These two issues are put together as they appear the most in the same transactions in private lending. The staged or multiple funding scenarios are most prevalent in new construction and rehab loans – properties that are not ready to market or cash flow. The Deed of Trust is created by multiple fundings at scheduled times for the borrower. The borrower doesn’t want to pay interest on the entire loan if they can only use portions at a time to construction schedules. So, the broker will set up a funding schedule with the borrower based on his needs and use of funds. The Broker will then have several fundings or opportunities for the investors to get involved. This scenario is risky as investors are putting their money into property that is not complete, therefore not marketable or sellable which significantly reduces exposure.
And if one of the following three things occurs they are in serious jeopardy.
The borrower has management issues, the Broker can’t raise the rest of the funds, and the property becomes obsolete before competition. The Broker is directly incintivized to commit to funding the total amount of the loan amount even if the Broker does not presently have access to the remaining funds. If the Broker is unsuccessful in raising the remaining amount the borrower is left with a partial project and a loan to repay and the investors are relying on incomplete collateral to secure their principle.
Trust Deed investors may be offered an investment opportunity that is based on the value of the project after the project is completed based on projected market rents that will determine an estimated end market value of the project. The initial significant risk for the investor is that the principle may never be covered by the asset until after the exit strategy is realized. This is much like PITFALL #4 with the only difference being that the time horizon is estimated to be shorter than land. All the same considerations should be taken as on unimproved land.
Only invest when all funds are identified to complete the project, and when the track record of the developer or manager has been verified. And when future value is offered as part of the Loan to value risk analysis of the principle investment; take precaution similar to the land transactions and know who you are dealing with and the market conditions around the project.