The presumption by some lenders may be that the increased property value after repairs, upgrades and rehabilitation will serve as the protective equity. But, as many lenders are discovering, they unintendedly assume major financial risk rather than the owner/borrower. Speculative real estate purchases require the allocation of risk-capital into high-risk, high-reward projects, usually intended to be assumed by the owner/borrowers rather than the lenders.
There is a significant difference in the security position between a lender making a loan to a borrower with current identifiable protective equity, or lending to an owner/ borrower with no cash equity, or any significant financial contribution to the project. No-skin-in-the-game is used to refer to an owner/borrower who has little or no financial capital at risk. The lender becomes the primary “risk capital” provider rather than the owner/borrower.
Here are a few current examples:
- Facts: Borrower purchased an SFR in a high demand coastal residential neighborhood with the intent of demolishing the structure down to the studs, shoring up the foundation, adding a second level, and completing a reconstruction which will put the property in new condition. The dwelling square footage would increase from 1,500 to 3,500.Purchase price $888,000 with a new of $980,000 originated from a fix & flip lender. From day one the lender had all the risk. Borrower obtained approval for plans to reconstruct home. The borrower immediately tore down the home with only old studs showing, while using borrowed funds from the original loan. The home was supposed to be worth 1.8 million after the reconstruction and completion of the brand-new home. First loan came due. Borrower attempted to obtain a new loan for $1,300,000 to complete the construction. But the first foolish lender did not consider that any other lender would require equity. Could there be another foolish lender that would lend speculatively? The tear-down value has been diminished to a land-value-only conclusion of between $600,000 and $700,000. The first lien lender is upside down by at least 30% of their capital. They can foreclose, assume the risk of the developer, finance the completion of the new home and sell on the open market. Or, they can scrape the lot and sell the bare lot at a substantial loss.
- Facts: Borrower purchased a run-down motel in a secondary market with the idea of fixing it up and flipping for a profit. The borrower purchased the property for $1,300,000. The borrower obtained a purchase money SBA/Construction first trust deed for $1,400,000 enough to pay 100% of the purchase price and closing cost. The borrower then obtained an additional loan for $800,000 for the construction and improvements. An appraisal for “as-is” condition came in at the purchase price of $1,300,000 and an “as-completed” of $2,600,000. The final valuation was without the contributory value of the tangible personal property and the going-concern business value.The borrower ran out of borrowed money and attempted to obtain a new $2,700,000 loan to pay off the first, second and provide capital to complete the construction, open the business, and operate until stabilization. Who has the real risk in this instance? The lender rather than the borrower since the borrower had very little skin-in-the-game.
- Facts: Borrower purchased an SFR for fix & flip in a coastal residential neighborhood, San Francisco, for $950,000. with a new purchase money first loan of $1,200,000. Borrower financed 100% of purchase, cost, and some rehab expenses. In less than 24 months the completion was nowhere near done and the loan went into default. The process including completion of architectural plans, submission for building approvals and permits were not completed. With default the payoff was $1,250,000.The borrower needed $250,000 to complete the rehab and carrying costs. The borrower requested 75% of the speculative completed value of $2,650,000. What foolish new lender would replace the first defaulted lender and finance $1,900,000, when only the lender has the risk of capital loss? The borrower has no skin-in-the-game.
- Facts: Borrower purchased a 5.5-acre parcel of land for $1,000,000 with a purchase money new first of $1,150,000. The borrower decided to subdivide the parcel into 5 separate parcels and got an appraisal for each lot even though there were no approvals nor subdivision map recorded. The entire process was speculative, including the requirement of rezoning the property to subdivide into 5 parcels instead of 1 parcel. The appraised value of the 4 parcels, and 1 parcel with a home attached would be worth $7,000,000. The borrower was able to replace the $1,150,000 loan with a $2,000,000 loan based upon the speculative improvement. When he ran out of money, he now came back to the lending market to look for a lender to give him a $3,000,000 (12) month loan with interest reserve. During the entire time no approvals were completed, and the condition of the parcel remained as one. This borrower had no-skin-in-the-game.
- Facts: Owner/borrower purchased a partially completed small commercial location for tenancy of 5, including an existing a Starbucks franchise. The purchase price was $1,900,000. The owner/borrower obtained an acquisition construction completion loan of $2,800,000 with a construction holdback account and interest reserve while the property is being leased up. The proceeds were to pay for tenant improvements and leasing commissions.The speculative completed value was $4,000,000 upon full lease up and rental stabilization. The first loan came due with a balance and unfunded portion of the $2,000,000. The borrowers requested a new loan of $3,000,000. The same problem arose when the borrowers had little skin-in-the-game since the acquisition, lease-up, tenant improvements were completed
with financed dollars.
I have only given a few examples. Thousands of these examples exist. Each example always has 6 components; (1) Owner/Borrowers coming up with a speculative plan to make a substantial profit, (2) Owner/Borrower seeks to locate a lender, sometimes (foolish lender) to make the purchase money loan with full knowledge that the borrower has little capital invested. The perceived protective equity will occur after an extended period with upgrades or rehabilitation of the subject property. (3) Owner/Borrowers having little or no-skin-in-the game, and willingly transferring the equity investment risk to the lender. Yes, in some cases to a foolish lender! (4) The plan is executed to complete the project until the owner/borrower runs out of borrowed money, or something goes wrong such as rejected approvals of modifications by the municipality or discovery of significant cost overrun. (5) Owner/Borrower seeks out a new lender to replace the first lender and to assume the future lender investment risk. (6) The original lender and the replacement lender have the stress of working out the problem to completion, with a substantial risk of capital loss.
Underwriting guidelines of lenders may differ according to the type of real estate loans, collateral pledged property, perceived risk, yield requirements, licensing, and state and federal regulations. Also, an educated perception of the health of the real estate market comes in to play. When inflation and excess demand are highly expected lenders tend to take larger risks. When there is a perceived consolidation and expected deflationary market, then lenders tend to tighten up their standards. Massive stress between supply, demand, and lending interface will also occur when the market is shifting from inflationary to static or deflationary. Lenders may be caught on the wrong side of the curve as the above examples reflect.
The no-skin-in-the-game owner/borrower can walk away from this financially failed stressful situation with the newfound knowledge that “Good judgment comes from experience. Experience comes from bad judgement!”
Business and Private Money Finance Consultant
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