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 things get tough and the investment does not work out, leaving the lender with the burden of 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 things get tough, leaving the lender with the burden of a problematic investment, potentially leading to significant financial loss.

The loan request:

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 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 has no personal capital and minimal risk in this transaction. The lender was sucker enough to make a loan and inadvertently assumed 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 partially completed building with open construction will necessarily be sold and discounted in price to compensate for the cost to complete, plus cost contingency and speculative developer profit. A foreclosing lender could lose their shirt, losing 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 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 to mitigate potential risks and protect their investment.

In an accelerating market, fix-and-flip lenders may appear brilliant. However, they may seem somewhat foolish in a declining market. This highlights the importance of being cautious and prepared for potential risks, a crucial perspective for lenders evaluating loan applications and ensuring the stability of their investments.