Points and Loan-Term and Rate, Oh My!
Start with LP Preferences, Internal Capabilities & Asset Expectations to Solve for Loan Structure
Why does one private lender charge 3 points and 12% while another charges 1 point and 15%? Why do some lenders make five-year loans while others make six-month loans? Too often inertia drives loan structure. Co-investors or limited partners (for simplicity I’ll refer to both as LPs) develop an expectation that they’ll receive a certain rate. If a lender gets overwhelmed with loan requests maybe she charges an additional point and keeps her rate the same. After all, she has to manage future LP expectations right?
But that’s not the way it should be. Loan structure should be driven by:
Limited Partner Preferences
The Hard Money Lender’s Capabilities
Future Asset Value Expectations
Limited Partner Preferences
There are LPs that are active “deal guys” who only want to make short-term loans to preserve optionality should a killer deal come along in another asset class.
There are other LPs that want to collect mailbox money for years as they chill on a hammock sipping daiquiris.
The Hard Money Lender’s Capabilities
A private lender that also renovates or builds houses in the market where she lends, is better positioned to fund deals involving serious construction. She can foreclose knowing that if she takes an asset back, she has the internal skills and relationships to finish the job and force appreciation.
A lender with a low-cost structure is better positioned to fund deals with built-in equity that require no construction and will therefore churn quickly out of her loan book.
One is stronger in the field, the other stronger in the office.
Future Asset Value Expectations
The Hard Money Lender’s and the LP’s mutual expectations for the future value of the asset class they lend against determines whether they want to be long unfinished collateral for an extended period of time. In this case, you would expect a loan book with unfinished loan collateral in the form of lots or larger renovation jobs that involve total gut jobs or adding square footage.
If you expect finished home values to fall, why would you want to be long lots?
Let’s start with a blank slate and solve backward for loan structure based on these three criteria above.
If you want loans that pay back fast (2-6 months), taken to the extreme you’d charge no points but a high-interest rate with no prepayment penalty and no minimum amount of payments due, on a 6-month (or shorter) term. This will attract borrowers that buy relatively “clean” property from motivated sellers. These motivated sellers are willing to sell a property below market. This structure works for LPs that don’t mind getting paid back every 2-4 months or for LPs that invest in funds that do deals like this. It’s ideal in environments with falling asset values. Reinvestment risk is your biggest risk.
If you want loans that pay back over a more intermediate term (6-12 months), you’d collect a few points but charge a lower rate with a minimum amount of payments that are to be collected. This will attract borrowers that find deals that might be a little below market but definitely have value that can be added. If you extend the term to a year you’ll start to get ground-up construction or fire-burned building loan inquiries. This structure works for LPs that prefer getting paid back every 6-12 months. It’s ideal in environments with rising asset values. Construction risk is your biggest risk.
If you want loans that pay back over a longer term (4-5 years), you might collect even more points and lower the rate further. You’d build in a prepayment penalty. This will attract buy-and-hold borrowers. They will have credit problems in a normal credit environment or will have fine credit in a credit-constrained environment. This structure works for LPs chilling on hammocks provided they are ok with some defaults in a normal credit environment. It works well in flat markets but if the LTV is low enough, it is fine in falling markets as well. Credit risk (might) be your biggest risk.
As always, I welcome feedback and would enjoy hearing from readers about this.