FAQ | Working with Hard Money Lenders

 
 
business meeting with a hard money lender

FAQ | Working with Hard Money Lenders

By Jan Brzeski
Managing Director and Chief Investment Officer, Arixa Capital

Definition and Types of Hard Money Lenders

  • A hard money lender, also known as a private lender, provides a loan to a real estate investor or developer, secured by one or more properties. Hard money lenders charge higher rates and fees than banks or other traditional lenders, but they can also move much more quickly. Frequently, they focus more on the collateral for the loan (the property) and less on the borrower’s precise financial situation and credit scores. For this reason, hard money lenders are also sometimes called ‘asset-based lenders.’ For more information about hard money lending generally, please refer to our FAQ about money lending.

  • Some hard money lenders are funds that specialize in making these types of loans while others are wealthy individuals who often own real estate and make loans on the side when they have extra cash. A third type of lender is a mortgage broker with a number of high net worth clients who like to invest in loans. In this case, the actual lenders are the high net worth individuals while the borrower’s contact is the broker who arranges the loans.

How to Find Hard Money Lenders

  • The main ways to find a hard money lender are to: (1) search on the Internet; (2) ask other real estate investors and developers whom you respect which lenders they have used; (3) attend real estate-related events and ask people whom you meet for names of reputable private lenders; and (4) ask affluent people whom you know have an interest in real estate investment whether they would be interested in making a loan, or whether they know someone who would.

  • The best person to ask is someone who is currently doing what you want to be doing, once you have secured a hard money loan. In other words, if you want a loan to purchase a vacant house or retail building, ask someone who has purchased multiple similar properties recently.

  • Try searching for “Hard Money Lender Los Angeles” (using the applicable major city for your area). You can also use the state name rather than the city. You might also try directories such as those on the website of the American Association of Private Lenders (AAPL) or Koss Resource.

  • Real estate events tend to attract three types of people: (1) people with a flow of potential investments and projects who are looking for money (also known as “sponsors”); (2) people who have money to invest and are looking for projects and opportunities; and (3) service providers of various kinds, including accountants, lawyers, real estate brokers and mortgage brokers. Almost any real estate event can be helpful for making contacts, including finding a hard money lender. We have found that the best events include a mixture of more and less established investors, sponsors and service providers.

  • When it comes to finding capital, as with any type of sales, remember that it is your number of “at bats” that is much more important than your “batting average.” In other words, if you meet dozens of people, you are very likely to find what you are looking for, but if you only meet five people, even if you are extremely persuasive and/or lucky, your chances are not very good. For this reason, going to events is critical. There is no better way to meet a large number of people quickly than by attending real estate conferences, meetings and networking events.

  • Remember that you are there specifically to have lots of “at bats” to find valuable contacts. It is fine to attend with another person but do not spend your time talking to that person. Instead, make sure you meet lots of new people. Bring business cards and introduce yourself. Ask the other person about his or her business and role at that company, and briefly explain your own business and role and let the other person know what you are looking for (for example, “I am looking for investors for my latest project”). Ask what you could do to be helpful professionally to the other person, and seek ways to deliver value to the other person. Often, this means making an introduction to another person you have met. If you meet someone who is not related to your business and is unlikely to be a valuable contact, it is okay to politely move on soon after you establish this information. You can simply say: “It is a pleasure to meet you, and I hope you have a good evening.” In a one-hour networking event you should aim to meet at least 8-12 different people. Even if you meet a potentially very good contact, it is best to ask whether you can follow up after the event to talk or have coffee, rather than spending too much time speaking to a single person.

How to Start The Process of Working With a Hard Money Lender

  • The first step is to establish personal contact with the lender. Pick up the phone and call, explain what you are looking for, and ask to whom would be the correct person at that company to talk. Once you have identified the correct person, make a note of his or her name. Use a contact manager such as Outlook, Google Contacts or Salesforce to record the name of the person as well as any notes on that company’s lending criteria or preferences. You can also reach out via email; through a company’s contact form; or via InMail on LinkedIn. In any of these cases, keep your email very brief and to the point. A rule of thumb is to use no more than four or five lines of text.

