A common theme and industry standard in private lending is that the largest portion of underwriting is based on the value of the asset in relation to the amount of the loan (LTV) and is touted as the ultimate insurance plan for the investors – and if anything goes wrong; the lender will take the asset and recoup all losses based on the lower LTV. For our purposes we will call this: loan to own underwriting. Certainly the value of the asset is of fundamental importance to the underwriting as the value of the asset is the actual security for the principle. However; this is a significant PITFALL in the industry as it manifests itself as the projected cure for any issue. This form of underwriting almost begs for inflated valuation of the property and may ignore threats to the transaction such as; weak due diligence or weak borrower.
This is important as weak underwriting indicates inexperience in lending and real estate or the lack of consideration on the part of the Broker or borrower with the investor’s principle loan amount. And clearly, if this style of underwriting is used to compensate for a weak borrower and investor would be wise to seek additional or other compensating factors as available. Neither of these are particularly good for the investors and is exposed as such in market conditions that shifts to the downside on values, it leaves the investors totally exposed to principle loss with expense to acquire, maintain and exit the investment.
Perhaps the most damaging manifestation of this practice is its use with second position Trust Deeds (PITFALL # 10) also called second mortgages and sometimes referred to mezzanine financing due to its subordination to a senior debt.
Ask if your investment is based on Loan to Own standards, or what the qualifying criteria of the loan is. If you choose to invest in Loan to Own Deeds of Trust, an investor is advised to seek significantly lower loan to value ratios to compensate for the added risk and use a very conservative value of the asset.