How Good Is the Collateral?

How Good Is the Collateral?

This is the second post in what I hope will be a good series on private lending from self-directed retirement accounts.  My question for today is, “How good is the collateral?”  I’m referring to the asset being pledged to secure the loan of which ownership could be taken by the lender if the borrower defaults or fails to perform?

When evaluating whether to make a loan from a self-directed retirement account, there are two aspects that need to be looked at:  the character and quality of the borrower, and the character and quality of the collateral.  Here are some of the things you want to know about the collateral:

  • What is the collateral?
  • Where is it located?  Find out what is going on in that neighborhood, not just with comparable sales, but with local schools (particularly high schools), criminal activity, and what is happening in the community from an economic standpoint.
  • What is its current condition, and what will be the condition of the collateral during the life of the loan?  Will the property be improved through rehabbing, or will it be properly managed by a good property manager if it is a rental property?
  • Are there other liens on the property?

When it comes to real estate, it’s been said that the three most important things regarding the value of the property are location, location, location.  I disagree in part, as I believe it’s time, location and circumstances, but these are some of the many factors that a good due diligence analysis of collateral will consider.

It’s also important to look at the trends of growth, demographics, and development, as well as the price changes in the city and neighborhood where the collateral is located.  Look at not only how many days properties are on the market, but also look at how close to the original asking price they are selling for and what price reductions, if any, are occurring.

One final thing to understand about the collateral you are considering lending against is its previous transactional history over the last couple of years.  Is it a stable property, or is it one that has been bought and sold multiple times because other rehabbers have failed to complete the job?  Is it one of those properties we’ve all seen that is just the wrong type of structure in the wrong location, and no matter what you do with it, you can’t overcome those issues?

When making a loan, remember to make it based not just on the enthusiasm of the potential borrower, but on the cold, hard realities of the collateral.