An industry standard is for a Broker to strengthen the offering (to Investors) of the Trust Deed to investors by creating an interest reserve for the borrower. An interest reserve account is money set aside to ensure the investors interest payments on a loan over a specified term. This can be a good feature in the correct circumstances; however often times the actual source of the interest reserve and the math is not to the benefit of the investors and this may hide the weakness in the borrower’s cash flow and qualifications.
The PITFALL occurs by a taking a good attribute and distorting it with the Deed of Trust originator and the borrower. For example:
Borrower acquires a parcel of land for $100,000 with $50,000 down payment. This land later ‘appraises’ for $500,000.00 based on that value;
Borrower requests a loan of $375,000 (75% LTV)
The investor is offered a “terms sheet” or “offering” indicating that a borrower is requesting a 12 month loan at 12% at a low loan to value of 75%. The loan is for $375,000 on property he only owes $50,000. And to strengthen the deal the investors are told that there is 12 months of Interest Reserves set aside to cover the payments to the investors (12 month loan) on the land.
Investors may have no idea that the only “skin in the game” from the borrower is $50,000. The initial cash down payment.
The borrower is not making the payments; all payments are made form the interest reserve account. The investors may not understand that the $45,000 in interest payments for the year from the borrower are actually the investors own principle balance.
The $45,000 for the reserve account is clearly not being used to improve the property to increase the investor’s security.
It may sound unbelievable but, the investors are actually lending their own principle to the borrower for income payments from the borrower to the investors so that the Broker can get the upfront commission in this case of at least $37,500.00 to put the investors in the Deed of Trust with the borrower.
Most private lending notes have short terms such as 6 to 24 months in length. If a transaction is facilitated that is a 12 month loan with 12 months reserves, it may well literately be almost a year before the investor(s) have any contact or information on the borrower or the property, as all the payments are paid as agreed from the reserves for the lengths of the loan and a lot can change with a borrower or property in that period of time without the investors knowing it.
Clarify all the funds in the transaction; verify that the borrower is actually taking their own funds set aside in a separate account for the purpose of the payments – or that they have the income with all the other debts in their lives to cover your payment due. And this should not replace the other standard underwriting categories; property qualifications and borrower qualifications.
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I am the CEO of EquiAlt: real estate based alternative investment firm with activities in equity, debt and private equity. Since 2008, EquiAlt's management has demonstrated a high level of competence in hundreds of distressed asset transactions, recapitalized companies while lending on landmark Las Vegas projects.
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