  • The most important thing is a specific project that the borrower controls, that has a high likelihood of being a profitable investment. Frequently this means that the borrower has secured a purchase agreement on a property at a favorable price, for some reason. For example, he or she may have purchased it from a bank or from some other motivated seller. Frequently the buyer has a plan to improve the value of the property, in order to generate, say, $2 of value for every $1 of improvements. If the underlying project is very strong, even relatively inexperienced borrowers can often find financing.

Things to Know Before You Call a Hard Money Lender

  • The key facts will likely include the following data:

    • Address of the property

    • One or more up-to-date photos of the property

    • Purchase price and purchase date

    • Estimated as-is value, if different from purchase price

    • Proposed renovation budget, if any

    • Estimated “as repaired value” (ARV), if the property is going to be improved or expanded

    • Requested loan maturity

    • Business plan–will the loan be paid off through a sale, a refinance or via cash that the borrower will have at a future date?

    • Basic borrower background (see below for details)

    • Amount of loan requested

  • Borrower background depends on the type of lender, maturity of the loan and other factors. For single family home renovation loans to developers who specialize in buying, improving and reselling homes, the borrower’s track record is very important. What other projects has the borrower done recently, and how profitable were they? Other important factors include the borrower’s credit, any important issues that need explanation such as a bankruptcy or a criminal record, and the borrower’s personal financial statement, which lists assets including real estate owned by the borrower, liabilities including mortgages on properties owned and any other debt, and net worth.

  • Once again, this depends on the lender and the details. Many hard money lenders will disqualify loans that fall in the ‘life is too short’ category. In other words, if a borrower has shown a clear tendency to misrepresent information, and shows no evidence of having learned from past mistakes, he or she probably will not get a loan from a competent lender. However, some borrowers who do have a bankruptcy or even in some cases a criminal record may receive a loan, if they are skilled and demonstrate that they can live up to their commitments now.

What are Hard Money Lenders Looking For

  • While each hard money lender is different, they all tend to focus on a few items, including the following: (1) deliverability of the loan; (2) risk of loss based on the loan amount and underlying asset value; (3) borrower strength; and (4) business plan of the borrower and how he or she plans to repay the loan.

  • To the lender, deliverability means as follows: “If I put in the work to understand this loan request, and make an offer that is acceptable to the borrower, will I actually have a high likelihood of being able to make this loan? Or are there factors outside of the potential borrower’s control that might well result in the loan never being made, which means I will have no revenue to compensate for all the resources invested in making this loan.”

  • For hard money lenders and brokers who arrange these loans, the most precious resource they have is time. They cannot afford to invest lots of resources in loans that are speculative. Frequently, borrowers want to know whether a lender could make a particular loan, if the borrower were able to buy the property. Lenders are usually happy to provide general terms and conditions under which they would make a loan, but they do not like to make actual proposals until they know that the borrower controls the underlying property. In other words, the borrower should have a purchase contract at a price acceptable to the borrower, executed by the seller, with sufficient lead time to be able to perform.

  • The underlying property is very important. Hard money lenders will often overlook a borrower with imperfect credit, but they almost never overlook the property. The key considerations for the lender are, (1) what is the property really worth, right now?; (2) if the property is going to be improved, what will it be worth once it has been improved; (3) how easy would it be to foreclose on the property, if the borrower defaults on the loan; and (4) how liquid is the market? If the borrower did foreclose and had to sell the property, how long would it take?

  • Many lenders will not make home loans to owner-occupants, because consumer protection laws can make foreclosing very expensive and time consuming. Also, some lenders prefer never to be in a position of needing to kick a borrower out of his or her own primary residence. Also, states divide into ‘judicial’ and ‘non-judicial’ foreclosure states. Judicial states are those where foreclosure must be processed through the courts in front of a judge, and the time involved is usually much longer. For example, in the state of New York it takes more than 1,000 days on average to process a foreclosure. For a map showing the average time and foreclosure process for each state, click here.

