As we discussed many times before, to be a real estate investor, you need to have something to invest. I am not talking about investing “blood, sweat, and tears.” I am talking about hard cold cash. Yes, private money lenders do require you to contribute your own funds to the transaction. The reasons for that are simple. Lenders want to work with borrowers with a demonstrated history of making good financial decisions. This history is typically evidenced by certain levels of savings. In addition, lenders naturally want their borrowers to share in the financial risks of the transaction. “Investing” entirely with someone else’s money is not investing, it’s speculation. In such a case, a borrower’s thinking typically goes like this: “If the deal works out and the profit is made – great! If not, oh well, too bad for the lender.” This is why promises of 100% financing evaporate as soon as you start digging into details.
Another requirement of any lender with sound underwriting standards is adequate reserves. Reserves are money left at the borrower’s disposal after they’ve made the required contribution towards the transaction. We often run into potential borrowers who are ready to go “all in” and invest their last dime in their fix-and-flip transaction. They effectively become a ticking time bomb ready to default on their obligations to their lender, their state, or their other creditors. Even worse, they are putting themselves in an unfortunate position where, instead of making money, they can lose it.
What reserves can be used for?
Let’s look closer at what reserves are used for and why you need them.
Meeting unanticipated renovation expenses
Accurate estimation of renovation expenses is one of the most valuable skills a rehabber can have. Usually, this skill comes with experience and having a trusted crew. Even then, the renovation processes are typically full of surprises – and often not pleasant ones. The detailed scope of work can mitigate the risk but only to a certain extent. The truth of the matter is that you should be prepared to shell out more money than originally planned and have this extra money available on short notice. Moving fast and efficiently is the key to keeping your overall costs low. However, it’s difficult to be nimble when you are strapped for funds.
Let’s look at a simple example. Supposedly, a monthly payment on your private loan is $1,000. Your contractor has hit you with a $2,000 change order that you currently don’t have. You have no choice but to wait until your next paycheck which is not until next month. That basically means that the change order’s amount increases over 30% from $2,000 to 3,000 – an extra $2K quoted by your contractor plus $1K in interest for an additional month your loan is outstanding.
Paying your property taxes and property insurance
As Mark Twain said: “There are two things that are certain in life: death and taxes.” Your property taxes are typically pre-paid in advance at closing, but sooner or later they will be due again. Can you pay them promptly without creating a financial burden for yourself and your family?
The same with property insurance. Since private lenders are asset-based lenders, they require insurance to protect that asset, which, in your case, is the property you’re renovating. It’s typical to collect the cost of this insurance at closing and to prepay it six months or a year in advance. However, if your project extends longer than that, the lender will require you to pay for the extension of this coverage. If you don’t extend the coverage on your own, your lender is authorized to buy insurance on your behalf. This type of insurance is called “lender’s placed insurance” and might cost more than your original policy. It’s a good idea to maintain your coverage: it helps you protect your interest in the property, lowers your operating risk, and builds a stronger relationship with your lender. All your need is some funds in your checking or savings account to meet your obligations.
Making payments on your private loan
Last but not least, you need reserves to make your monthly payments to your private lender. If we use the example above with a $1K monthly payment to your lender, you would pay $12,000 a year to your lender (this is why it’s in your interest to reduce the number of months your loan is outstanding). Can you afford to do it without sacrificing your current lifestyle or increasing the risk of defaulting on your other debts? Your goal is to be laser-focused on your rehab. It’s difficult to maintain that focus when you’re worried about paying your bills.
How much in reserves is required in a typical private loan?
As a hard money lender, we at New Funding Resources don’t have an absolute number you need to meet when we’re evaluating your reserves. It just needs to make sense. If you have a small rehab budget of $30,000 to $40,000 and a modest loan amount, $7,000 to $10,000 might be sufficient. If you are planning to get involved in a complex transaction with elaborate renovation, your reserve requirements will logically need to be expanded. Our financial goals are aligned with yours. We want to work with borrowers who are positioned for success and who, if they encounter any challenges, can overcome them without jeopardizing their entire project. The best way to do it is to have extra money ready.
What is considered “reserves” in private lending?
Unlike construction funds that are typically held in an escrow account, your reserves don’t need to be escrowed. They remain with you for the duration of the loan but need to be verified prior to closing. The best type of reserves are the funds that can be easily deployed should you need them fast. The money that is sitting in your business or personal checking or savings accounts is the perfect example. However, your lender might also accept an ample stock, mutual fund, or even retirement account (if you can borrow against it). While you can use credit cards at your own discretion to finance your project, credit cards or equity lines are not considered reserves. Neither is equity in your primary residence or any other property that is not already serving as collateral for your current loan.
At New Funding Resources, our goal is to help you make money in real estate. We do so by making sure that our underwriting reflects all elements nessessary to ensure success – including adequate reserves.