How to Evaluate a Private Money Construction Loan

May 21, 2018 by Dennis R. Baranowski, Esq.

If you have been making hard money loans for the past several years, you have likely seen the amount of new prospective clients dip some. After the housing crisis, many private lenders were flush with new clients seeking money for fix-and-flip properties. However, now that housing has snapped back, and there is a severe shortage of inventory – especially in California – lenders need to find clients outside of their typical flip borrower.

It may be an excellent time to explore funding private money construction loans. As housing starts continue to soar, not all builders can easily obtain traditional bank financing. They need the specialized services private money lenders provide, and if done right, these types of loans can be very lucrative for your portfolio. 

Reviewing the Deal 

The first thing you have to be concerned with is the speculative aspect of the deal. A construction loan is different from most loans, in that you have to understand the market to know what the property will be worth after construction. Unlike fix-and-flip loans, where a property is already built and just being renovated, ground-up construction projects vary, and the finished value is going to ebb and flow with the economy and market conditions. 

The other thing you are going to run up against is that it is not a typical lender-borrower relationship like you have with most standard loans. You are going to be dealing more with third-parties, such as the appraiser to value the property, and the builders, designers, architect, and others who can help you determine the future value of the property. These pieces of the puzzle that you do not typically see in other loans will be vital in making an informed decision as to the real value of the finished property. 

Key Aspects to Consider When Making a Construction Loan 

With so many characters involved in the process, it is not always guaranteed that they will all do their job right. When just one party fails to perform, it could affect the jobs of other participants and could result in jeopardizing the entire project. Another different aspect of constructions loans is that it is important to monitor the project carefully to ensure they are meeting expectations. This extra scrutiny can help protect you by making sure the project is on task and moving forward on schedule. 

So, unlike a typical loan where it closes and you service the loan, a construction loan is going to require the lender to monitor the project and follow its progress. Typically, there are advances that are going to be made that allow the contractor to meet certain milestones. It is also important to know how far the project has progressed and what still needs to be completed in case there is a possibility of foreclosure. This knowledge will help determine whether you want to step in to finish the project, or just foreclose. 

Effective Underwriting 

One of the best ways to protect yourself while making a construction loan is through the underwriting process. During underwriting, you want to learn more about your borrower than just what’s on the application. For instance, what is their background? How’s their track record? How many properties have they built over the past year or two? Get a list of properties that the borrower completed and check the selling price.  

It is also essential to find out how long it took them to complete the projects. Ask the borrower to provide before and after photographs of previous projects. This information will give you a perspective not only about the quality of their work but about how well they can drive a project from beginning to completion. 

A construction loan needs to be evaluated based not just on the borrower, but also the project itself. It is essential to list all the trades that will be involved in the project and have the borrower produce names for each one. This list will help you dig deeper into the viability of the project getting completed and your loan getting repaid. 

Protecting your Investor 

The key to funding any construction loan is looking out for the best interest of your investor. If done correctly, these loans can provide a great return, but not doing the proper due diligence and vetting of the project could lead to complicated problems.  

The additional risk presented by a ground-up construction project can be mitigated through properly underwriting of the project, adequately collateralizing the loan, and making sure you have the proper insurance coverage in place.  

Adhering to these principals will improve your chances of success and significantly enhance your ability see the project through to completion. Utilize all the resources at your disposal, and if you are still unsure, employ the help of a third-party experienced with validating and confirming the likelihood of you achieving success.