Builders looking for ways to fund new construction projects, like spec or pre-sale home building, may consider financing using a private lender. While it is one way to get a spec house construction loan, working with a private lender can be quite different from working with a bank lender. While they both provide loans, there are significant differences between them.
Builder Finance is a bank subsidiary, not a private lender. However, for those considering using this method of financing, we answer some questions about private lending and spec construction projects.
What is considered a "private lender?"
A private lender is a non-bank lender. This type of lender gets money from private investors, generally high-net worth individuals. It is often loaned at a higher rate than what a bank would charge. For a spec builder, accessing this money tends to be expensive, with a high return expectation on the part of the private lender.
How are private lenders financed?
In addition to capital from investors, a private lender is likely to also borrow money. This borrowing can come with challenges.
For example, let’s say the owners of a private lender put $10 million of their own money into the company and have raised another $10 million from investors. They then go to a warehouse lender and ask for $30 million of financing, saying the $20 million of investor capital will be the "first loss" cushion. Though the investor money has to be lost before the warehouse lender would take a loss, the warehouse lender also asks for other protections such as limits on how much spec construction can be done, how long the lender can borrow, and a provision that any defaulted loan will significantly reduce what the private lender can borrow.
What are some benefits of working with a private lender?
Private lenders are only “lightly regulated” or not regulated at all. Because they’re not subject to the same kinds of government regulations as banks, they can have greater flexibility regarding their process, including loan qualification criteria. As such, a private lender may be willing to fund a project that a bank would not.
A private lender may also be able to provide financing more quickly, depending on the kind of process they’ve put in place. If the project timeline is tight, getting financing at the right time may offset the overall higher cost of the loan.
Another potential benefit or detriment is that private lenders are unique — one private lender can be very different from another private lender. Private lenders tend to be small or medium-sized firms and without an "institution feel." This also means that the personalities and temperaments of the lender’s executives can show through (for better or worse.)
What are some risks of working with a private lender?
This question is important to spec construction.
With most types of lending, a loan is fully-funded at closing. That means that if you request a $250,000 loan, when that loan closes you receive $250,000. Since the lender has funded their entire obligation to you, you don’t need to worry a lot about the lender’s ongoing business health.
However, construction loans are funded over time. At closing, a spec construction loan might be 20% funded with the borrower receiving $50,000 of the $250,000. So it’s critical to have confidence that your lender will be there for the other 80% because you’ll need the rest of that $200,000 to successfully complete your building project!
Keeping that in mind, when it comes to spec construction, being a private lender is very challenging. Construction loans feature large, unfunded components. As a private lender it is difficult to keep the right amount of money around so it’s not sitting on unused cash, but is also able to fulfill unfunded components of ongoing projects.
Unlike banks, the government is probably not checking a private lender’s business practices to make sure that they can fulfill their funding obligations. So you may find that a private lender can’t meet its obligation to you, which would have a negative impact on your ability to complete your project.
Overall, private lenders tend to be a higher-risk option, relative to bank lenders. Banks have access to low cost funding sources. It is relatively easy and inexpensive for them to obtain money as needed. Banks are also regulated which helps ensure that they are able to honor their lending commitments.
What are other ways to fund spec construction?
Other than working with a private lender or a bank, two common alternatives are described below.
One common alternative is raising money from friends and family to make up the difference between the money the builder can invest and what they need to successfully complete the project.
Another way is by receiving seller financing on the land. This means that rather than paying cash to buy the land, the seller accepts a loan promising payment at a later date, likely when the spec house sells.
What advice would you give to someone who’s never worked with a private lender before on a spec construction project?
The most important piece of advice we can give is to encourage you to make sure that the private lender is legitimate and can fulfill its obligations. Don’t be afraid to ask tough questions. And, when it comes to the loan itself, make sure that the lending terms are clearly laid out.
