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.Why Private Lenders Focus on Total Cost and Borrower Cash Investment in Real Estate Deals
In real estate transactions, especially when dealing with private lenders, one factor is often scrutinized more than anything else: the total cost the borrower has invested into the deal. This goes beyond the simple acquisition cost and includes both the hard costs (like construction, renovations, and infrastructure) and soft costs (such as permits, architectural plans, and legal fees) associated with the property. But why do private lenders focus so intently on this aspect of the deal, especially when the property has been recently purchased?
"Skin in the Game" – The Importance of Borrower Investment
Private lenders want assurance that the borrower has substantial financial commitment—what’s commonly referred to as having “skin in the game.” This means they are looking for the borrower to have personally invested significant cash into the property, both in terms of the initial purchase and ongoing development or maintenance costs.
A lender sees this personal investment as a measure of the borrower’s confidence in the deal. If the borrower has committed their own resources, it indicates they believe in the property's future value. A higher borrower investment typically means they are less likely to walk away from the project, even in tough times. This reduces the lender’s risk, as the borrower is more financially and emotionally tied to the property's success.
Loan-to-Cost (LTC) and Loan-to-Value (LTV) Ratios
Private lenders often use specific financial metrics to determine how much they are willing to loan. The Loan-to-Cost (LTC) and Loan-to-Value (LTV) ratios are two critical measurements in this process.
- Loan-to-Cost (LTC): This ratio measures the loan amount compared to the total project cost. Lenders often have maximum LTC ratios to ensure the borrower has made a significant cash contribution to the project. For example, if a private lender offers a maximum LTC of 75%, the borrower must cover at least 25% of the total cost with their own funds.
- Loan-to-Value (LTV): This metric measures the loan amount relative to the property's current or projected value. While similar to LTC, LTV focuses on the appraised value of the property rather than the borrower’s investment. A lender may have a maximum LTV ratio to ensure the loan amount is not too high in relation to the property's value.
By imposing these limits, private lenders aim to prevent borrowers from fully cashing out of a deal. If the borrower has too little of their own money in the deal, they may be more likely to abandon the project if challenges arise, increasing the lender's exposure to risk.
Why Lenders Care About Recent Purchases
When a property is recently purchased, the focus on total cost becomes even more critical for private lenders. In many cases, they may be concerned that the borrower is attempting to leverage financing without having made substantial improvements or investments in the property. They want to ensure the borrower is not trying to “cash out” without enhancing the property's value.
A private lender will carefully evaluate:
- How much of the borrower's cash is tied up in the initial acquisition.
- The level of hard and soft costs invested after the purchase.
- Whether the total cost aligns with the property's current or potential value.
This approach ensures that lenders are financing properties that have been actively invested in, reducing the likelihood of defaults and protecting the loan's viability.
Conclusion
Private lenders’ focus on total cost and borrower cash investment is rooted in risk mitigation. By ensuring the borrower has a substantial financial stake in the deal, lenders can feel more confident that the borrower is committed to seeing the project through to completion. Loan-to-Cost (LTC) and Loan-to-Value (LTV) ratios play a key role in this process, helping lenders maintain a balanced risk profile while ensuring the borrower has “skin in the game.”
At Dynasty Capital Group, we understand the importance of structuring deals that make sense for both borrowers and private lenders. Contact us today to learn more about how we can help you secure the right financing for your next investment.
Contact us at: Joe@dynastycapgroup.com
