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Article by: Brent Virkus of Find the Capital and TRiTON Capital Advisory

One of the biggest questions we hear from our real estate investor and development clients’ is “should I pay upfront due diligence fees to a potential lender?” Since the conventional lending market is basically shut down, real estate investors are forced to seek financing through alternative sources, such as, hedge funds, private lenders and opportunity funds. More often than not, these type of capital sources will charge up front fees to conduct their due diligence on your funding request.

Unfortunately some capital sources have been taking advantage of the current environment and are taking due diligence fees with no ability or intention of close the loan. They have made due diligence fees a way of supporting their company’s overhead in a market that not a lot of deals are getting done. So what we are going to attempt to do in the article is help you protect yourself and recognize who is real and who is simply trying to rip you off.

Understanding the due diligence process

Due diligence is the process a potential lenders goes through when evaluating whether they want to fund your opportunity. This can take many forms and can range from “relaxed” due diligence to “tight” due diligence. With the real estate market in the worststate since the great depression, lenders are leaning more toward the “tight” side of the spectrum. So you need to understand what due diligence may encompass:

• Legal review of documents related to your property
• Credit and background checks on you the sponsor
• Physical “on-site” inspections
• Detailed review of the title and property survey
• Review of historical operating statements
• Detailed review of your prospective business plan for the property
• Conducting feasibility studies
• Review of all required entitlements, permits, licenses and approvals
• Insurance reviews
• Environmental assessment report (i.e. Phase I and II reports)
• Appraisal review
• Third party structural and engineering reports

As you can see, their is a lot that goes into a prospective lenders due diligence. Keep in mind, this is just an example of what a prospective lender’s due diligence could entitle. Costs may range from $5,000 – $250,000 or more depending on the complexity of your deal.

A lenders prospective on due diligence fees

Because of the uncertainty in today’s market, the lenders are really doing their homework before they commit to fund a project. The issue that the lender is experiencing is it takes a lot more time and money to conduct proper due diligence than it has in the past. Unfortunately, more often than not they are discovering the prospective borrower has misrepresented the deal. Hence, they have expended a lot of time and money on a project they fully intended on funding and find out it’s not what was represented on the front end. Their solution to sift out who is real and who is not is to charge the prospective borrower up front for the costs and then reimburse them at closing.

The problem – Some unethical financing firms are using this as an opportunity as a revenue sourse. They are charging for due diligence (because they can) and then finding some reason to not proceed with the loan. Hence, taking advantage of the current lending environment and collecting up front fees to support their infrastructure with no intention of providing the financing.
What can you do to protect yourself?

Examine the lenders! A good friend of mine once said “many people seem to spend more time researching and doing due diligence on a new TV purchase than they do when selecting a mortgage lender with which to work with”. As an experienced Investment Banker that has been directly involved in close to $1 billion worth of transactions, here are a few things to ask a prospective lender:
Are you a direct lender or investor? If they state they are a direct lender, ask where their funds come from. Some groups will say they cannot disclose that information, but in fact they can. Remember, you are asking for the source of funds, not specific names of the investors. If they refuse to give you this information, this should be a red flag. The reason this is important is there are many firms representing they are lenders when in fact they are nothing more than an “intermediary” trying to connect you with the actual money and take a fee for doing so. Their goal is to negotiate a deal with you and then take it to market and try to raise the money on your behalf. If you are paying them a due diligence fee, the most important thing you need to understand is whether they actually have the money to fund your transaction…

If they are a direct lender, have them “prove funds”. It is very easy for a direct lender to produce a letter from their bank stating the have the funds liquid in their account to fund your financing request. Such a simple thing to do, but you would be amazed how many people don’t ask for this.

Ask for references. Always make sure to ask for references from other borrowers who they have loaned money to. Make sure to ask for references that are similar to your deal. If the lender will not or cannot, this should clearly be a red flag.

Ask them for their due diligence process up front. Make sure they quantify exactly what they are charging you for and what gets reimbursed in the event they do not close. Remember everything is negotiable. If they truly want to do your deal, they will be flexible on their fees.

Do they accept third party reports ordered by the yourself prior to them conducting due diligence? You may be able to conduct some of the lenders due diligence prior to submitting your deal. If you are going to have to pay for this anyway, you mine as well control the process. This also allows you to include these items in the submittal upfront as part of the loan package. Hence, you are providing the lender as much up front allowing them to give you a genuine indication of interest, prior to charging you a due diligence fee.

One more bit of advice

Remember to ask a lot of questions. You didn’t get to where you are by being naive. Treat locating financing with the same level of due diligence that you would when running your business and by all means don’t be afraid to hire an advisor to represent you in the entire process. A good advisor will know who the real players are and who actually has the ability to fund your transaction. Don’t try to navigate this world by yourself, unless of course you truly understand how the financing world works. Make sure when you select an advisor to ask them the same questions. What have they funded? Who have they funded transactions for? Ask for references! etc. etc.

It’s OK to pay due diligence fees. You just need to make sure you are paying them for the right reason.

 

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