BOTH a Borrower and a Lender Be
This article originally appeared on the Castellar Investments blog at www.castellarinvestments.com.
In William Shakespeare’s immortal classic, “Hamlet” Polonius advises his son, Laertes:
“Neither a borrower nor a lender be…”
Poppycock.
Some of humankind’s most vital enterprises — exploration, discovery, colonization, creative expression — take first flight on the wings of borrowed money. In fact, there is very little going on in the economies of most developed nations that doesn’t involve at least some amount of lending and borrowing.
My personal mantra has long been the exact opposite of Old Polonius: Be both a borrower and a lender. Of course, there is a time and place for each, and either role can be performed well or poorly.
Borrowing money can be a very smart move. The availability of credit to smart, hungry entrepreneurs and the effective management of good debt are drivers of growth, expansion, and progress. A hefty influx of borrowed money can fuel the development of a product that changes human life for the better, provide aid to those in need, or put a roof over a family’s heads.
Borrowed money can help to put people to work, rejuvenate communities, and revitalize economies.
Properly applied, it can enable people to change their lives for the better.
The Lender’s side of that same scenario is likewise often a smart place to be. After all, where there are borrowers, there is a lucrative market for investors who have cash to lend in exchange for a nice rate of return, or even a share of a venture’s profits. A long working relationship with the right borrowers can make an investor extremely wealthy, with a minimum of actual effort. This is precisely why angel investing and private lending are core passive income activities of high-net worth individuals worldwide.
But the other side of the “borrowed money” coin is ugly. A borrower who mismanages their funds can end up crushed by the repayment obligation. Projects occasionally go badly, as a result of mismanagement by the borrower, or sometimes due to entirely unavoidable events.
In the wrong hands, a lender’s capital can evaporate without a trace.
So how do savvy investors determine which borrowers can be trusted and which are too risky? What specific qualities do steadfast, reliable borrowers have in common? Who exactly is our “ideal” borrower?
What Makes an Ideal Borrower?
There are virtually limitless opportunities out there in the world on which an investor can lend cash. The elements that make a borrower “ideal” generally apply to any of them, but we’re going to examine them against the backdrop of private mortgage lending; making private mortgages directly to borrowers for a fixed period of time, typically 6–12 months.
Why?
Private mortgage lending is simply one of the smartest investments out there. Done properly, it offers unbeatable risk:reward ratios, especially when you take into consideration the many options available to the lender for preserving their capital if things don’t go exactly as planned during the construction/renovation of a piece of property.
Our Ideal Borrower Lives and Breathes Real Estate
People are jumping into the world of real estate investing in record numbers, particularly into the business of “flipping” houses (thank you very much HGTV). The chances are good that you probably know someone who has, directly or indirectly, dabbled in residential renovation as an investment.
But as lenders, we aren’t looking for “dabblers” in real estate. We aren’t looking for hobbyists. We aren’t looking for someone who just wants to make a little extra cash this year to buy that Mercedes. That’s certainly not to say that part-time fix-and-flippers never deserve a chance, but the gods of real estate unquestionably smile more favorably upon their pious devotees, whose faith and attention to real estate is undivided.
Our ideal borrower is a fanatical purist for whom the project is a purpose; full-time builders and developers for whom renovating and selling properties is their life’s work. With very few exceptions, they won’t have a “backup” 9–5 job that competes for their time, attention, and effort. Real estate investing and development is their primary activity.
Our Ideal Borrower Breaks It Down, Kindergarten-Style
The numbers for purchase, construction, holding costs, and sale price must make sense, and our ideal borrower will have no trouble articulating these in a straightforward format that is quick and easy to grasp. A good deal is inherently simple, and our ideal borrower knows that.
This is hands-down, the most crucial factor when deciding “yea or nay” on a lending opportunity. The numbers simply must work. “Attention on deck! Good morning, Captain Obvious!”
Here are just a few factors to consider:
- The projected sale price should be well above the sum of the anticipated acquisition, construction, and holding costs (30–35% is usually a good baseline, but every project is different). The sale price should also be justified. Are there houses in the neighborhood similar to what the finished product will be that have sold at or near the projected sale price? Boundless optimism works well for endurance sports like distance running and parenting, not for determining a realistic sale price for real estate. Our ideal borrower knows this, and will provide a list of recently sold comparable properties, which support the projected sale price.