  • In some markets, a well-priced property can be sold very quickly with multiple offers. An example of this would be a newly renovated home in West Los Angeles in early 2015, where homes might sell in less than a week. Other markets and/or property types may be much less liquid. For example, a one-of-a-kind home that’s asking price is far above the median price for the neighborhood would take much longer to sell. Also, most types of commercial real estate take longer to sell than homes. This matters to lenders because in case of a default, their recourse is to foreclose, finish any work needed on the property, list the property and recoup their investment, plus lost interest payments, through a sale of the property. If the last step takes six months, the margin of safety is smaller because the amount of interest lost will be higher. If the market is very liquid, there is less risk for the lender because the time to sell and the lost interest are shorter and less, respectively.

How Hard Money Lenders Decide to Make a Loan

  • One should distinguish between balance sheet lenders and brokers who sometimes advertise themselves as lenders. Brokers often focus on whether–and with what amount of effort–they believe they can earn a fee by placing the loan with a particular investor. If they feel there is a good chance of earning a fee with a few phone calls, more than likely the broker will pursue the loan. For a balance sheet lender, the considerations include knowledge of the type of asset, risk as measured by loan-to-value, among other factors, availability of capital to make a particular loan.

  • Most hard money lenders aim to get paid interest and have their capital returned at or before loan maturity. As mentioned in the previous paragraph, these lenders usually focus on a particular type of loan with which they have a comfort level. Some lenders will not lend more than 65% of a property’s as-is value. Others who charge higher rates are comfortable lending at 75%. It should be noted that a few hard money lenders make loans as a way to acquire properties at attractive prices. In other words, they ‘loan to own.’

  • These reasons include the following:

    • the loan falls outside of the lender’s stated lending parameters

    • the lender does not want to lend money to a particular borrower (for example, if the borrower has a history of suing his lenders)

    • the lender does not have enough capital to make the loan at the time it needs to be funded

  • The loan may be on a different type of asset (for example, the lender lends on commercial real estate and the borrower needs a loan on a home that is going to be renovated The loan is in a geographic area where the lender is not active The requested loan amount is too high relative to the value of the underlying property (the requested loan-to-value ratio is too high) The loan is a consumer loan and the lender only makes business-purpose loans (for example, most owner-occupied home loans involve extensive documentation beyond the scope of many hard money lenders)

  • A business-purpose loan is to be distinguished from a consumer loan. This link explains the difference in some detail. Most loans to an individual secured by his or her own home run the risk of being deemed consumer loans. As such, they require extensive consumer protection documentation. Any flaw in the documentation, no matter how small, could be used by an attorney representing the borrower to invalidate the terms of the loan. The borrower will still need to pay the money back, however the interest rate and maturity could be changed dramatically by a judge or jury. For example, a one-year loan with an interest rate of 10% could be restated as a 30-year self-amortizing loan with an interest rate of 4%. For most hard money lenders, this would be considered disastrous, because they depend on getting paid back so that they can lend the money again, earning a fee with each new loan, and their investors expect returns far above 4% per year. For these reasons, most hard money lenders today avoid making loans on owner-occupied homes.

Pitfalls of Working With a Hard Money Lender

  • Pitfalls include working with a lender who fails to perform or changes the terms of the loan after it is too late for the borrower to find an alternative (known as ‘re-trading’). Some hard money lenders have also been known to compete with their borrowers, making back-up offers to purchase properties that their clients have put under contract, so that they can benefit if the borrower is not able to close. All of these practices are unscrupulous but unless there is an explicit agreement to the contrary, they are probably legal. Let the borrower beware! This is why working with a reputable hard money lender is so important.

  • Re-trading means changing the terms of an agreement after the parties have agreed to the key terms. In a real estate purchase and sale agreement, an example of re-trading would be if the buyer lowered the offer price after tying up a property. This technique can be effective because some sellers become fixated on getting a sale concluded as time goes on. In the context of a hard money loan, re-trading refers to the lender or broker first saying he or she can get the loan funded at one level of proceeds and pricing, and later reducing the amount he or she is able to deliver in funding and/or raising the rate of fees. Re-trading is particularly painful for borrowers because usually they are under extreme time pressure to get a loan funded (otherwise, they may well have gone to a bank to receive lower pricing).

  • Some hard money lenders are also buyers of the same kinds of properties that they lend on. For example, in Southern California some of the lenders who specialize in making loans on homes being renovated for resale also buy such homes, competing with their own clients for projects. Look for a lender who is not actively competing with you in your target market!

