Comprehensive Guide to Hard Money Loan Investing
Part 3: The Due Diligence Checklist
Questions I ask a hard money loan fund manager before putting down my money.
July 16, 2017 BY IAN IPPOLITO
(Usual disclaimer: I’m just an investor expressing my own personal opinion and not a financial advisor. Consult your own financial advisor before making any investment decisions).
In this, part three of this guide, I'll now share my personal due diligence checklist when evaluating funds. For those interested, here are the other sections of this guide:
Evaluating A Manager
Even if you’re not looking for a fairly conservative investment like I am, the questions will still help you evaluate if a fund matches your strategy or not. (And if you're looking at individual notes on a platform, rather than a fund, you can still use many of these questions as well because they still apply).
The Make Or Break Questions
I ask these in my first round of questions. If I don’t like any of the answers, then it saves me the time of asking all the rest.
Who are your borrowers and what kind of properties are they buying (and where)?
First, it’s important to know this information to make sure I would feel comfortable with the strategy risks, asset class risks and geography risks.
For example, I personally would never do hard my loans on extremely cyclical class like hotels. You might feel differently. The important thing is to ask and make sure it fits with your strategy. (For more information on analyzing asset classes and subclasses click here).
Second, it lets me see how the fund might fit in my portfolio. If I already have a hard money loan fund for apartments in Seattle, I don’t want to waste my time looking at another one.
Does your PPM (Private Placement Memorandum which is the legal agreement) allow leverage? If so how much?
We talked about the risk versus reward trade-off for leverage in part two. In my case, any leverage is too much. So if the PPM allows it, then I’m out. (Your own situation might be different).
Some funds will tell you that they don’t use leverage, even though the PPM allows it. For me, I still pass on that. I would rather go with a manager who fully committed to a no-leverage scenario, than one who preferred to keep their options open to pursue a path I don’t want to go down.
What is your maximum allowed loan-to-value in the PPM? Also what’s the current maximum loan-to-value and current weighted LTV?
This seems like a mouthful. But I learned the hard way that simply asking what their max LTV is, didn’t always get me what I thought I was asking for.
Really what I care about is the maximum allowed loan to value in the PPM. As discussed in part two, I won’t invest in any funds where this is more than 70% (and it's even better if it 65% or lower).
Similar to leverage, many funds will say their PPM allows a high LTV but they currently don’t do it and don’t intend to. Again, I prefer to avoid these funds. I prefer to invest with a manager who has committed to the strategy I want, rather than leaving themselves the option to go either way in the legal agreement.
What is your withdrawal policy?
If they lock up money for longer than what I want, then again I’m done with looking at that fund.
Do you loan in any states without a non-judicial process?
As we talked about in part one, the judicial process can take years and lots of money to foreclose. Personally I’m not interested in this, so if the answer is “yes”, then I pass.
Do you loan to any owner-occupied properties?
As we talked about in part one, some investors are fine with these, but I personally am not because I don't want the extra expense and hassles in the foreclosure process. So again a “yes” means the fund isn’t for me.
Do you loan in anything but the first position?
If things go bad, the first position loan gets paid first, anything that may or may not be left over goes to loans in the second and higher positions. Again, I’m not looking for risk so if they say “yes”, then it’s not for me.
How aggressively do you foreclose on delinquent borrowers?
Some of the real estate crowdfunding sites will allow a delinquent borrower to go for months without initiating foreclosure in an attempt to “save costs”. However, experienced hard money lenders say that delaying foreclosure rarely works.
If the fund doesn’t immediately start foreclosure after they are late (which is usually 30 days after missing a payment), and aggressively pursue each and every step in the process at every point, then I’m out.
What’s your minimum investment?
Minimums range widely. The more popular/larger funds tend to have larger minimums, to prevent them from going over structural limits (such as the 2000 investor limit for some funds) .If the minimum doesn’t match what I’m looking to commit, then there’s no use looking further.
Are your financials audited? If so, for how many years, and who is your current auditor?
Lack of audited financials is a red flag for m. So if they aren't audited, or haven't done it for at least several years, then I'm done. The name of the auditor isn't usually a make or break question, but a well-known auditor like Ernst & Young is a plus. If it's some firm I've never heard of, it may be worth the time to Google them to make sure they seem like they are on the up and up.
What is your current and past performance?
After you review a few funds, you can just look at the current return and tell if it's going to be even a possibility for you or not. For me, I’m looking for fairly conservative, so if I see a speculative 14%, I know it’s not a match. Others who are looking for more speculative, might see a 7 to 8% conservative return and realize the fund is not a match for them.
It's also very helpful here to look at how consistent or inconsistent the past performance was. Significant drops are probably a sign of a problem, and deserve further questioning and scrutiny.
Phase 2: operations and details
If the fund passes the big tests, then I drill into the smaller details.
Do you calculate loan-to-value based on cost or after repair value?
See part two for a discussion on the difference. Again, I'm conservative so I prefer loan to cost. If it's after repair value, I need to feel comfortable with how that's being done, since it can result in being stuck "upside down", if the borrower drops out in the middle of construction.
If after repair value, then what is the maximum allowed loan-to-cost in the PPM? Also what’s your current maximum loan-to-cost, and weighted average loan to cost?
This gives me more additional information to feel comfortable or not with how they handle after repair value.
Do you do construction/rehab draws? How do you verify the work was done correctly before releasing money?
