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Understanding Real Estate Loans
October 16 | 2013

Underwriting

Real estate crowdfunding sites like RealtyMogul.com present pre-vetted opportunities to investors, meaning that we try to present only those opportunities that satisfy our own risk/return criteria.  This “underwriting” involves special criteria for loan investments involving a first trust deed or senior mortgage, and we review here some of our process of evaluating a potential borrower’s loan request.

At RealtyMogul.com, we offer both equity and debt investments; this discussion focuses on our debt offerings.  We generally start by performing some due diligence on the borrower.  If we haven’t worked with the borrower before, then we first start with a getting an overview of the company’s general background, along with resumes of the principals and their track record – a list of other transactions – that we can assess.  Then, we review the borrower’s banking and industry references, and ultimately we obtain criminal and background reports and run credit checks.  While one can never be certain of the innate character of a project’s leader, this review process helps us to make sure we are reasonably comfortable in working with that company. 

Once we’ve reviewed the borrower, we do some due diligence into the proposed loan itself.  We start with a review of the property and its given valuation; if we don’t have an appraisal to work with, we usually do some back-up research into recent sales of comparable local properties (with commercial properties, this often requires utilizing special industry services).  We review the offered investment summary or business plan; the rent roll (if applicable); the proposed budget for rehabilitation or capital expenditures to be made; and other information about the market, submarket, and neighborhood.

The loans we present are always in “first position,” meaning that, in the event of a borrower default, no other lenders would have a claim to the property before we do.  We also don’t present any transaction where the borrowers don’t have some “skin in the game,” i.e. have themselves invested a significant amount into the property. 

Given the above, an important remaining question is, “how much value remains in the property above and beyond the loan amount?”  It is important that there be a healthy margin of “equity” in order to assure that, even in a case of default, the property will likely still be valuable enough so that the proceeds of any sale will repay at least the principal amount of the loan.  Overly aggressive home lending was, after all, the primary cause of the recent Great Recession.

At Realty Mogul, we generally insist on the following criteria:

  • The loan-to-value (LTV) ratio should be less than 85%
  • The loan-to-cost (LTC) ratio (including the budget for any rehab work) should be less than 70%
  • The loan-to-after repair value (ARV) ratio (after improvements are made) should be less than 65%

Here’s an example of a transaction – let’s we see how it works with our criteria:

Purchase Price $230,000 This is the amount actually paid to buy the property
Loan Amount $180,000  
     Loan-to-Value ratio 78% Loan amount divided by purchase price
Rehab Budget $40,000  
Total Cost $270,000 This is the purchase price plus the rehab costs
     Loan-to-Cost ratio 67% Loan amount divided by total cost
After Repair Value (ARV) $300,000 Expected value of the property after repairs, based on comparable sales of similar properties in that neighborhood
     Loan-to-ARV ratio 60% Loan amount divided by after repair value

This transaction would thus meet all of Realty Mogul’s primary criteria.  The LTV ratio of 78% falls below our 85% mark; the LTC figure of 67% is less than our 70% gauge; and the ARV ratio of 60% is below our ceiling amount of 65%.  Assuming that we are comfortable with the borrower and the details of the investment proposal, and our satisfied with the state of the property’s title and the amount that the borrower has invested into the property, this would likely be a loan opportunity that we would put on our platform to offer to investors.

This overview is necessarily simplified; for example, if a borrower can demonstrate that he can acquire a property at less than current market value, we may be willing to use a current appraisal (rather than the purchase price) to assess appropriate LTV and other ratios.  In any event, this summary should give investors a good idea of our general process and the primary numerical criteria we use in our loan underwriting process.  When underwriting loans, we want to be comfortable that, even if a borrower were to default on a loan, the property serving as security for the loan would still have to suffer a significant decline in value before the outstanding loan balance would be jeopardized.  

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