Private Lender Paul met Big Bad Brad at a local real estate investor networking group.  They hit it off pretty well, and Brad told Paul that he’s got this rehab he bought but needs some extra cash to finish out.  Or maybe it was to buy and flip a house?  Does Paul know anyone interested in coming in as a partner or junior lender?  Paul says “Do I?  Me!”  A few days later Brad sends Paul some papers, Paul sends his money to Brad.

This is one of several ways unwary private lenders can get caught in a scam.  A partial list is:

• Brad is almost done with a rehab and needs just a little more to finish to be able to list on the market for sale.
• All of Brad’s money is tied up in one property, but has a really great deal under contract and needs money to take it down.
• An unscrupulous contractor ran off with the rehab money, and now Brad needs to give up his profits to anyone willing to come in with more.
• Brad can run your rehab, but you have to give him all the money up front “for materials.”
• Brad gets Paul’s friends to contribute on the next, bigger deal.

How do Lenders protect their capital from scammers?  

With prudent and reasonable Underwriting and Policies.

Underwriting

Define your lending criteria.

Paul never has a written set of criteria.  One way to look at underwriting is that it is the process of investigating whether a proposed transaction meets your lending criteria.  To do this, you have to have criteria.  Whole books can be written on underwriting, but for this topic, if the proposed scam doesn’t fit the type of transaction you lend or invest on, you won’t be interested in parting with money.  If Paul only funds 1st lien loans, taking a 2nd lien position just won’t be a deal he will do.

Investigate.

Paul doesn’t look into the facts.  Another aspect of underwriting is to investigate whether Brad’s representations are true.

Get a copy of the borrower’s driver’s license and social security card.  If you have to file a police report or sue to recover, you will need these.  States publish ways to spot fake ID’s and you can pull background checks.  Visit the borrower’s business and home addresses (drive by).  Mailbox store fronts are sure warning signs.

Get a copy of the closing docs from where the Borrower purchased the property, the Lender’s info, and proposed rehab scope of work.  Talk to the Lender and see if they have any warnings.  If the scope says one thing and the job site says another, that will tell you something, too.

Policies

Draws.

When Paul funds the construction, he gives Brad all the money.  Seasoned lenders will work off draw schedules.

Borrower does work, makes a draw request (listing work done).  Lender sends a licensed inspector with the list to do a visual check, who reports back the status of the work performed (% done).  Lender cuts check or sends wire to the borrower in a timely manner.  Borrower gets reimbursed for work done and Lender is assured that funds go into the collateral.

Docs.

Paul might get a “promissory note,” “lien instrument,” “partnership agreement,” or “JV agreement.”  Lenders hire attorneys to draft documents; Borrowers sign documents.  Some papers look really convincing, but might not be worth much if you have to put them before a judge.  Lenders wire money, if any, to title companies, not Borrowers.  The title company will verify, to some extent, identity and record lien instruments as needed, deliver copies of everything, and disburse any money they are instructed to pay out.  Unrecorded liens can put Lenders in unstable positions.

Take Away

Scammers like the Brads in the world (apologies to people named Brad) will fight against these defenses.  They may comply on the first deal, chaffing the entire way, to get Paul to drop these “ridiculous” requirements on the next, bigger, deal.  Or Brad may perform as promised (without Paul asking for any of this), to get more of Paul’s money on the 2nd deal or more time before Paul calls out Brad’s scam.  Brad may work a scheme to pay Paul from Peter’s loan (the next Lender).  There are many variations, which makes it hard to spot and defend, but Lenders must always stick to the tools that keep them safe.