Real Estate Financing Tips

A Wrong Way To Make A Short Term Loan

by Marvin Levin

I have kept a real estate mistake book since 1959, and this is one of my most embarrassing mistakes. 

My partner Paul Menzies and I manage a small fund that makes offbeat real estate loans.  About 10 years ago, a non-profit organization came to us with a request for a land loan on a parcel in Northern California.

The amount of the loan requested was $500,000, and it seemed to us that the property was worth between $1.5 million and $2 million.  We believed their story that replacement financing was available, but would take a few months to close and repay. So, we granted the loan on extremely favorable terms at that time (remember what interest rates were 10 years ago), and the agreement was that it would be repaid in six months.

After our loan closed, the president of the borrowing organization distributed substantially all of the loan proceeds to herself to pay salary and bonuses and was unable to repay the loan when due.  We granted some loan extensions, but after a while it became obvious that we had really provided all of the equity to carry the property.

After a couple of years, we started a foreclosure.  The borrower filed Chapter 11.  The Chapter 11 was still pending approximately five years later when the property sold.  We did receive our principal back and a relatively moderate rate of interest, which was then approximately 9% per annum.  The borrower, however, sold the property for $5.5 million; a great result for the borrower.  Because of our cost of money at that time, we lost about $100,000, while the borrower used our funds to earn a windfall of $3 million.

A Better Way

The lesson is a good one for someone who is lending or joint venturing.  What we should have done was to make a two or three-year term instead of a six-month term and give the borrower the privilege of repaying early (e.g., in six or nine months).  Our two or three-year loan would have had a profit sharing participation, such as 40% of the profits on resale.  However, the loan agreement would also provide that if the loan were repaid early, then the profit sharing kicker would terminate. 

That would have created for us a “point of indifference.”  We would have been able to say that we didn’t care if the loan was repaid early or not.  If it were paid early, of course, we would have received everything we expected.  And, if the loan were repaid late, we would receive a profit sharing kicker, which would be only fair if the other party over-represented the marketability, the value, or the refinancing funds available.

If you happened to take my Real Estate Ideas class at UC Extension, you will probably recognize the above story.  In any event, I hope you might be able to put the idea to use in your practice. 

And, if you have a client who needs flexible financing as indicated by the above case, please contact me.