Real Life Example

Summary:

A lender is not in the business of assuming all the development and construction risks like a quasi-joint venture partner. The borrower must have some 'skin in the game,' a term that describes the borrower's investment in the project, typically in the form of their own money or assets.

A lender will expect a borrower to have significant risk capital in the transaction to ensure their economic risks.

When a borrower has no personal investment at stake, they may choose to walk away if the project fails, leaving the lender to deal with the fallout of a failed investment. This lack of personal investment means they have no financial risk or emotional attachment to the outcome, which can lead to potential issues for the lender.

Article:

When a real estate owner has no skin in the game, they have invested little or no money or assets in the property or transaction. The loan request:

The procuring mortgage broker, who acts as both a fiduciary on behalf of the borrower and  an intermediary between the borrower and the lender, says:

My client has a partially completed home with an outstanding balance of $650,000. His construction lender stopped funding during construction because of various delays, and the borrower defaulted. He needs another $300,000 to finish the project. The borrower believes the finished value will be about $1,400,000, so your loan to value, a financial ratio that compares the loan amount to the property's value, will be 68%.

The lender's response after reviewing the file:

Your borrower purchased this distressed property for $499,000 and obtained working drawings and permits for rehabilitation. Concurrently with the purchase closing, he recorded a construction loan of $650,000. The borrower obtained a loan for 100% of the purchase price plus $150,000 above the purchase price. The transaction must be a fix-and-flip from a lender specializing in these high-risk transactions.

The borrower's lack of personal capital and minimal risk in this transaction led to the lender inadvertently assuming development partner risks, which did not work out. The only solution is a bail-out loan or foreclosing on a partially completed property and selling it at a discount. A foreclosing lender could potentially lose significant money, a sobering reminder of the risks involved.

The lender declined this transaction because the borrower has no capital at risk and could walk away at any time, leaving a lender holding the bag with a partially completed problematic property. This decision-making power is crucial to the lender's role, empowering them to make informed and responsible decisions that can mitigate potential risks.

In an accelerating market, fix-and-flip lenders may appear brilliant. However, they may seem somewhat foolish in a declining market, highlighting the importance of being cautious and prepared for potential risks. This alertness is key to navigating the complexities of real estate financing.