Summary:
A lender will expect a Borrower to have some risk capital in the transaction to ensure their economic involvement.
If the Borrower has no risk capital to lose, they may walk away if conditions deteriorate and the investment does not work out, leaving the lender with a problematic investment.
A lender does not want to take all the risks as a quasi-joint venture partner.
No Skin in the Game:
When a real estate owner has no skin in the game, they have not invested any money or assets in the property or transaction. This lack of personal investment means they have no financial risk or emotional attachment to the outcome. Consequently, the Borrower may be more likely to walk away if conditions worsen, leaving the lender with a problematic investment that could result in a significant financial loss.
The loan request:
My client has a partially completed home with an outstanding balance of $650,000. His construction lender ceased funding during construction due to delays, and the Borrower defaulted. He needs an additional $300,000 to complete the project. The Borrower believes the finished value will be approximately $1,400,000, resulting in a loan-to-value ratio of 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 secured a $650,000 construction loan. The Borrower obtained a loan for 100% of the purchase price, plus $150,000 above title. The transaction must be a fix-and-flip from a lender specializing in these high-risk transactions.
The Borrower has no personal capital and minimal risk in this transaction. The lender was suckered into making a loan and inadvertently assumed development partner risks, which did not work out. The only solution is a bailout loan or foreclosure on a partially completed property and its sale at a discount. A partially completed building with open construction will necessarily be sold at a discount to cover the cost of completion, the cost contingency, and the speculative developer’s profit. A foreclosing lender could lose a significant amount of money.
The lender declined this transaction because the Borrower has no capital at risk and could walk away at any time, leaving the lender holding the bag with a partially completed problematic property. This decision-making authority is crucial to the lender’s role, enabling them to make informed, responsible decisions that mitigate potential risks and protect their investment.