well as reserves for at least half the payments of the full loan term.
Finally, understand there’s actually a trend towards more consistency as investment banks, seeing the success of private lenders, have entered the game. This has led to the securitization of residential transition loans (more commonly known as fix-and-flip loans). Securitization is a process in which pools of loans are consolidated and sold to institutional investors. The institutional investors (the purchasers) won’t buy the loans without a third-party assessment of risk. This has led agencies like Morningstar Credit Ratings to develop criteria to rate fix-and-flip securitizations. As credit rating agencies have begun to rate real estate loans from private lenders, it has created a need to standardize the underwriting process because these loans must meet certain criteria to attract Wall Street investors.
What does that mean for you?
Going forward, where you get your loan can shed light on the borrowing process. With private lenders that balance sheet and hold their loans, the underwriting guidelines are more discretionary and proprietary. With a private lender that sells their loans, the underwriting guidelines must conform to their purchaser’s guidelines, so these lenders can’t always use as much discretion in making underwriting exceptions.
How Lenders Structure Their Loans
Now that you know how lenders analyze borrowers, let’s look at how they structure loans on each asset. This will help illustrate how you can get max leverage for a real estate deal.
Lenders typically look at loan structure from either a “cost” or “value” perspective. To structure real estate loans and determine the loan amount, they examine one, two, or all three of the following three ratios:
Know that lenders like to see “skin in the game.” When you are willing to commit your own funds toward a project, lenders don’t take on as much risk — statistically speaking. After all, they’ve seen the data from the years leading up to the Housing Crisis. The lower the down payment, the more likely a default was.
If you’re searching for max leverage in scaling your real estate operation, understand that private lenders will always use the lesser of two calculations when sizing your loan. For instance, if your LTC structured loan amount is $210,000, and the ARV is $280,000, and based on the aforementioned factors you can only go up to a max ARV of 70%, then loan sizing is restricted by ARV, since it is the lesser of the two structures, and thus you can only get a $196,000 loan.
When underwriting a loan, lenders will also change a loan’s leverage based on items related to the asset, such as the amount of rehab versus the purchase price. They’ll even look at restrictions due to geographic regions or asset types. The factors that impact leverage are so vast we could write an entire article on this topic alone!
Getting the Best Loan for Your Real Estate Operation
Though you can’t create a one-size-fits-all formula for getting your desired loan, you can increase your chances of maximizing leverage by knowing how private lenders operate.
As you move ahead, pay attention to your borrower profile and continue to build a real estate portfolio that proves you can execute. When you apply for a loan, prepare thoroughly, and don’t be afraid to ask questions to your lending specialist. If lenders see that you have the experience, have analyzed the costs of a deal, and have sufficient funds on hand, you’ll be in a great position to get max leverage at desirable rates and terms.
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