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One Trick for Private Lenders to Use

One of the common errors made by amateur private lenders is to spend money and time on research without adequate protection. Consider this scenario:

You are introduced to a lending opportunity. The borrower is a local real estate developer who concentrates on adding value to properties. In this case, she wants $50,000 to completely refurbish the kitchen area in a large house. By her estimates, once renovations are complete, the home will be worth an additional $150,000.

The developer is willing to pay interest at a rate or 12% per year for a total of 18 months. She will allow you to place a second mortgage on the home as security for your loan.

It sounds like a good deal. You’ve been looking for a good asset that produces income. The two of you agree to the terms and shake hands on it. Then, you reach out to your lawyer to help with the paperwork and mortgage registration process.

After a week, your lawyer comes back to you with some troubling news. He discovered that the government had registered a lien on the property for $80,000. Apparently, the developer was behind on her taxes and was being pursued by the government for the debt. As such, your mortgage would be in third rank.

You are no longer willing to proceed with the investment. While you aren’t necessarily opposed to being in third position, you didn’t appreciate being misled by the developer. You don’t trust her.

Three weeks later, your lawyer issues an invoice for $500 for the work he did. Instead of earning a profit, you lost money on this investment opportunity without even getting the chance to make it.

This is known as origination risk, according to Alexis Assadi, a Canadian real estate lender. The way to mitigate it is to require the prospective borrower to sign an Offer Letter before proceeding with research. This document confirms that the lender is willing to finance a loan, on the condition that nothing new arises during due diligence. The borrower must also agree to reimburse you for any expenses that you might incur.

Therefore, the earlier example could have benefited from an Offer Letter that read similarly to this:

“I will advance a $50,000 loan to you for 18 months at a rate of 12% per year. It will be secured by a second mortgage on the property. You confirm that there is only one registered debt on the asset at this time. You also promise to reimburse me for all fees that I incur in connection with this loan. I will not complete funding if any new information arises during the course of due diligence that could materially impact my security. You hereby accept this offer.”

In fact, most Offer Letters are substantially lengthier and will outline all of the borrower’s representations, including property price and the value of all debts, etc.

Ultimately, the power of the Offer Letter is that it allows the lender to do research without losing money. Moreover, it is unlikely that a prospective borrower will accept it unless the terms therein can be met. It is better for both parties.

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