If the fund does construction, they shouldn’t just give the borrower a lump sum that they can run away with. Instead, they should be paying out in small pieces (called draws) after verifying the work for that stage is done.
How the verification is done is important. In the past, some of the crowdfunding platforms appear they may have skipped fully verifying the work was complete. Anytime this happens, this can lead to unnecessary investor losses.
The best answer is that the fund physically sends a qualified person to the property to inspect the work. Next best is to get comprehensive pictures which they scrutinize from the office. Anything less than that is suspect to me.
How do you handle the reserves for construction draws?
Reserves present a conflict to a manager.
The best way to make sure the fund has all the money money to fund the entire loan is to set aside100% for the construction draw into a reserve. On the other hand, doing that is a cash drag that reduces the fund return.
So this question finds out how they manage that conflict, and they do it in a way that matches what I'm looking for. Personally I like to see that all or the vast majority is kept in reserve.
Do you charge penalty interest and if so how much? Does the investor or the sponsor received this income?
A fund that doesn’t charge substantial penalty interest, loses an effective tool to discourage borrowers from defaulting. Funds that charge it also have another advantage: they can trade some of it away as a carrot to keep a defaulting borrower at the negotiation table.
Also, it’s important to know if you get the income or not.
What’s your definition of when a loan becomes overdue, defaults, and becomes an uncured default? What percent of your loans are currently overdue, defaulted, uncured default, completed foreclosure, REO?
Every fund has different definitions. So asking this question lets you understand how this fund defines things so you can make an apples to apples comparison with other funds. Once you do that, you can benchmark it to competitors and see how it stands up.
For the funds I’m interested in, they generally have a 2% or less uncured default rate (and less than 1% is even better). When I see real estate crowdfunding sites or funds that are significantly higher than this, I know that they are either engaging in a strategy, underwriting process or default resolution process that's too risky for me.
What’s the average recovery rate on foreclosures?
Preferably I like to see them recovering both the principal and the interest. But at a minimum, they should be recovering all the principal (especially since we are not in a downturn currently).
A loan or two where this doesn't happen due to extenuating circumstances is understandable. But if it's happening under ordinary circumstances, or there are just too many "extenuating circumstances", then that's a big red flag for me.
What are your current REO LTV's, and as a percentage of assets under management?
REO’s are a great way to look at what has gone wrong with the fund in the past. If the fund doesn't provided, make sure you ask what the current LTV is after all the carrying costs, etc. The higher the LTV’s, the more something has gone wrong.
I look to see if the mistakes seem reasonable and if they have taken steps to fix them or not.
The REOs as a percentage of assets under management, tells me how much of the portfolio is currently at risk if they don't sell. (Note that this risk may be offset if the properties are generating income. So I usually drill in to find out).
What percentage of loans are extended because they can't be collected on in the initial term? What's the average extension length?
A successful extension is a great alternative to foreclosure. On the other hand, a portfolio that has a very high percentage of extensions compared to another fund with similar foreclosure rate, is probably at higher risk in a downturn. So this is very helpful information .
Nice to Haves
These are for additional information to help me make my decision, and aren’t necessarily make or break all on their own.
Do all properties have a second opinion done on them by an independent third party appraiser?
Originally, this was a make or break question for me. If they didn’t have a third-party appraisal on all properties, I was out. But I recently changed my opinion, and it no longer is.
Loan Oak is a fund which has one of the longer track records of excellent historical performance… including making money all through the last recession. They don't do third-party appraisals. Their counterargument is that often broker opinions and/or other third-party appraisals can be too high. So relying on them would actually increase risk. They would rather do it themselves (and have multiple people in the company do it independently as a double check).
So if I feel I can be very comfortable with management for other reasons, I personally will overlook the lack of a 3rd party appraiser.
But not everyone will feel the same way. However you feel about this issue, asking this question helps you make sure that the fund is aligned with what you’re looking for.
How much money do the principals have invested in the fund? Did they invest with cash and at the same price and terms as regular investors?
It’s common to see a 10% investment by principals (or perhaps principals and close family members) for the conservative funds I’m looking at. Anything under that to me is a yellow flag. If you’re looking at a less conservative fund, then it might be okay that it is less.
Also, some funds say they have a huge investment, but then it turns out that they didn’t put any cash in, but instead used their fee. Others bought their shares at a much cheaper price than investors (which essentially dilutes you). By asking it this way, I can see if any of those of the case.
What’s your performance in the last recession?
Most funds were not around back then, so I can’t hold that against them. But if they were and they did well, then that is a huge plus. If they did badly, then I will probe into exactly why, if it seems reasonable, and find out what steps they have done to prevent it from happening again.
What are your management fees?
This question is just to make sure they are not out of line.
How long before newly accepted capital is deployed?
Just gives me an idea what to expect.
How long has the fund been in business? What is your current assets under management and how many properties?
For me there is no horribly wrong answer (other than they just started recently and they would be learning the business using my money). The longer the better, if I'm comparing two otherwise equal funds to each other.
That’s all the generic questions I ask. If they managed to pass that barrage, then I drill into their brochures, legal agreements, audited financials, etc. and ask further questions on what I find there.
Great, now where do I start looking?
Here are some hard money loan funds that are currently accepting new money. I've personally put in money (or am currently considering putting in money) in the ones with stars. Depending on what you're looking for, you may find it best to build up a diversified portfolio of several of these.
Best Hard Money Loan Funds:
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About Ian Ippolito
Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.