Private Lenders May Ask for Repayment
The Coronavirus pandemic is accelerating in Canada and we have been working diligently to help our readers understand the effects on real estate. Recently, we have helped readers understand:
How conventional mortgage lenders are helping homeowners with COVID-19.
Why Airbnb hosts in Toronto, Vancouver, and Montreal might sell their homes or turn them into long-term rentals.
In this article, we explore why Private Lenders may ask borrowers to repay their loans in the face of Coronavirus risks.
What is Private Lending?
Private Lending or ‘Hard Money’ Lending is simply a short-term loan secured by real estate. The loan durations are usually about 12 months. Private lending is riskier than conventional lending, so they charge higher fees and much more interest than traditional lenders. A borrower typically wants to use private lenders in an emergency and refinance the mortgage with a regular mortgage as quickly as possible.
A study by CIBC in 2017, found that nearly 10% of new mortgages in the GTA had been issued by private lenders.
A private lender does not focus on your income or your personal creditworthiness. They are focused on two things:
What is the property worth?
What is your exit strategy (i.e., how will the borrower repay the loan)?
Private Lenders Play an Important Role
Banks and credit unions hold Canadians’ savings, and then lend those deposits to other Canadians. Deposits held at banks and credit unions are mostly guaranteed, and that’s why the loans they provide need to be very conservative.
Many Canadians have been turned down for a mortgage at some point in their lives, and that’s where a private lender may be appropriate. Private mortgages are suitable when the financing is lower risk but the borrower doesn’t ‘tick all the boxes’ to get approved by a regular lender.
Typical scenarios are when a borrower:
loses their job in the midst of buying a home, but they are very employable.
needs financing within a few days and a bank can’t guarantee a fast enough turnaround.
wants to use the home as an Airbnb (most banks only finance long-term rentals).
wants to take more equity out of their existing home than a bank will lend.
is buying a fixer-upper and plans to flip the property within a few months.
needs short-term ‘interim’ financing (e.g., to complete an improvement that would make a home eligible for bank financing).
A private lender focuses on the value of the property and the exit strategy (how the borrower will repay the loan when it comes due).
Property Valuation
An appraiser will confirm the value of the property, or the lender may rely on a government assessed valuation. How the lender verifies the value is at their discretion.
Exit Strategy
The exit strategy can be achieved by selling the property or refinancing it.
Here are some examples of exit strategies that involve repaying the private lender with a traditional bank mortgage.
Renovate to raise the value of the property and then refinance with a bank or credit union.
Hold a new job past the probation period and qualify for traditional bank financing.
Find a long-term tenant to be eligible for a conventional mortgage.
Sell another property and repay the private lender.
Liquidate savings or collect an inheritance and repay the lender.
Exit strategies that involve the sale of the property:
Renovate and then sell it (fix and flip).
The borrower sells the property.
Private lenders specialize in short-term lending, and they do not want to foreclose on homes. They want you to repay them using your exit strategy so they can lend the money to someone else.
The impact of Coronavirus on Private Lenders
The COVID-19 outbreak is of grave concern because it brings more uncertainty to property valuations and the borrower exit strategies.
Impact on Property Valuation
The value of a property is assessed by comparing the property to recent sales of similar neighbouring properties. On March 20th, the BC Real Estate Association suspended open houses in support of COVID-19 containment efforts. On March 21st, the Ontario Real Estate Association (OREA) followed suit. Quebec and Alberta joined them on March 23rd.
We are entering a period in time were very few transactions will be completed and, therefore, there will be fewer recent comparable sales to use for assessing the value of a home. When private mortgages come due this year, appraisers and lenders will struggle to calculate accurate property values to confirm they have enough collateral to support the size of the loan. Many may become uncomfortable with this higher level of risk and ask their borrowers to repay the loan immediately.
Effect on Exit Strategies
Borrowers are going to find it difficult to execute their exit strategies. To illustrate the point, we will explore a few of the more common exit strategies and show how COVID-19 has upset the apple cart.
Example 1: Renovate and then sell it (fix and flip).
It will take longer to complete renovations. The provincial trade unions have not suspended work yet; however, based on the European lockdowns, we know that it is a matter of time before trades stop working, and hardware stores are ordered to close. In the interim, work will be slower because workers should not be sharing or borrowing tools from each other. Private lenders require repayment in a fixed period of time and this lack of control over renovation completion timelines is a big concern.
If a property flipper manages to get their renovation completed on schedule, they face a slow market with no open houses, which will make it more challenging to turn a profit on their property flip.
Example 2: Employment improvements expected so the borrower can qualify for traditional bank financing.
A large proportion of people who obtained private lender financing before the crisis with the hope of getting a new job will find it is more difficult to find work today.
The closing of most hospitality, travel, and tourism businesses has led to mass layoffs. Of course, major Canadian banks will be very supportive of their existing borrowers, but they will be much more conservative when underwriting new mortgages.
As well, a traditional lender will be trying to confirm the value of the property, so even if the borrower has a new job, a lower than expected appraised property value may prevent them from refinancing with an ‘A’ lender.
Example 3: The borrower sells the property.
The current environment will make the sales process drag out over a longer duration. You can get a virtual tour of a property and sign a purchase agreement with digital signatures. Still, the home inspection and appraisal require a physical property visit, and the lawyer needs an ‘old school’ black ink signature.
Bottom line – Private Lenders May Ask for Repayment
As traditional private lenders refrain from renewing and extending mortgages, borrowers will need to sell into a slow market. Many buyers will judge that only VERY motivated sellers will sell their home during a pandemic, and that is an opportunity for them to get a good home for a low price.
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