http://www.nytimes.com/2011/07/27/business/affluent-buyers-reviving-market-for-miami-homes.html?pagewanted=1&_r=1

It seems that the Miami market, one of the worst hit during the real estate turn down, is on the mend, and that is attributed to investment buyers who have stepped in and said with their dollars: This market has gone about as low as it is going to go. There are opportunities here. We are ready to buy and hold and make our money down the line.

This has provided the much needed buffer, almost like say those who speculate in commodities markets, to balance out the market and absorb the gap that would otherwise exist between supply and demand.

I’m curious: how many of you think this could be a trend for the entire nation? Is this the way that it will all get turned around, and is this the beginning of that turn around? Please comment.

– Clay (clay@privatemoneysource.com, 503-476-2909 or 800-971-1858)

Clay is Vice President of Fairfield Financial, a primary source for private money loans since 1964.  Fairfield works with a broad range of private money investors, in a broker capacity, finding, underwriting, presenting, closing, servicing, and when necessary, assisting in the workout of difficult loans.

We’ve been through nearly 3 ½ rough years in the real estate market—and projections seem to indicate that we will finally see clear up-turn in the second half of this year, but no one really knows for sure.  We have managed to survive this down-time (thus far) and continue doing loans even in the face of uncertainty to borrowers and investors.  Certainly our loan volume is down.  Less people are borrowing for projects at the moment (though we are starting to see some upturn there) and our investors are being more conservative given the level of uncertainty.  The key areas we look, I would say, even more carefully than we did before the crash are:  (1) LTV: we used to do a lot of stuff at 75%.  Now most of what we place is at 65% or less.  (2) Professionalism of the borrower: we want to see that the borrower is proceeding with caution, has done his/her homework, has backup strategies in place, and has a reasonable track record.  (3) Exit strategy: it is hard to be certain in this climate that an exit strategy will work, but we beat this to death to be as sure as we can that there is/are one or more ways to exit the loan.

Rigorously following these guidelines has served us well and has generally worked out well for our investors.  By way of example, here are four loans that we have closed (or are in the process of closing) recently.

Mini-condos for simple living on the Washington coast

1.     Loan Amount: $286,000

2.     Term: 1 year

3.     Interest Rate: 13%

4.     Monthly Payments: $1,895.83 Interest Only

5.     Construction Holdback Account: $265,000

6.     Security:  Deed of Trust in 1^st Position security interest in real property at xxxxxxxxxx

7.     Projected Value by Borrower Comps: $476,000

8.     As-is Value by Borrower Estimate $30,000

9.     As-Is Front End LTV Borrower Estimate:  70%

10.     Completion LTV by Borrower Comps:  62%

This loan is to provide funds to build four detached condos on the Washington Coast.  The borrowers, xxxxxxxxxx of xxxxx company requested a loan of $286,000 to provide funds for the construction and various loan costs and closing fees.  $265,000 of this was deposited into a construction holdback account.  The borrowers have $21,000 invested into the purchase and clearing of the lot so far, which is effectively being considered as their down payment or skin in the game.

This will be the 3^rd group of condos that the borrowers have built.  The first set of condos was built in the fall of 2009, and the borrowers report that they sold in approximately 2 months.  The 2^nd set was completed in the fall of 2010 (this is an existing construction loan with Fairfield), and at least one of those units has been sold for the full asking price.  The borrower reports that there has been a lot of activity and interest in the remaining units.

Partner xxxxx  is a realtor, and her husband is the contractor who will do the actual construction.  The borrower plans to exit this loan through the sale of these condos, and has requested that each condo be released with a principal reduction of $75,000.

The property is located on a cul-de-sac approximately 1,800 feet from the average high tide line, and two blocks from public beach access. These condos will be 480Sq/Ft with a full kitchen and bath, and made with eco-friendly materials.

Adult care facility in Washington

1.     Loan Amount: $270,000

2.     Term: 24 Months

3.     6 months minimum interest

4.     Interest Rate: 14%

5.     Monthly Payments: $3,150.00 Interest Only

6.     Security:  Deed of Trust in 1st Position security interest in real property at xxxxxxxxxx

7.     Value of Collateral by Appraisal:  $750,000

8.     LTV based on Appraisal:  36%

The borrower, xxxxx, inherited an adult care facility approximately 2 years ago.  She requested this loan to funds to pay the probate and costs incurred in the transferring of the estate.

The subject property is a 4402 SF 8 bedroom 3-bath home being used as an adult care facility.  There are several outbuildings being used as rentals to the borrower’s family.  Leases were provided.  The home sits on 5 acres, adjacent to a bare 5 acre parcel that is also being used as additional collateral.