- The figure for the forecasted construction budget should be supported by a detailed scope of work that includes a line-by-line cost estimate for all the work to be done. Any budget that is worth the laptop it is written on will also include a reserve for unknown events and expenses, commensurate with the size and scale of the project. Things do happen, after all.
- The proposed renovations and/or additions to the property should make sense for the neighborhood. Will this house be the nicest house on the block? Will it be the most expensive? Does it really need a winecellar and dumbwaiter? Our ideal borrower knows better than to build a mini-mansion in a neighborhood of 2 bed, 1.5 bath ranch-style homes.
- The expected timeline for construction and sale should make sense. Is it reasonable to assume that the scope of work can be completed in the allotted time? Has the borrower factored in a reserve of time to account for things like inspection delays and inclement weather? Will the property be ready to sell during a time of year that is typically a good time to sell, i.e. Spring or Summer (in most markets)? If not, can the borrower afford to hold it for a while, or are they willing/able to sell low if need be?
The borrower should provide a pro-forma financial projection that addresses the above questions and illustrates the strength of the project in detail; basically the equivalent of the project’s “business plan.”
If the borrower doesn’t make a habit of documenting the financial forecast for each project, it could mean one of two things:
1) They are so experienced and efficient, and know their market so well, that they no longer need to put one together for each project; it simply exists in their head. Believe it or not, such people do exist. They are exceedingly rare, like a leprechaun riding a unicorn, racing a sasquatch.
If you find one of these, you should hold onto them and never let them go. The borrower too.
2) They are flying by the seat of their pants. This tendency is common among less experienced developers, but it can certainly happen with more experienced builders. A few successful projects and a teensy bit of overconfidence can lead an otherwise talented real estate professional to believe that they have “graduated” and they no longer need to have a diligent planning process.
That’s not the safest place for our money.
Either way, in the “getting to know you” stages of a relationship, our ideal borrower will be able to provide a comprehensive overview of their plan for executing the project. If they can’t or won’t, sorry folks. “No soup for you. NEXT!”
So, while we lenders may possess the brilliant minds of scholars, the wisdom of sages, the passionate hearts of poets, the souls of saints, and the chiseled physiques of mythological Greek deities, we are still only human. We still need to have the deal summarized for us in a way that would make sense to a five-year-old. Any deal that requires a more complicated level of explanation than that may very well be hiding some underlying “surprises.” We hate surprises.
Complexity = Risk. Our ideal borrower is in the habit of keeping the plan simple.
“And so, Prince Profit and Princess Principal freed Construction Castle from the clutches of the wicked Budget Muncher, and they lived happily ever after. The End.”
Our Ideal Borrower Can (And Will) Back It Up
Every bit as important as the strength of the project, is the as-is value of the underlying property, before a single drop of paint is applied.
Imagine this: a developer buys a house that is on the brink of falling apart, for $50,000. It’s current worth is $100,000, and it needs $100,000 worth of repairs, after which it will sell for $450,000. That’s a tidy $200,000 profit on the deal (not including holding costs.) Not bad at all.
The developer wants to borrow the full $150,000 required to buy and renovate the house. With such a nice cushion of expected profit, it seems like a no-brainer.
But what if, on Day One of construction, the developer has a heart attack, is hit by a bus, or mysteriously vanishes all together? If we, the lender, end up having to take possession of the house at $150,000, do the numbers still work? Do we have the connections in place to jump in and finish the project? Do we have enough additional money to complete construction? Does the current value of the property support the total amount of the loan?
Assuming our developer-borrower “checked out” on Day 1 without pounding so much as a single nail, we may be entitled to foreclose and take over the property, but we’ve spent $150,000 so far for a house that is only worth $100,000, and it still needs $100,000 of work to get it in saleable condition. We’re now faced with a major decision; do we (or can we) finish the project on our own, or do we sell at a loss? Worst case: Do we pass on our right to foreclose and walk away all together?
I’d never recommend doing the above deal without some additional level of security for the $150,000, in the form of an additional mortgage on another property and/or a personal guarantee (likely both). A personal guarantee is a fantastic way to “bridge the gap” when a borrower would like to take a leap on a project that has great potential, but lacks much as-is value in the beginning, if they are willing to back up the loan with their personal net worth. And if they believe the project is truly worth doing, why wouldn’t they be?
