Hard Money – Benefits and Risks To Using This Financing

It’s a deal too good to pass, a distressed building that can easily be remodeled and instantly leased, or perhaps it’s the perfect time to start that new construction project. Going through the bank will take weeks, stacks of paper, and the deal could slip away.

This is fertile ground for a hard money loan on the project.

“It’s a shorter term form of lending (for commercial real estate) unlike a typical construction loan or mortgage,” said Gordon Lamphere, vice president of Von Vissinger & Co. “The loans are less reliant on the borrower’s creditworthiness. Some form of security usually backs hard money loans.”

What are CRE Hard Money Loans?

Hard money loans are financial bridges that progress a project to lease or sell. With lower credit thresholds—essentially the value of the project the loan is for—the financing carries higher interest rates and shorter maturities.

“They are used in construction development,” said Lamphere. “With their fast approval process, it’s a loan most likely used by businesses and commercial real estate investors.”

Hard money, more technically known as private lending, is available from individual investors or through brokers.

Dorfman says the premium can run two or three points higher than bank lending, but the trade-off is that it is loaned based on project value rather than whether a bank’s risk manager believes in the project developer or the project value.

The bottom line is that it’s a readily available form of financing that’s not credit-dependent. It carries risks to create opportunities.

“It’s a bridge,” said Dorfman. “You get in, you get out.”

Pros and Cons

Borrowing or investing in private lending entails risks and opportunities. The risk is a project going south; the opportunity is obtaining financing quickly. Some hard money lenders promise next-day funding.

“You need to get into hard money lending with a good attorney at your side,” said Lamphere. “You want someone reviewing the paperwork before you sign so you know what you’re getting into.” Lamphere said that private lending is heavily regulated, and it’s imperative for the borrower to have legal advice and apply through a broker.

On the plus side of the ledger, money can be readily available, applications are simple, and paperwork can be standard. The project equity secures the loan. According to Dorfman, it’s basically the same for a borrower or a lender.

The risk is a change in market value or the economy, undermining the project’s success, construction delays or cost overruns that run completion past the loan’s maturity date.

“One of the big risks is liquidity,” Dorfman said. “Look at what happened in 2008. The market crashed, and lenders started selling foreclosed properties (at steep discounts). It snowballed.”

He said that value plummeted because there was too much real estate on the market and insufficient buyers. Hard money lenders ended up sitting at maturity with incomplete or empty projects to try and unload. Developers ended up with empty pockets and property loss.

Dorfman said risk can be mitigated by investing in hard money developments in growth areas, such as Texas, Arizona and the Southeastern region.

Hard Money Loan Repayment

“There are any number of ways to repay, but the most common is interest only and principal at the end,” said Lamphere. “You have to understand finance and some of the legal regulations that relate to it. The loan is  a real estate transactions and rules vary by state.”

Dorfman agrees that interest only is the most common, but it does leave significant exposure at the end of the lending period. There’s always the risk of being unable to pay back the principal. While the interest-only/balloon repayment is the most common, some lenders will let the interest accumulate and require a total repayment of principal and compounded interest at maturity.

“It all depends on how you structure the loan,” said Lamphere. One reason for sound legal advice is knowing what happens if there is a problem. A missed interest payment, or even a late one, could result in a foreclosure, according to Lamphere.

“If you’re a borrower, make sure you have a lawyer read over the documents,” he said. “Make sure you understand the legal and financial implications of what’s going on.”

It’s a high-risk activity, he said, and understanding the repayment process and its implications is crucial.

Refinancing

Dorfman said that hard money loans are generally not refinanced. The borrower must find another bridge loan or long-term financing as the maturity date approaches.

This means that a refinancing package needs to be prepared in addition to monitoring construction, finding buyers or tenants, and tracking costs. “If you default,” said Lamphere. “You’re going to lose a major asset. You’re betting big, so don’t miss.”

Legal Considerations

“It depends on state regulations,” Lamphere said. “Unlike conventional lending, private lending is regulated at the state level.” He said it can also be regulated by local requirements.

“States want to prevent usury,” he said. “Local regulations also affect the condemnation or foreclosure process if the loan becomes a bad debt.”

Lamphere said the foreclosure or title assumption can be very fast, depending on state law. An investor may take a formal judicial foreclosure process to gain control of the collateral.

“It can take five years to get the property back in New York,” Dorfman said. “Because of things like that, compliance is absolutely important. The biggest way to alleviate risk is working with someone who knows what the hell they’re doing.”

Dorfman points out that if a mistake is made, either the borrower or the lender could be hit with damages if there is a compliance failure. In many states, the foreclosure process can move faster because it’s a hard money loan rather than conventional borrowing through a bank.

When asked for the one piece of legal advice he’d give a prospective borrower or investor, Lamphere was adamant, “Get a lawyer in your locality that does (hard money lending review) and have a lawyer on either side of the transaction.”

FAQ

What is a hard money loan?

Private lending or hard money lending is a loan through a licensed broker, usually secured by real estate. It is used as a bridge or construction loan with higher-than-bank interest rates to fund a project over a short term.

How do I find a hard money lender?

Talk with commercial real estate brokers, use a search engine for “hard money lending” or talk with financial advisors to find a licensed real estate broker who arranges private loans.

What does a hard money loan cost in fees and charges?

In addition to normal title costs, recorded document fees and document preparation costs, lenders may charge points or finder’s fees. Sometimes, these must be paid outside the loan so that loan proceeds may not cover those costs.

How do I pay it back?

The repayment is typically interest-only monthly, with the principal due at maturity. However, lenders may agree to other repayment plans.

Do I need to have legal counsel to obtain a hard money loan?

Legal counsel is not required, but professionals highly recommend it to ensure a complete understanding of the loan’s regulations, requirements and conditions.