Vacation rental in central Oregon

1.     Loan Amount: $120,000

2.     Term: 36 Months

3.     6 months minimum interest

4.     Interest Rate: 13%

5.     Monthly Payments: $1,300.00 Interest Only

6.     Security:  Deed of Trust in 1st Position security interest in real property at xxxxxxxxxx

7.     Value of Collateral by Borrower Comps:  $227,900

8.     LTV based on Collateral by Purchase Price:  53%

The borrower, xxxxx company had negotiated the purchase of this property for $150,000.  The seller was in financial distress and needed to sell quickly.  The borrower believed that this price was well under value (the list price was reduced to $199,500 on 12/8/10), and were requesting 10K for cosmetic improvements.  They put down 25k, and the seller is carried back another 25K to make the loan work.  The loan was personally guaranteed.

The subject property is a 1,618SF home that will be used as a vacation rental.  It is located in the xxxxx subdivision which has amenities such as a club house, swimming pool, excessive common grounds use, and paved bike paths.  The property has 3 bedrooms, 2 baths, fireplace, and wrap around deck.

Self-storage facility in northern Washington

1.     Loan Amount: $375,000

2.     Term: 36 Months

3.     6 months minimum interest

4.     Interest Rate: 12%

5.     Monthly Payments: $3,750.00 Interest Only

6.     Security:  Deed of Trust in 1st Position security interest in real property at xxxxxxxxxx

7.     Value of Collateral by Purchase Price:  $565,000

8.     LTV based on Collateral by Purchase Price:  66%

The borrower, xxxxx, is an experienced owner and operator of self-storage facilities.  He had the subject property under contract for $565,000, and was seeking a loan of $375,000.  There was approximately $20,000 in credits that the seller agreed to provide, and the borrower stepped up with a down payment of approximately $200,000.

The borrower plans to live on site and manage the property which will greatly reduce his personal living expenses as well as eliminate the wages that are currently being paid to an on-site manager.  In addition, he plans to install a self-service Kiosk that would allow easier access for new tenants to sign up 24/7.  He also plans to improve the signage, making the property more visible.  Finally, he will offer a $1 first month move in special and change the name of the property from xxxxxxxxxx to yyyyyyyyyy.  He believes that this name change will improve the search engine rankings and ultimately increase occupancy.  Through these changes the borrower believes that he can increase his occupancy from the current 50% to 80% in the first year.

The borrower plans to exit this loan by refinancing with and SBA loan.  More info regarding the feasibility of this exit strategy is described below.

The subject property is consists of 2 lots with a combined 2 acres and 22,923SF of rentable space over 7 buildings.  In addition, there is a small 2br 1ba manufacture home on the property.  The property was reported to be in excellent condition, and located in a prime spot in northern Washington.  There are several self-storage facilities in this area, which are reported to have low vacancy rates.

The current occupancy rate is at 50%, which the borrower attributes to the current “absentee owner”.  As far as he can tell, there isn’t much for marketing activity and no incentive for the on-site manager to increase their workload by working to increase the occupancy.

– Clay (sparkman@lendicom.com, 503-476-2909 or 800-971-1858)

Clay is Vice President of Fairfield Financial, a primary source for private money loans since 1964.  Fairfield works with a broad range of private money investors, in a broker capacity, finding, underwriting, presenting, closing, servicing, and when necessary, assisting in the workout of difficult loans.

I would like to make a proposal.  I would like to propose that the standard universal laws don’t necessarily apply to private money lending.  That is, the things which we most take for granted—or assume to be true–may not be true in the realm of private money lending.

Let’s talk about systems for a moment.  Let’s take physics as an example.  Physics is the scientific mechanism which man has devised for describing, conceptualizing and predicting the behavior of the physical world.  In the realm of physics, if one rule or one aspect of the system is called into question—even a small matter—then the entire system must be called into question.  This has happened on various occasions as the science of physics has evolved, and as you can well imagine, it has caused quite a fuss among those who study physics.

My goal here is to break your notion that the things which you “know to be true” in the realm of private money lending can be correctly assumed to be true.  Let’s start with something absolutely fundamental.  Everyone agrees that there is a direct relationship between the perceived risk of loss of investment capital associated with a particular investment and the rate of return from that investment.  And I think it would be fair to say that pretty much everyone in the field agrees (1) that private money loans are riskier than their institutional counterparts (hereinafter referred to as institutional loans, a category to include conventional loans, sub-prime loans, and everything not included in the category of private money) and thus carry higher interest rates, and (2) that within the private money realm, riskier loans carry higher interest rates than those which are perceived to be less risky.  I would be quite surprised if any of my readers take issue with either of these two basic notions.  Let me clarify one more time because this is important: when I speak of risk here, I am referring to the risk of direct monetary loss of investment capital.