Our ideal borrower will come to the table with a property that has a current value sufficient to collateralize the loan completely. If the subject property’s value doesn’t cover the amount of the proposed loan, our ideal borrower will be willing and able to bring additonal collateral to the table.
Our Ideal Borrower has Both Experience and Reputation
As we mentioned previously, our ideal borrowers are not hobbyists, part-timers, or newbies. Experience matters. Reputation matters. A strong borrower will be able to provide a laundry list of successful past projects, and ideally one or two that closely resembles the project for which they are fundraising.
Does the borrower have an exit-strategy if things don’t go as planned? Does the borrower have other properties for sale that will help them spread the risk if one goes badly, or is this a borrower for whom the current project is an “all-or-nothing” enterprise? The reality is that real estate development projects rarely go exactly as planned. Our ideal borrower has a proven track record of dealing with challenges and overcoming unexpected setbacks long before they ever affect their ability to repay their lenders.
A few words on reputation: Real estate is a very social business. The top agents, brokers, realtors, investors, and lenders reach lofty levels of success in the business because they build quality networks full of other top professionals. People who do bad business tend to be exposed within these networks extremely quickly.
Our ideal borrower knows the value of maintaining a stellar reputation among their peers, an has numerous other real estate professionals who would go out of their way to vouch for their reliability and integrity.
Our Ideal Borrower Doesn’t Need the Money
Whaaaaaaaaat?
Then why would they borrow it at all?
Two words: Opportunity cost.
The post-2008 lending environment has left many people with the impression that borrowing money is not ideal, and that if you have debt, repaying it should be your first priority. That’s not always the case, especially if you are a real estate developer whose business is flipping properties for profit.
Imagine this scenario: A developer buys a fixer-upper for $50,000. It needs another $50,000 in repairs. When renovated, it will list for $225,000. Assuming there are no other unexpected expenses, the total profit will be $125,000.
The developer currently has $75,000 in working capital just sitting in the bank, ready to go. Why on earth would the borrow money at 10–14% interest for 6 months? Why would they pay $3,000–4,000 to borrow money that they don’t need to borrow?
Because if the developer comes out of pocket for the $50,000 in construction expenses, their working capital account is now down to $25,000. What happens when, a month later, a similar opportunity to purchase a cheap property comes across their desk? By using their own funds for construction on the first project, they torpedoed their ability to jump on the next great deal. To save the $3,000-$4,000 in interest payments, they may have to pass up a profit of $125,000, maybe more.
Borrowing that money — even at a high rate of interest — just started to make a lot of sense.
Our ideal borrower has the money in the bank, but they know that the smart move is to keep it there, pay the interest on their loans, and acquire new lucrative properties when opportunity comes a-knockin’.
Ignore at Your Peril!
We’ve seen what happens when the above criteria are ignored. The entire world witnessed the collapse of the U.S. housing market, when the mortgage banking industry’s dubious practice of lending to thoroughly unqualified borrowers on a massive scale, came to a head in 2008.
People saw their jobs, their life savings, and their carefully-planned futures vanish, literally overnight.
Post-2008, banks have tightened lending requirements considerably, using impersonal, inflexible metrics that they believe will protect them — statistically — from lending to the wrong people. This knee-jerk over-correction has left millions of highly qualified borrowers out in the cold.
Fortunately, this vastly underserved pool of highly qualified borrowers has a lifeline:
It’s us.
Private lenders like us now have a unique window of opportunity to make and cultivate relationships with highly qualified borrowers in the real estate industry. They can put their capital to work, enjoying all the safety and security of a good, old-fashioned home mortgage, but earn 3–4 times the return that banks receive, often in as little as 6 months.
Sooooo… Where Is Our Ideal Borrower?
It takes considerable work, research, and due diligence to find qualified borrowers and properly vet them to ensure they meet the high standards which make a borrower truly “ideal.” But that’s exactly the business we’re in.
Want to connect with ideal borrowers? We know boatloads of them, and we are constantly meeting and doing our due diligence on new applicants.
If you want to be the first to know when our pool of ideal borrowers is seeking funding for a quality real estate development project, CLICK HERE to join our group of private lenders. Jump on the deals you like, pass on those you don’t. Unsubscribe anytime.
Simple.
The ideal borrowers are out there. In fact, they’re right here.
Evan Dorren is the Investor Relations Director for Castellar Investments, LLC, a Virginia-based real estate investment firm.
