April 16, 2013

The real estate market recovery in 2013 created a different underwriting environment for private money lenders, trust deed investors, borrowers, and brokers.

After several difficult years following the recession, real estate values began moving higher, investor interest increased, and concerns about another housing bubble started to appear in market commentary.

This article was originally written as a historical market update on April 16, 2013. While the specific market data reflects that period, the underwriting lesson remains relevant: when values rise quickly, investors and lenders need to be more careful, not less careful.

A Different Market After the Downturn

During the years immediately following the recession, underwriting a trust deed investment was often more straightforward because many Southern California real estate values had already declined significantly.

In many cases, prices were below replacement cost or below levels that appeared sustainable over the long term. While additional downward pressure was still possible, the market had already absorbed substantial losses.

From an underwriting standpoint, that made collateral analysis somewhat easier. The question was still whether the value was supportable, but the downside case was often easier to frame because many properties had already repriced dramatically.

Rising Values Change the Risk Profile

By early 2013, the market had started to recover.

Home values had increased, inventory was tighter, and investors were more active. That created new opportunities, but it also required more disciplined underwriting.

When values are rising, borrowers, brokers, lenders, and investors can become more optimistic. That optimism can lead to higher valuations, more aggressive loan-to-value ratios, lower required yields, and looser assumptions about exit strategy.

That is where risk begins to increase. For definitions of common private lending and real estate finance terms such as LTV, lien position, deed of trust, exit strategy, and interest reserve, borrowers, brokers, and investors can also review our Private Lending & Mortgage Glossary.

Why True Value Matters More in a Rising Market

In a recovering market, analyzing true value becomes more important.

A property may appear to support a higher valuation because recent comparable sales have moved up. But an underwriter still needs to ask whether those values are sustainable, whether the comparable sales are truly relevant, and whether the borrower’s exit strategy depends too heavily on continued appreciation.

Important valuation questions include:

• Are the comparable sales recent and relevant?
• Are values rising because of fundamentals or temporary lack of inventory?
• Does the property support the requested loan amount today?
• Is the valuation based on current condition or future assumptions?
• Does the transaction still work if values flatten or decline?
• Is the borrower relying on appreciation to repay the loan?

These questions matter for private money loans because the lender and investor are relying heavily on the collateral, borrower equity, and exit strategy.

More Investors Can Mean Lower Yields

As more investors enter the trust deed investment market, competition can increase.

That competition may reduce available yields. It may also encourage lenders and investors to accept higher loan-to-value ratios in order to win transactions.

Lower yield and higher leverage can be a difficult combination.

A lower yield gives the investor less compensation for risk. A higher loan-to-value ratio gives the investor less protective equity if the borrower defaults or if the property value declines.

That does not mean trust deed investments should be avoided. It means the transaction needs to be analyzed carefully. Investors who want to understand FK Capital’s real estate-secured private credit approach can review our Trust Deed Investments page.

The Risk of Blending Lending and Ownership Thinking

Another issue we observed during that period was that some trust deed investors became increasingly interested in the real estate asset itself.

In other words, they were not only analyzing the transaction as lenders. They were also thinking about whether they would want to own the property if the loan defaulted.

That mindset can be useful in some respects because a lender should understand the collateral. However, it can also create risk if the investor becomes more willing to make a loan because they like the property rather than because the loan is properly structured.

A trust deed investment should be underwritten as a loan first.

The lender should ask:

• Is the borrower’s equity real?
• Is the loan-to-value ratio appropriate?
• Is the property value supportable?
• Is the lien position clear?
• Is the exit strategy realistic?
• Is the yield appropriate for the risk?
• What happens if the borrower does not perform?

Liking the property is not a substitute for disciplined loan underwriting.

What Borrowers and Brokers Should Understand

When market risk increases, private money financing may still be available, but lenders and investors may review transactions more carefully.

Borrowers and brokers can improve the process by packaging the transaction clearly.

A stronger private money loan submission should include:

• Property address
• Requested loan amount
• Estimated value and valuation support
• Current debt or payoff information
• Borrower equity or basis
• Use of funds
• Exit strategy
• Timing requirement
• Relevant title, lien, legal, or property issues
• Construction or rehab budget, if applicable

The more complete the submission, the easier it is for the lender or investor to evaluate the risk and determine whether the loan is supportable. General loan parameters can also be reviewed on our Hard Money Loan Programs page. For construction-specific scenarios, borrowers and brokers can also review our Hard Money Construction Loans page.

Why This Historical Commentary Still Matters

Although this article was written in 2013, the broader lesson still applies in any real estate cycle.

When prices are rising, investors often become more comfortable. When more capital enters the market, yields may compress. When competition increases, loan-to-value ratios may rise. When everyone becomes more optimistic, underwriting discipline becomes even more important.

Private lending works best when speed and flexibility are paired with conservative analysis.

A rising market can help a transaction, but it should not be the reason the transaction works.

Final Thought

Private money financing can remain available in a rising market, but quality transactions should still be analyzed carefully.

For trust deed investors, lower yields and higher loan-to-value ratios require discipline. For borrowers and brokers, a clear and complete loan package can help the lender evaluate the transaction more efficiently.

The central underwriting principle is simple: rising values do not eliminate risk. They change the way risk needs to be evaluated.

At FK Capital Fund Inc., our underwriting focuses on the property, borrower equity, valuation support, lien position, loan structure, execution risk, and exit strategy. Examples of prior real estate-secured lending activity can also be reviewed on our Featured Transactions page.

If you have a California business-purpose real estate financing scenario, FK Capital Fund can review the request based on the property, borrower, valuation support, structure, equity, and exit strategy.

Submit your loan scenario for review.

For general questions, you can also contact FK Capital Fund here.

Frequently Asked Questions

What is trust deed investment underwriting?

Trust deed investment underwriting is the process of evaluating a real estate-secured loan based on collateral value, loan-to-value ratio, lien position, borrower equity, repayment plan, exit strategy, and the risk-adjusted return available to the investor.

Why does a rising real estate market increase underwriting risk?

A rising market can increase underwriting risk because values may become more aggressive, investors may accept lower yields, loan-to-value ratios may rise, and borrowers may rely too heavily on continued appreciation.

Why do lower yields matter for trust deed investors?

Lower yields matter because the investor receives less compensation for the risk being taken. If yields decline while leverage increases, the investor may have less return and less protective equity in the transaction.

Should a lender make a loan just because they like the property?

No. Liking the property is not enough. A trust deed investment should be underwritten as a loan, with focus on value, equity, lien position, borrower strength, exit strategy, and downside protection.

How can borrowers and brokers improve a private money loan submission?

Borrowers and brokers can improve a submission by providing the property address, requested loan amount, value support, payoff information, borrower equity, use of funds, exit strategy, timing needs, and any known title, lien, legal, or construction issues.