So let me now proceed to turn these two basic notions upside down.  Fundamental notion #1 suggests that private money loans are riskier than institutional loans and that this is the reason why they carry higher interest rates.  This is quite simply wrong.  Institutional lenders don’t avoid risky loans per say.  In fact, the sub-prime realm tends to thrive on them.  Institutional lenders can (and do) factor known risk into their lending process.  What institutional lenders will not tolerate is this: they will not tolerate loans which cannot be analyzed or characterized within a specific manageable and objective framework.  Put another way, institutional lenders are only interested in commodity loans—as opposed, let’s say, to custom loans.

And why is this true?  It is true because institutional lenders choose to manage risk and this can only be done effectively within a commodity loan system.  Even though these lenders can accommodate almost any degree of risk, they cannot–and will not–accommodate unknown risk.  All risk must be measurable, and risk—to say it another way–is only measurable within a specific manageable and objective framework.  Using FICO scores and other specific measures, the typical institutional lender can predict to within a dime the value of their loan portfolios that will go bad.  So you see, by managing risk, in effect they eliminate risk.  Any given loan involves a certain amount of risk, but a portfolio of commodity loans is utterly predictable.

In case you’re not buying this particular line of logic, and you think that I’m just working with smoke and mirrors here, let me offer some (fairly) objective data.  At Fairfield Financial, we manage a portfolio of 200+ private money loans at any given time, a package that adds up to about $30 million dollars in face value.  Our average mid-score for that package is between 650 and 660.  That portfolio sees an average of 2 loans per year go to REO.  That is a 1% default rate.  Those are good figures: 650-660 mid scores and 1% default rate.  I suspect that many institutional lenders would rather enjoy such numbers.  And thus, it seems that our loans are not necessarily more risky—or even as risky—as their institutional counterpart.  Then of course then our rates must be on par with the institutional realm as well, yes?  No.  Our median interest rate is 13% (fixed).

Okay fine.  Certain irregularities occur in the risk-reward relationship when crossing from the institutional money realm to the realm of private money.  But surely we can say—with complete confidence–that within the realm of private money, riskier loans carry a higher rate of interest than those perceived to be less risky.  Here again, I would respectively suggest: it just aint so!

Private money lenders are averse to risk–as are all investors.  However, private money lenders on the whole are particularly averse to risk of default (as opposed to risk of loss).  Risk of default involves (a) temporary cash flow interruptions (something we affectionately refer to as “cashflowus interuptus”), (b) lying awake at nights and worrying about non-performing or sporadically-performing loans (which we call “bad boys”), and (c) lots of hassles and many hours of work (which tend to accompany the bad boys).

In fact, I would assert that on the whole private money lenders are less averse to risk of long-term potential loss then they are to risk of default, which we shall refer to hereafter as the “bad boy problems.”  I have spent the past 15 years of my life pricing private money loans and have a pretty good idea of how the market works.  Pricing private money loans is a little like pricing antiques but tougher; it is a highly subjective process.  But of course there are certain guidelines.  One takes a hard look at the long-term risk of the loan and at the potential for bad boy problems.  I would argue that the best indicator of long-term risk is LTV.  Bad boy problem indicators (such as credit, income, and pay history) may play into the risk equation, but as any private money lender will tell you, they are betting on the equity first and the borrower second—and in fact the borrower is a distant second.  Having established LTV as a risk indicator, let’s look for a bad boy indicator.  Let’s go with FICO mid-score.  I have found that FICO mid-score is indeed a very reliable indicator of the likelihood that you will have a bad boy on your hands.  When it comes to financial responsibility/performance, it seems that the past is a very good predictor of the future.

So now we have two objective scales to work with: LTV and FICO mid-score.  Here I’m going to take a giant leap (very unscientific, but also very interesting) and make the assumption that these two scales are basically linear.  The LTV scale for private money loans basically runs from 0% to 75%.  The FICO mid-score scale runs from 300 to 850.  So that now we have established a ratio of 7.33 between the two scales ([850-300]/75).  Thus we can say that a 10% change in LTV on the risk scale is roughly proportionate to a change of 73 in FICO mid-score on the bad boy scale.

If risk is the primary factor driving interest rate, then a 75% LTV loan to a borrower with a 700 mid-score would carry a higher interest rate than a 55% LTV loan to a borrower with a 554 mid-score.  Well, in fact just the opposite happens.  Equalizing for other factors, I would tend to price the first loan at 12-13% and the second loan at 14-15%.  So you see, long-term risk is a distant second to bad boy factors when pricing a private money loan.

Someone I respect immensely recently said that it is not what we don’t know that endangers us the most.  It is what we think we know but know incorrectly.

If you go away from this post knowing that the risk-reward relationship as applied to private money is a myth, then you have learned a little something.  If you lie awake tonight and wonder if things that go up in the private money universe really must come down—then that dare I say may qualify as an epiphany.

– Clay (clay@privatemoneysource.com)