Why Private Lenders Are in the Safest Position in the Deal, and the Least Likely to Lose Money — Even if the Market Starts Going Down

In a previous article I said, “Even if you’re on the wrong side of a market correction, a property you have a loan on might lose at most 1-2% of its value per month.”

So, the obvious question: doesn’t that mean that you — the private lender — are losing money? Doesn’t it mean you’re losing 1-2% per month on your investment?

Not at all. You’re just the lender in this context. Your collateral is losing a little value each month, but you’re a long way from losing actual money.

OK, so who loses money first if things don’t go as planned?

Easy…the active investor-operator aka the flipper. He or she has the “front-line” exposure. The passive lender, on the other hand, is in a much more protected position…and it takes A LOT of these 1-2% per month declines before the property is worth less than the loan amount.

Here’s why. First, because of how you’ll structure your loans. You should always structure your private lending deals such that you’re lending against the After-Repair Value (ARV) of the property, NOT the As-Is Value (AIV).

We’ll get more into that in future articles, but for now, here’s the quick-and-dirty explanation; when you loan on what the property WILL be worth when it’s all fixed up, you’re creating a “cushion” in the deal. You’re effectively inflating the value of the property to its future value and lending against that, but reducing your Loan-to-Value ratio accordingly.

The second reason is how the capital stack is structured.

If the bar above represents 100% of the property’s value, it’s the part in orange that gets eaten away first when home prices fall. 

That’s the flipper’s equity in the deal, which is usually a combination of:

Some cash they put down (because I require them to have “skin in the game”)

And the discount off of retail value they got from the original seller (what I call “instant equity”).

The part in green is the lender’s contribution via the loan. As you can see, it’s at the bottom of the capital stack, meaning it’s the most protected from downside. The property would have to lose 25-40% of its value (depending on the loan-to-value ratio) in order for the property to be worth less than the amount of the loan (i.e. be “underwater”).

Look, whenever you’re considering making a loan on a piece of real property, you’ll always want an accurate, objective opinion of value. And it should be based on:

Current market conditions

What you can reasonably expect from the market as you move forward in the deal over the next 6 to 12 months.

Why only 6 to 12 months? Well, if you do it the way we do it, private lending is generally short-term. We don't like to be in deals any longer than we have to when the market is at or near its peak.

Suffice it to say that when a market is at or near its peak, you want to do shorter deals in case the market begins to fall.

When you're near the bottom, you can afford to do longer deals because you've got a market tailwind rather than a headwind. A market tailwind increases the value of the property as the project is being completed and thus reduces your risk (because your Loan-to-Value ratio is getting progressively lower).

Bottom line: You don’t have to be an expert market timer to be an expert private lender. You just have to be smart about how you structure your loan.

In any market cycle, the less exposure you have, the better. And the more risk you feel — and everyone is different when it comes to risk — the more cushion and borrower “skin-in-the-game” you should require.