Growth in the real estate investment industry over the past decade has been staggering. As opportunity has grown more abundant, big banks have seized the opportunity to make money by pumping capital into the sector. This has made financing more available for private lenders and real estate investors. But it has also created an imbalance between capital and expertise. If a loan isn’t strictly underwritten or subject to thorough servicing processes, it could spell disaster for both lenders and borrowers. It’s crucial to have proven processes in place as an added layer of protection that ensures every real estate investment loan has the best possible chance of success and can achieve the maximum return. More specifically, thorough due diligence during underwriting and a tested loan servicing process protect everyone involved in the investment. There are three basic pillars for vetting a real estate investment that should factor into every decision prior to financing a project and throughout the course of a loan.
The Market
Without realistic expectations in place at the outset, it’s impossible to estimate the viability of a real estate project. Before a lender funds any real estate investment project, they conduct thorough due diligence through a stringent underwriting process. A seasoned lender will have spent years — even decades — developing a thorough understanding of the housing market in which they operate. This is arguably the most crucial aspect of the business because without knowing the intricacies of the markets, it’s difficult to accurately estimate the after-repair value (ARV) of a given property or gauge how long it might sit on the market. Not only should they examine the selling price of comparable homes in the area, but they need to understand pricing trends over time. While it’s not always easy to predict what the market will look like a year down the road when a project is finished, understanding data points like the absorption rate, months of inventory, and the average days a home spends on the market helps lenders more accurately predict the outcome of an investment.
Credentials
For private lenders, it’s essential to vet the real estate investor – not just the project – prior to financing an investment. Lenders will usually do this during the underwriting process, and there’s a number of things they will consider when it comes to vetting a borrower, but as it relates to making an investment loan, it largely boils down to evaluating a borrower’s level of experience, past successes, and their general credibility. Borrowers should be able to show evidence (HUDs) of past projects completed. But lenders typically look at every possible indicator of a borrower’s capacity and reliability. So, a comprehensive due diligence process should always consider the borrower’s financial history. Though the process and requirements will vary from lender to lender, it’s important for borrowers to realize that they are accountable for every aspect of the project and every person involved including the vendors and contractors they may be working with.
Workmanship
The quality and scope of work of a renovation or construction project is also a key factor in the success of a real estate investment and grows more complex with larger projects like multifamily renovations or community developments. Professional workmanship will help the operator achieve the target ARV and possibly even help the home sell faster. The amenities and features of the property should align reasonably with those of the properties used as comps during the underwriting process. If they don’t, the due diligence process was fatally flawed from the beginning, and the project may be doomed to fail.
Likewise, the materials and quality of work must track accurately with what was laid out in the budget, and it must all be verified at intervals throughout the construction process. For example, if the budget specified real hardwood floors and laminate is installed instead, it would significantly diminish the actual market price of the home and damage the profitability of the project. It could also hurt the borrower’s credibility with a lender. An experienced lender with a strong loan servicing practice can ensure that these discrepancies are avoided by having a construction draw process in place, which will act as a guardrail by confirming the quality of work at each stage of construction. This isn’t just in the lender’s interest; it also protects the borrower.
We’re All In This Together
The lender’s process for underwriting and servicing loans contains many layers of complexity, so this article can’t detail every aspect of how a lender vets its investments. And these kinds of processes can’t be developed overnight. It can take decades for companies to build processes and refine them, but these processes are meant to protect lenders from getting into a bad real estate investment, and they have proven even more valuable for borrowers in preventing their projects from being unsuccessful. If you’re a real estate investor and want to learn more about what lenders look for, or you’re a lender and would like to know more about how we approach underwriting and loan servicing, feel free to reach out. I’m always happy to help!
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