Private lending is a relatively simple concept – it is a loan between private parties. That is, a loan that isn’t provided by a bank or other institutional lender to a borrower. Private lending, when done well, can offer higher returns to lenders and flexible finance to borrowers. For those that are interested, we offer a complete guide to private lending that encapsulates my 25 years experience as an investor, lawyer for lenders and borrowers and member of a credit committee for a private lender – available here.
In recent years the major banks have reduced their lending to smaller scale developers. In turn, this has led to the rise of non-bank specialist construction lenders. These construction lenders tend to have higher fees and interest rates and their loan terms and conditions can be more restrictive. This has led to some smaller scale developers looking to private finance to fund their developments.
However, in the last year or so, construction costs have risen and the feasibility of many small scale developments has been undermined. We have had a number of clients with planning permits and pre-sales cancel their projects as they weren’t viable with increased building costs.
Warren Buffet is reputed to have said that “only when the tide goes out do you learn who has been swimming naked”. In a similar way the past year or so has exposed both some private loan borrowers whose developments no longer stack up and as a result some private lenders that didn’t do their homework. This has led to some private lenders losing all the funds that they loaned.
In this article, I want to explore some common mistakes that Private Lenders make. If you are contemplating lending money to someone privately please get advice and make sure that you don’t make these mistakes!
Due Diligence
Let’s face it – due diligence is tedious and definitely not fun. Notwithstanding this it is an essential part of the private lending process. Warren Buffet is also supposed to have said that he doesn’t invest in things that he doesn’t understand. I believe that this is good advice for the rest of us as well.
Hence, as a private lender I think we need to be choose to do due diligence property to understand the deal – or choose not to lend privately. There are certainly private lending funds that you could invest in if due diligence isn’t something you want to do.
Due diligence includes a diverse range of issues depending on the nature of the deal, but will usually include:
- Credit Checks on the borrower and guarantors;
- Title Searches;
- Independent valuation of the property involved;
- Reviewing the feasibility study;
- Reviewing any pre-sales;
- Assessing the skills and experience of the developer; and
- Confirming the quantum of any first mortgage or other debt against the property.
To put this in context, the private loan fund that I am associated with has a 100+ point due diligence check list!
Documents
It should go without saying that there should be some written record of the key terms of any loan. Beyond this, some thought should go into the provisions included in the loan documents.
Too often I see clients who have loaned funds based on documents that were provided by the borrower or downloaded from the internet. The range of common defects is staggering.
Common examples of this include:
- loan documents signed on behalf of a company that doesn’t own the property and no personal guarantees from directors;
- caveat / security clauses from documents prepared in another state that don’t work; and / or
- No default interest rate, repayment date or default clauses.
Such loan documents are close to useless and will seriously compromise your ability to get your money back.
The most disappointing aspect of poor documents is that it is conventional for the borrower to pay the lender’s legal fees in private lending transaction. Typically the borrower has been talked into accepting poor quality documents by the lender who doesn’t want the borrower to get advice.
Security
It is critical that your loan is properly secured. After all, this is how you get your money back if something goes wrong.
This means understanding the value of the property and the value of any other debts against the property. The most common way for established lenders to assess value is a formal valuation – at the expense of the lender.
It also means obtaining direct security over the property in question or potentially other property. A first registered mortgage is usually the best form of security. However, depending on the deal you may have an registered or unregistered second mortgage with or without a caveat.
Finally and most importantly, security is often useless if you don’t register it. I have sadly seen too many cases where securities weren’t registered and the borrower has given security to other lenders who have then got priority by registering their security. The original lender can miss out despite having an earlier dated loan agreement and having advanced funds first if their security is not registered.
Management
Private loans are not passive assets.
That means that they are not set and forget investments – like some shares might be. They require constant supervision. You need to ensure your interest is being paid, monitor the progress of the project and most importantly action any defaults that arise.
It is tempting when defaults arise to accept the inevitable assurances from the borrower that all is in order or that the default is a technicality or somehow explicable. In some instances the right approach may be to do nothing. However, in other circumstances prompt action can be critical.
It is my experience that proactive lender generally fares better than passive lenders. The right steps to take will very much depend on the nature of the default and other circumstances of the loan.
Advice
The common denominator in many of these mistakes is that the lender didn’t get advice. Borrowers are often charismatic and offer very attractive returns on exciting projects. Lenders are told that lawyers are deal killers and the lender will miss out on the returns on the deal as there are other lenders queuing up to advance funds…..
Truth be told there are some deals that I have killed and some that I have tried very hard to kill. In the latter category I can think of a dozen clients who came to regret not taking my advice after losing collectively losing millions of dollars.
However, my primary goal is to find a sensible way forward. That means, when acting for a lender, helping the lender to get their due diligence done, putting proper documents in place with reasonable security and generally trying to make sure that the lender is as informed as possible.
As a lender myself, lawyer for lenders and borrowers and a member of a credit committee I have seen hundreds if not thousands of deals over the past 25 years. Isn’t that the sort of experience you want on your side before you hand over your hard earned dollars?
If you aren’t thinking of investing in, selling or developing property, but know someone that is please share this article with them.
Lewis O’Brien
Your Preferred Property Lawyer