I’m sure you’ve heard the nightmares of borrowers defaulting on their loans and everything going as bad as possible.
Every lender fears the defaulted loan scenario because we’ve been trained to assume the worst based on the aftermath of 2008. But the foreclosure disaster left in the wake of a major mortgage fraud crisis doesn’t necessarily have to be the outcome private lenders will face.
Many non-performing loans can have positive outcomes if—and this is a big if—the loan was originated carefully with equity buffers in place to protect your principal investment, among other due diligence executed by the lender before funding the loan.
This is also an excellent time to address that any private lender must have appropriate legal support to draft up the proper loan paperwork to execute your loan safely. Failure to do so could result in an inability to foreclose on the property should the loan default.
How a Loan Turned Into $172,900 in Profit
In my personal experience placing investor capital into private loans lent to borrowers who are active real estate investors, less than 4% of our loans have defaulted, and, of those, none lost any of their original investment and instead received default interest income once the loan was paid off. Since the Covid-19 pandemic began in March 2020, we’ve only foreclosed on three properties out of hundreds.
One occurred in July 2020 when one of my clients placed his funds as the lender on a single-family rental acquisition. Unfortunately, the loan defaulted within the first couple of months, and the lender began the foreclosure process.
During this time, the borrower filed for bankruptcy, not once but twice. I’d be lying if I told you the lender was calm and cool about the situation. And to be honest, it always makes me a little nervous, too, simply because it’s never an easy process.
At this point, it was pretty obvious the borrower would not be able (or willing, in this case) to perform on their loan, so the lender naturally assumed the worst might happen, particularly with a potential bankruptcy proceeding further complicating a tough foreclosure situation. Issues with squatters, canceled property insurance, and other concerns kept us on our toes as well.
However, each time after filing for bankruptcy, the borrower did not follow up within the specified timeframe to file the required paperwork needed for the courts to allow the case to move forward. After the second request for bankruptcy was dismissed (using a false social security number) and with an auction date already set, our lender client placed his own minimum bid amount for the auction to protect what he was owed, including legal fees he’d incurred.
Surprisingly, no one bid an amount higher than our lender, and he was granted title to the property. At this point, our lender client had a few options to consider. He could put the property back on the market in as-is condition and try to offload it as quickly as possible. He could flip. Or, he could sell off-market to an investor capable of completing the rehab themselves for a profit.
As the originators who placed this loan for our lender client, we tried to help him wholesale the property to some of the active investors we know immediately after the auction. With a few verbal offers in hand, it was clear the lender could easily make a sizable wholesale fee close to several tens of thousands on top of what was owed to him from the loan. Ultimately, our lender, a seasoned buy-and-hold investor, chose to flip the property himself. He listed it at $720,000 and closed.
This flip endeavor certainly had its own added complications for our client when his general contractor took much longer to complete the project than expected and delayed the sale of the property by three months. In spite of it all, our client made lemonade out of lemons with this loan opportunity, making a sizable cash-on-cash return on his investment.
Here’s a brief rundown on the stats for this loan to illustrate the positive outcomes achievable even when a loan goes wild and needs to be handheld across the finish line.
Initial loan rates and terms
- $325,000 in the first position on a stable rental property
- 10% interest rate with a 24% default interest rate*
- Loan-to-purchase price: 70% LTV
* Permissible default rates will vary depending on the property’s location.
Timelines
- Loan is funded in July 2020
- Defaulted in September 2020
- Filed Notice of Default on January 26, 2021*
- Filed Notice of Trustee Sale on March 18, 2021*
- Date of auction on August 13, 2021*
- Planned rehab: August 2021 through March 2022
- Actual listing date on May 12, 2022
- Final sale posted on June 10, 2022
- Total number of months with capital deployed: 23 months
*Required by the State of Washington: An NOD filed with a 30-day cure period followed by a Notice of Trustee Sale with a minimum 120-day cure period before it can be sold at auction.
Financials
- Principal investment: $325,000
- Total interest owed and legal fee reimbursement at the time of auction: $409,320
- Rehab and other costs to flip property: $165,000
- Final sale price: $720,000
- Total profit after closing costs and interest income: $172,900
- Approximate cash-on-cash return (over 23 months): 53%
Conclusion
This loan represents a pretty extreme outcome in favor of the lender due, in part, to appreciating market conditions and his own expertise in rehabilitating distressed properties. While we never “loan to own” and try to eliminate as many risk factors as possible, you can’t fend off every potential risk and situation.
Sometimes, as with our client’s borrower, you place your bets on a bad player. Either way, if you safeguard your loan with a solid amount of equity in the property and try to mitigate as much risk on your loan as possible with the limited information you have available, you can come out ahead even when the borrower is behind.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.