Due Dilligence

At the heart of every loan we make is protective equity in real estate. There is, however, a lot more to the decision making that goes into whether or not to make each loan. Our underwriters carefully scrutinize every aspect of each loan request including the underlying property, in terms of overall desirability, marketability, condition, and associated value, with primary consideration given to liquidation value as opposed to the ethereal “market value”. We conduct a complete examination of the title to the property and obtain title insurance on every property we lend on. We also keep a keen eye out for any environmental issues that may affect the property. We carefully scrutinize each borrower in terms of their credit, income, expenses, assets, liabilities and overall motivation for requesting a loan. Each loan request must also pass the basic “make sense standard.” Only after all of these things are considered do we decide to accept or deny a loan. We only fund roughly one in every 50 loan requests we receive, and we only lend when the theoretical worst-case scenario is in fact the best case scenario. In other words, our decision is a function of our determination that our investors theoretically stand to gain considerably if it becomes necessary to go through the process of foreclosure and liquidation. 

Further insight into our exhaustive underwriting and due diligence process follows.

Underwriting the Collateral
Without significant protective equity, we will not consider making a loan. Verifying this equity, however, involves more than just having the property appraised by a third-party appraiser. A thorough understanding of the appraisal and who made it are critical.

The definition of an appraisal is an estimate of value, but whose estimate is it and under what assumptions was the estimate made? All opinions of value are not created equally.

To begin with, there are three basic types of appraisal methodologies, the comparable sales approach, the replacement cost approach, and the income capitalization approach. Regardless of the methodology and approach used to arrive at the final conclusion of value, each appraisal is just someone’s opinion of value. How this appraised value relates to the amount a property will likely sell quickly for in an open market with a willing seller and a willing buyer is the real question.

In the comparable sales approach to valuation, the appraiser attempts to compare the subject property to other similar properties that have recently sold in the same market. In the replacement cost approach, the appraiser will summate the costs to develop a project and deduct the depreciation to arrive at a final conclusion of value. Whereas in the income capitalization approach, the appraiser discounts the future value of net income generated from a property, given a market capitalization (cap) rate, and uses this to arrive at the appraised value.

But these are not the only perspectives of value, and solely relying on an appraisal can be a costly mistake. Our loan-to-value ratio is calculated quite differently, as we are primarily concerned with the liquidation value as opposed to the market value. Additionally we give no consideration to the future value of a property and only lend based on today’s value.

Liquidation value is usually significantly lower than market value and is of primary concern in real estate lending. Our evaluations are primarily made on the basis of liquidation value, and in arriving at a proposed loan amount, we anticipate the costs associated a worst-case scenario. For example, if we have a liquidation value of $200,000 and a loan amount of $100,000, ostensibly this is a 50% loan-to-value ratio. However in the case where a borrower defaults and does not make payments, the loan amount can rapidly increase with interest not being paid (arrearages) and the costs associated with foreclosure and liquidation of the property. Once these numbers are factored into a loan, it is easy to see how a 50% loan-to-value ratio can easily escalate to 60% and above. This worst-case scenario loan-to-value ratio must be given primary consideration when deciding whether to make a loan.

Our comprehensive analysis also contemplates the particular market a property is located within. We examine all relevant trends in that market, including, employment trends, absorption rates, population trends, occupancy rates, capitalization rates, rental rates, and property trends. We regularly consult with local professionals including, real estate brokers, rental agents, investors, and banks.

Additional Collateral
We regularly receive additional collateral beyond just one property, and often secure our loans by multiple properties. In the case of a corporate borrower, we often require personal guarantees from the principals of a corporation and then often secure those personal guarantees by additional real property. Our basic philosophy is that if a borrower won’t “leverage the farm”, then we won’t make the loan.

Substantial protective equity in the underlying property

Title and Hazard Insurance
After arriving at a conclusion of value, it is critical to analyze the title of property. We examine every document recorded against a property, including liens, both voluntary and involuntary, easements, tax assessments, etc. Title insurance insures against the risk of not getting clean title to a property, and we get more than just title insurance on every property we lend on. First we order title insurance in the amount of 120% of our loan in order to have insurance that includes the costs of actually foreclosing. We order many endorsements to each policy of title insurance to not only insure our lien position, but we also want to insure who owns the property and what type of improvements are located on it.

In addition to title insurance, we require that the borrower maintain hazard insurance to cover us in the case of fire or other damage. We are named as loss payee, additional insured, and lien holder on each policy of hazard insurance. We require evidence of insurance that contains a minimum of 30 days written notice of cancellation and continuation of coverage in the event of a default, all of which allows us to continue making payments to the insurance company should the borrower default on their insurance payments.

Environmental Concerns
If the property type and/or situation warrants, we investigate for environmental issues of concern.  As needed, and in addition to environmental questionnaires, we also examine existing and/or order new Phase I and Phase II environmental reports.

Going Beyond the Collateral: Underwriting The Borrower
Real estate is the foundation of every loan we make, but a careful evaluation of the borrower is equally critical. Even in the case of “stated-income” loans, we analyze each borrower to determine the likelihood of timely repayment.

Our process includes examining the borrower’s credit and credit score and looking beyond just the numbers. We are concerned with their overall financial health as it relates to their ability to repay the loan. This can include examining income, expenses, assets, and liabilities. In the case of entity borrowers, we also examine each principal behind the entity. Most important, however, is the “why.” Why is the borrower borrowing and how does our loan help them achieve a goal such that they can repay our loan?

In general there are two types of borrowers, those who borrow for need and those who borrow for profit. While we do make some needs-based loans, we specialize in lending to those who borrow for profit.