  • Some brokers who position themselves as lenders have been known to make back-up offers on the very projects they are asked to finance. For example, suppose that Developer A has put the property at 123 Main Street under contract at a very favorable price, but does not have enough money to close escrow and is running out of time. Developer A approaches Broker X or Lender Y to obtain a loan. Broker X or Lender Y indicates he can help Developer X to get a loan but at the same time, he or she may submit a back-up offer to purchase 123 Main Street on the same favorable terms that Developer A has negotiated. Broker X or Lender Y may or may not inform Developer A that he or she has made a back-up offer. When Developer A is unable to close, Broker X or Lender Y is able to put the property under contract and may (1) assign the purchase agreement to another developer for a profit, or (2) may pursue the project as a principal. To do this without explicit consent from the original buyer/developer is highly unscrupulous because Broker X or Lender Y is purporting to be in business to provide service to Developer A, but is really using information obtained under this pretense to potentially undermine Developer A.

  • ‘Loan to own’ refers to hard money lenders who make loans as an indirect method of acquiring property at attractive prices. In case of a default, these lenders will likely pursue a foreclosure at the first opportunity. This can be a valid business model, but it is very different from the model of making loans for cash flow. The amount of profit from one property acquired via a foreclosure could be as much as five or ten short term loans that perform and pay off. However, the amount of work is probably five to ten times as much as well (or more).

  • If the lender has lots of happy clients who have paid off their loans and borrowed again from the same lender, that lender is probably not in business to loan to own. As the lender for references of repeat borrowers to ensure your lender will work with you in case of a hiccup that comes up which is outside of your control.

Decrease Your Borrowing Costs With a Hard Money Lender

  • Hard money lenders differ greatly in their lending criteria and target returns. Most lenders have a target return they aim to hit; a specific type of project they like to finance; and a maximum risk level they are willing to take on. In general, rates are higher to the extent a project is riskier and/or it falls further outside of a given lender’s target lending criteria.

  • The keys to securing the best rate and points include the following:

    • Don’t ask for more money than you need. Lower loan-to-cost (LTC) and loan-to-value (LTV) ratios mean less risk for the lender and can translate into better pricing.

    • Going direct to the lender can save money. Many borrowers work with a mortgage broker to arrange their financing. These brokers tend to charge a fee–often 1% of the loan amount, but it can be either higher or lower–which the lender adds on to their own fees. If you can identify a lender specializing in your type of project, loan size and geographic area, you may be able to save money by approaching the lender directly, rather than working with a mortgage broker.

    • Shop for the best deal. As with any product or service, you get a better deal mainly by finding multiple providers of what you need and trying to make them compete for the business. This is where mortgage brokers can potentially earn their fees, if they know all the best providers for a certain type of loan.

  • Yes, in general the all-in cost of a loan will drop as the loan size gets bigger. The reason is that it takes a similar amount of work to structure, underwrite and document a small loan as it does for a larger loan, so lenders who have the capital available prefer larger loans, all other things being equal. In today’s market, natural break points are $500,000, $1 million, $5 million, $10 million and $20 million. Pricing on a $20 million twelve-month loan at 75% of cost might be 6% vs. 10% for a $500,000 loan.

Alternative to Hard Money Lenders

  • If you are put off by the rates and fees charged by hard money lenders, your best option is to find a wealthy individual willing to make the loan to you. Often individuals do not expect to receive loan origination fees and they do not charge any processing fees. The only disadvantage is that they may be slow to respond and their lack of experience making loans might make them uncertain and anxious, resulting in some risk that they will change their minds after indicating that they will make a loan.

  • Several real estate crowdfunding sites emerged in 2013 and 2014 to offer loans to real estate investors, developers and “fix-and-flip” operators. Two such firms are www.realtymogul.com and www.patchofland.com. These firms operate much like a mortgage broker, in that they do not typically fund loans themselves, but instead aim to structure and document a loan, and to then bring in one or more high net worth investors or funds to fund the investment. They usually charge a fee, in the form of up-front points and/or a ‘spread,’ which is the difference between the interest rate paid by the borrower and the return received by the investor or investors.

 
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