Why would a borrower ever pay 12% interest and share in the profits on a deal?

One of the top questions I get is “Why would a borrower ever pay 12% interest and share in the profits on a deal?”

There are actually quite a few reasons.  In the next several blogs I’ll review some of the “whys”.

Borrower’s Credit

There are a lot of borrower-contractors that got caught in the downturn but they are extremely experienced and know how to find and complete really good deals.  These can be some of the best borrowers not only because of their extensive contracting experience but also because of the lessons learned with the downturn.   Although it was very painful while going through the process they now know a lot more things to watch out for and protect against.

We actually really like working with this type of borrower.  As a lot of you may know, my background includes over 30 years of experience in real estate construction and general contracting business.    That’s why we feel very comfortable looking at every deal we fund as though we are going to take the project over ourselves.  Now, we structure our deals so it is very unlikely that we would ever need to do that but just in case, we have a team ready, willing and able to jump right in and complete the project if something were to happen to the borrower (in most cases if we did take over the project our profits as a lender would be higher).

So, what are the risks with working with borrowers with bad credit?   First thing to do is find out why the credit is bad.  Is there a logical reason for the bad credit or does the borrower just have a long-term habitual problem with paying bills.  If it is a long-term issue maybe the character of the borrower is questionable.  To me, a character issue is more risky and would be a red flag to watch for.

How about ability to make monthly payments?   For this risk I suggest always building in an interest reserve for the full term of the loan.  This way everyone knows the payments will be made on time from this third party interest escrow account.  It also allows the borrower to focus on getting the deal done rather than worrying about making the next month’s payment.

What about being able to refinance when the project is completed?   Generally the projects for this type of equity share on the back end have an exit strategy of resale of the property upon completion.  The other option though, if the borrower wants to keep the property when completed is to require that they bring on a credit partner so the refinance is possible.

Remember, this is asset based lending.  The loan you make is secured by the property.  By keeping your loan to value lower you are reducing the risk on your investment.

Until next time…Happy Lending!

Tom