Fairfield Financial Services, Inc. - Private Money Loans, Lending & Borrowing

Twenty-eight questions you must ask

Clay Sparkman

I first wrote and published this piece in its original form in September of 2009. I am of the firm belief that the key to success (defined as: having fun and maximizing your return, two closely correlated phenomena), is rigorous and comprehensive vetting of the loan proposal. If you do this right, the rest tends to follow. With that in mind, a quick review of this list tells me that not much has changed in this regard, in spite of going through the greatest economic depression since the great depression. So I see it fit to publish this again, with a few slight variations and several rather important changes (the three new items). You can never overthink and over-analyze the vetting process. So here you go:

I’m going to make a list today of twenty-eight important questions that I believe an investor must ask prior to funding any private money loan transaction. I’m not going to elaborate much on each particular item here, but will drill down on each of the individual items in future posts. For the sake of simplifying this discussion to a reasonable level, I’d like to start with several assumptions: (1) we are only talking about loans secured by real property, (2) we are only talking about first position loans, and (3) we are not talking about land development or raw land loans. (Each of these exceptions, if removed, would be good for another whole list of special questions; we’ll save those particular scenarios for future discussion.)

(1) What is the Loan-to-Value (LTV) ratio of the loan you are considering and how does that fit with your own risk limits regarding this particular loan and property type?

(2) If this is a value-added loan (construction, rehab, or development), what is the front-end LTV?  Font-end LTV refers to the LTV immediately after the close of escrow but prior to any construction/development or disbursement of construction hold-back funds. (I generally reference this as FLTV, and it is understood that LTV, for a project, actually refers to the LTV upon completion of the construction/development and full disbursement of any/all hold-back funds.)

(3) How confident are you of the value?  The “L” part in LTV is easy.  It is the “V” part that can be quite difficult to accurately determine, and in fact it must be understood that any such determination (no matter how good) is only an estimate. (I.e., It must by definition be an estimate.)

(4) What are the recent market trends for the area in which the property is located? Given the real estate market of the past two years, this question is particularly relevant.

(5) How is the borrower’s credit? What is the mid-score, what are the issues, if any, and what is the trend?

(6) If the loan is a refi: how is the borrower’s pay history on the existing loan?

(7) How much “skin” will the borrower have in the game at the close of escrow? In other words, how much cash or additional collateral is the borrower bringing to the table?

(8) If this is a real estate development or investment loan or a loan to a business owner occupying his own property: what is the relevant experience and background of this borrower?

(9) What is the purpose of the loan and how will the funds be utilized?

(10) What is the term of the loan?

(11) Can the borrower afford to make payments OR does the loan scenario otherwise involve an adequate interest reserve?

(12) What is the borrower’s plan/exit strategy, and–upon careful evaluation of the project/plan–how likely is the borrower’s likelihood of success?

(13) What is the borrower’s net worth and how liquid are the borrower’s assets?

(14) If there are one or more structures on the property, will you be listed as loss payee on a hazard insurance policy or a builder’s risk policy at the close of escrow (or prior to the beginning of construction if new construction is being funded)?

(15) If there is a construction hold-back, who is administering this and do you trust them to do so effectively?

(16) Have you reviewed the operative preliminary title insurance policy and approved any liens that your title insurance policy will be listing as exceptions to your position?

(17) Is your loan compliant with all state and federal disclosure and usury laws?

(18) Will all property taxes be paid current at closing?

(19) What is the likelihood that there are any serious hazardous waste issues associated with the property?

(20) What is the likelihood that there are any wetland issues associated with the property?

(21) If relevant: what is the status of all required permits, entitlements, and/or other government approvals?

(22) What is the likelihood of one or more construction labor/materials liens taking precedent over your lien position?

(23) Does the loan size/amount, location, type etc. allow you to obtain optimal diversification?

(24) What is your plan for servicing the loan?

(25) If the loan involves a fractional interest, how comfortable are you joining with the other lenders involved in the loan?

(26) Is the property in or near a major city? Keep in mind that if values fall, the fall tends to begin in rural areas, and the fall tends to be more dramatic in such areas over time.

(27) How is the area performing currently? What does the price trend look like over the past few years?

(28) And perhaps most importantly: What are the leading indicators of potential future value changes telling you? Keep in mind that price trend is a trailing indicator. You cannot assume that because values have gone up 10% per year in a given area for the past two years, that this gives you any reasonable indication of what to expect in the two years which follow. If we learned anything over the past 13 years (and oh … how we learned it), it is this. You must look at leading indicators if you want to get any kind of real handle on where values might be going. I recently published two blog entries on this subject, If you haven’t read them , please do. They are at Three potentially useful indicators of the likely movement of property values and Leading real estate value indicators.

I may well have left out some important items, so please provide feedback as to which items you agree with, which ones you don’t. Surely we can get this list up to 30!

— Clay (clay@privatemoneysource.com)

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.

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