The 4 C’s of underwriting
As we have discussed in previous articles, private lending offers a flexible alternative to traditional bank financing for real estate projects. That sounds great…right? So, how do private lenders decide who gets a loan and who does not? The answer lies in the framework known as the “4C’s of underwriting.” These 4 areas provide the lender with a picture of what they want to know about you and your project.
1. Collateral: In real estate, the 3 most important things are Location, Location, Location! In private lending, it’s Collateral, Collateral, Collateral! This is the project itself and the property that will be encumbered by a lien if the loan closes. Collateral is the most important area of underwriting the collateral provides the protection to the lender if the loan does not perform and/or if the borrower walks away from the project.
Does the project have a realistic after repair value (ARV)? Does the repair budget match the scope of work? Is the repair timeline reasonable? Is the purchase price at or below 70% of ARV minus repairs? What is the exit strategy (sell or hold & refi with long term debt)? If the private lender’s analysis of the project does not meet their requirements, the loan will usually be denied at this initial step in the underwriting process.
2. Character: Private lenders are not just providing funding for your project, they are entering into a business relationship with the borrower. Most private lenders will want to interview you during the underwriting process and in many cases meet you face-to-face to get to know who they are considering partnering. Be prepared to not only discuss the project you are seeking funding but also your experience and how you are well-prepared to successfully execute your plan. Let the lender get to know you. It is important to be readily available during the underwriting process. Respond quickly and completely to all calls, emails and requests from the lender. Treat this as you would a job interview and get the lender comfortable that you have what it takes for a successful outcome on your project and repayment of the loan.
3. Capacity: Another way of saying this is: Does the borrower have adequate cash not only for the down payment but also for the carrying costs (including interest payments) and unforeseen issues? It is essential to have enough liquidity to complete the project. If you don’t have the cash available, find a minority partner that can provide the funds for you. If you have high equity in other investment properties, your lender may be willing to cross-collateralize that property in lieu of bringing cash.
Another component of capacity beyond just cash, is aligning the borrower’s experience with the project. A cosmetic rehab would be aligned with a less experienced investor; however, a full gut rehab would not. If you lack the experience, bring an experienced partner.
4. Credit: Although private lenders do not have the same credit requirements as a bank, most private lenders will review a potential borrower’s credit history. This will provide evidence of how a borrower manages their financial obligations. If you have some dings are your credit report, be prepared to provide solid reasons of why as well as how you managed to recover. In many cases, a lender may be willing to accept a lower than average credit score by decreasing the loan to value and requiring the borrower to bring more of their own cash to the table (more skin in the game). If credit becomes a stumbling block, bring a partner to guarantee the loan.