UNDERGROUND INSIGHTS | Issue #2
For years before we ever lent a dollar, we were the ones asking for the loan. Seventy-five plus flips in Connecticut and Rhode Island, and on every one of them our instinct was the same. Get the biggest loan we can get.
Now we're on the other side. And the thing we understand differently from that seat is that the number a borrower fixates on isn't the number that protects the person whose capital is at risk.
This is a monthly note on how we think. No hype. Just the mechanics.
Two Numbers That Sound the Same and Are Not
Loan-to-cost and loan-to-value. Four words apart. They answer completely different questions.
Loan-to-cost is what the borrower gets funded. On our loans that's up to 90% of the acquisition price and 100% of the rehab budget. It's measured against what the project costs to do.
Loan-to-value is the ceiling. Our loan will not exceed 70% of the after-repair value. It's measured against what the finished house is worth.
Both are true at the same time, and the second one governs. Here's what that looks like on paper.
Say a house is $300,000 to buy and $75,000 to renovate, and it's worth $500,000 finished. The cost side allows $270,000 on the purchase plus the full $75,000 of rehab. That's a $345,000 loan. The value side caps us at 70% of $500,000, which is $350,000. The loan fits under the ceiling, so the deal funds. And $155,000 of finished value sits underneath our position. That's 31% of the house that would have to evaporate before our investors' principal is exposed.
Now change one input. Same house, same budget, but the finished value is $450,000 instead of $500,000. The cost side still says $345,000. The value side now says $315,000. The deal doesn't fund at the number the borrower wants. Either they bring $30,000 more of their own money to the closing table or we pass.
Nothing about the project changed. The borrower is the same, the contractor is the same, the scope is the same. The only thing that moved was the finished value, and it moved the answer.
That's the whole point. The cost side sets what a borrower asks for. The value side sets what they can actually have. A lender who underwrites only the cost side is funding a plan. A lender who underwrites the value side is funding an outcome, and leaving room to be wrong about it.
So when you're reading any private credit fund, find out which number they're quoting you. If a fund tells you it lends at 80% and never says 80% of what, you don't know your cushion. You just think you do.
What Happens When a Loan Goes Sideways
Every lender who's been at this long enough has had a project run long. Contractor walks. Permit stalls. A supplier misses by six weeks. The interesting question isn't whether that happens. It's what's already in place before it does.
Four things, in this order.
The interest reserve. Six months of interest is held in escrow. A borrower whose job runs over doesn't miss a payment in month four because framing is behind schedule. That gap between a slow project and a missed payment is where most bad outcomes start, and the reserve closes it before anyone needs it.
Work the problem first. When a project is in trouble, the first move is to fix the project, not to file paperwork. We've been the operator whose contractor disappeared. We know the difference between a borrower with a problem and a borrower who's done. Most of the time it's the first one, and most of the time it's fixable.
Then a hard line. If a payment goes 30 days late, the borrower is in default on day 31 and foreclosure starts immediately. That's not a threat we hold over anyone. It's the mechanism that lets us step in and take the project over while there's still value left to protect. A lender who lets a late loan drift for six months out of politeness is spending someone else's money to avoid an awkward conversation.
Nobody in front of you. Every loan sits in first position on the property. And the fund itself doesn't borrow. Investor capital goes in as equity, and the fund lends that capital out directly. It never takes on leverage of its own to make loans. That matters more than it sounds. A fund that borrows in order to lend has a lender sitting above its investors, and in a bad market that lender gets made whole first. There is nobody above our investors.
That's the yield story too, and it's a plain one. What the fund earns is the interest and origination points our borrowers pay, minus what the fund costs to run. There's no promote and no spread skimmed off the top, and we invest alongside investors on the same terms. That's why the 11% is a target and not a promise. Operating costs move, so the number moves with them. Distributions go out quarterly.
The lesson underneath both halves of this issue is the same one. Capital protection isn't a feature you bolt on. It's an order of operations you commit to before the deal, when saying no is still cheap.
If you're evaluating any fund, ours included, three questions will tell you most of what you need to know. What is the loan measured against, cost or value? What's held back for the months when a project runs long? And is there anybody standing in front of me if this goes badly?
Good managers have quick answers. That's the tell.
Real Estate Underground
Ed hosts the Real Estate Underground podcast, with new episodes every Tuesday at 12pm. The most recent episode, number 203, is a conversation with Joel Friedland, who calls himself the most risk-averse real estate investor in the country. He was carrying $70 million in personal guarantees across 50 buildings when 2008 hit, and he now runs an all-cash, zero-debt model because of it. If this issue's subject is your subject, that one is worth an hour.
Clark St Capital offers securities under Rule 506(c) of Regulation D to accredited investors. Past performance is not indicative of future results. Target returns are targets, not guarantees.