Anyone with aspirations for building or renovating a home, whether for themselves or others, may need help financing their project. In many cases, financial institutions have become more difficult to access for construction loans, as they reign in their willingness to lend during uncertain economic times. How can you evaluate the alternative option of a private lender and what will it mean for your project?
Looking Beyond Institutional Lenders
Let’s explore some of the key differences that will change a borrower’s experience through the construction process when comparing an institution with a private lender.
Underwriting Criteria and Borrower Approval
When an institution such as a bank, credit union, or pension fund looks at a construction mortgage, it rigorously qualifies borrowers through a standard application process focused on the strength of the covenant, specifically ensuring a borrower’s financial position meets its ratios. The approval process can be especially challenging for individuals involved in multiple projects at one time; self-employed individuals, or real estate investors that hold multiple investment properties and need to qualify based on GDS/TDS for the subject and any of their other properties. As a result, many borrowers are forced to keep their working capital idle, or in some cases have their application rejected altogether. Construction loan applications also test the loan-to-value (LTV) ratios of a given project, and institutional lenders have very little flexibility to adjust the limits of leverage they can offer.
A private lender is not restricted to a rigid formula when underwriting a loan, so it has the ability to look at each loan based on its individual merits. Where an institution is a covenant lender, focusing on a borrower’s income or net worth to qualify, a private lender takes an asset-based approach, emphasizing the value of the real estate. Private lenders have the ability to structure construction loans with different parameters for advances, which can sometimes work for borrowers with less available working capital. Private lenders will also consider lending in 2nd position where an institutional lender may be unable to, (this is also a cost consideration, as discussed below).
Speed and Flexibility – Hallmarks of the Private Lender
Institutions are known for their bureaucratic nature. Many layers of administration and approval can lead to a construction draw process that will stop the momentum of a build. Advances to fund construction costs are typically limited in number and only upon achieving certain milestones. As a result, it could take an institutional lender up to a month to fund a construction draw, which could stretch out the length of the project, and in some cases lead to trades registering liens against the property—a costly and further time-consuming process to clear up.
Private lenders have the ability to be more nimble when responding to project changes or other borrower needs. A private lender can increase or decrease the number of draws based on each project’s requirements without being tied to rigid restrictions on the timing of each draw. This is critical for a borrower as they rely on their lender to advance funds quickly (days rather than weeks), both to keep the project moving and to ensure that all trades and suppliers are paid on a timely basis.
The Cost Trade-off: Is it Really More Expensive to Borrow from a Private Lender?
As we’ve seen, a construction loan from a private lender can reduce the time it takes, both to initiate, and to complete a project as a result of their flexibility and turn-around time. This key difference would result in loan interest being paid over a shorter duration until the finished product could be sold or refinanced with a conventional mortgage. In many cases, this may actually equate to a less expensive loan.
Also, it is worth noting that some private lenders are prepared to provide the construction loan as a 2nd mortgage behind an institutional lender, and this could result in a low blended rate between the two loans. (Our article, “Second Mortgages are Worth a Second Look” explains how to calculate the blended rate.)
Managing the financing for a construction project can be a challenge for many individuals and builders. The goal of a private lender is to keep builders focused on completing their projects in a timely manner, with speed, and without an added layer of administrative hassle. Ultimately, you may want to consider a private lender to finance your,or your clients next construction build—once you dig a bit deeper into the process you may end up coming out ahead financially have fewer headaches, and have a more positive experience completing construction projects with a private lender.
Article by Catalin Popa, Manager, Underwriting, at Hillmount Capital. Catalin can be reached at firstname.lastname@example.org