Biggest lessons learned from making 1,800 real estate loans over 17 years (Part 2)
In my last article, I shared some of my important lessons learned while making 1,800 loans over 17 years. In this article, I cover part two on the same theme: red flags to watch out for that I have learned the hard way.
As Mark Twain said, “Good judgment is the result of experience, and experience is the result of bad judgment.”
Lessons learned: red flags to watch out for.
Some of the below points can be generalized to any type of real estate loan, while others are specific to the type of loan that I have the most experience with, namely loans to homebuilders and developers secured by single-family homes, small subdivisions and apartment buildings.
Not enough borrower “skin in the game.” Time and again, I have seen how borrowers who have little to lose are much more likely to default. If the borrower has little cash invested, they have little “skin in the game” and are much more likely to take large risks or play a game of chicken with the lender, which means more work and risk for the lender.
Volatile property value. Some property values remain more stable when conditions change, while others may drop in value dramatically. A good example of a volatile property would be land in a major city that has been approved for a high-rise building. When the market is good, the property value may be very high. But at certain times, like after the pandemic, when construction costs rocketed and interest rates rose, the value for such properties dropped dramatically. The value may recover but it may take years for that to happen.
If the borrower suggests meeting in a very fancy location, use extra caution. Over the 1,800 loans, most of our meetings happened at the subject property (the location of the proposed loan) or at a coffee shop nearby. But one potential borrower suggested meeting at the Beverly Wilshire Hotel. In retrospect, he was a little too eager to build a rapport with my partner and me and to find things we had in common. This borrower ended up defaulting and we had to foreclose. I’m not sure that the fancy meeting location he suggested correlates to higher risk, but it might.
Be careful when you see too many stairs. Two different loans we made featured hillside lots with incredible views and lots of stairs, including a full flight of stairs or an elevator to the main living area from the front door. As both loans led to foreclosures, we learned that traditional methods of valuing a property, such as using a price per square foot based on sales of renovated homes nearby, can be misleading. Too many stairs limits the appeal of a home to many end buyers and with a much smaller buyer pool, the value per square foot can be much lower than nearby homes with fewer stairs required.
A property with a limited buyer pool. Generalizing a little from the last point, any property with a very limited buyer pool brings extra risk. In case of a foreclosure, the lender will end up hiring a broker to sell the property and too few buyers equates to a lower sales price. Many factors could cut down the buyer pool, including a design that does not appeal to most buyers, a poor layout, a property type that doesn’t fit with the neighborhood or a remote location. Of course, in a market with enough buyers any property can sell but in a slower market these factors can result in a lower value than expected. Note that properties in lower-income areas have typically had many potential buyers or renters as long as they are designed with the needs of local buyers and renters in mind.
Any loan to a borrower who doesn’t communicate well. When a borrower encounters a problem, we want them to call us or at the very least return our call quickly. It’s not easy to tell which borrowers will go quiet when they are having trouble or are late with an interest payment. As with any relationship, there are often some signs early on that a borrower might fall into this camp. Pay attention to their communication style and ask yourself, is this the kind of person who deals with problems or tries to pretend they don’t exist and delay making tough decisions? I’ve found that if a borrower is a poor communicator during the diligence process before we fund a loan, their communication almost never gets better after they have our money.
Any sign of potential fraud. We once had a loan request in the San Diego area. It was a large home in one of the best communities there and the loan amount and value seemed to suggest a good loan. We had recently started a joint venture with a very experienced older real estate investor to make loans on higher-end properties, and when we explained the loan to him, he expressed concern that something didn’t feel right. This home was owned by a group that had purchased many high-end homes in the region, and we ended up not making the loan based on our partner’s discomfort. About a year later, I read that the ownership group was being investigated for misleading investors and running some type of fraudulent scheme. Sometimes, there is no substitute for the sixth sense that our older partner had, which comes from lots of experience. Any time that partner had concerns about a loan, we made a special effort to learn from his experience and try to further develop our own antennas to detect hidden risks.
Potential disputes within borrower partnership. Most investment and development properties are owned by a partnership rather than a single person. If the partners get into a dispute, work can stop, which leads to a time-consuming workout for the lender. The same can be true of a project where the owner gets into a dispute with the contractor performing the work, especially if the contractor becomes a partner in the project in some way. It’s not easy to anticipate which partnerships are more likely to become contentious, but you will save yourself money and headaches if you can be alert and spot this problem ahead of time.
These are some of the red flags that I’ve learned not to ignore. I strongly recommend that as you gather data from your own investing successes and failures, that you document the patterns you’ve observed. Learning from our own experience is one of the easiest ways to improve our future performance, whether in real estate lending or any other type of investing.
