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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   June 2005

Hard money loses its jagged edge

In 1990, I wrote an article titled “The Hard Facts about Hard-Money Lending.” In it, I attempted to debunk for readers the myths and misconceptions about the hard-money business and explain why hard-money lending is a useful financing tool in certain situations. Although well-received and appreciated, the article barely penetrated hard-money’s negative stigma within the borrowing and brokerage community. In fact, thanks to the behavior of some bad apples in the business, many tried to shed the title of being a pure hard-money lender.

As the years passed, the mezzanine business has become more difficult and competitive. Previously wide open, it became saturated by Wall Street institutions and banks in search of higher returns and new outlets for their capital. Deals are widely shopped and tightly bid, resulting in a departure from prudent lending and risk-return analysis. As a result, the hard-money-loan business is booming, and the negative stigma once associated with it has largely disappeared.

Born in the early 1990s, the hard-money industry spawned from the mix of a recessionary economy, the effects of the savings-and-loan crisis and the tightening of credit, particularly for real estate. Loan defaults and foreclosures were rampant. This set the table for private-capital sources to take advantage of desperate situations where capital was required and could name its price. While the hard-money business boomed, its reputation plummeted.

With nowhere to turn, hard-money borrowers reluctantly and begrudgingly kept borrowing record sums at exorbitant rates. Although loans closed, the bad taste left in borrowers’ and brokers’ mouths solidified the reputation of a hard-money lender as a “last resort.”

Making matters worse was the presence of some disreputable fee collectors — firms that preyed on desperate and naive borrowers in order to collect excessive upfront fees without closing a loan. The fee collectors were experts at baiting applicants. They pressured applicants to pay upfront commitment fees. Meanwhile, they legally positioned their commitment so that the resulting loan would be useless to the borrower but the fee would be earned and nonrefundable. Despite countless lawsuits and even physical threats, this despicable practice lasted through the ’90s.

When the real-estate markets began booming in the late ’90s, the hard-money business — accompanying a huge growth in available institutional debt and equity — slowed to a crawl. Surviving companies had a capital base that was flexible enough to lessen their return requirements or change their products and focuses completely. The hard-money business survived and has once again evolved into an important part of commercialreal-estate financing with an improved reputation and acceptance. The business has grown in activity and repute for a number of reasons.

First, while the hard-money lenders of yore pared back, Wall Street and banks with an increased appetite for risk and higher returns filled the void. Higher-rate lending has received a stamp of approval and acceptance in the mainstream-capital market. While hard-money lenders still might take higher risks and get higher returns, the spread clearly has narrowed. As a result, the response from borrowers and brokers to hard-money lenders’ terms and rate quotes are less confrontational and more constructive. Borrowers and brokers see somewhat-similar quotes from the institutions on a risk-adjusted basis.

Second, as mentioned, rates and fees charged by hard-money lenders have dropped dramatically and are no longer as offensive. In fact, they are even more justifiable in light of developers’ high returns and value appreciation.

Third, despite the fact that significant institutional capital is available for commercial investment, there continues to be a dearth of such capital available for opportunistic land-acquisition and development. Here, hard-money business has exploded and become a regular and welcomed source of investment capital. In particular, residential development has experienced investment returns that can easily absorb higher rates of borrowing. In return, lenders are assuming higher leverage and risk. With institutional lenders still unwilling to step up to the plate, land-developers are soliciting hard-money lenders more than ever.

Finally, disreputable fee collectors have disappeared, been exposed or otherwise mitigated. Conversely, the number of reputable hard-money lenders has increased dramatically, and the business has gained acceptance in the real-estate-finance industry. Companies with minimal overhead and limited experience have started doing several-hundred-million dollars of business annually.

Most hard-money lending relates to land acquisition and development, residential construction, condominium conversions and nonstabilized commercial projects. Each hard-money deal usually requires a quick closing and has a reason for being conventionally unfinanceable. However, such projects often are exciting, value-added opportunities. Once the project is stabilized, it often leads to additional financing possibilities for the lender, such as mezzanine or equity.

Although the hard-money business has evolved, the fundamentals of the business have not changed much since its beginning. In turn, it still might be wise to dispel a few myths about the industry.

Myth No. 1: Hard-money loans are named for lenders with hard-to-accept terms who are hard to deal or negotiate with.

The nature of the business does require hard-money lenders to hold relatively firm stands on their lending criteria. But the “hard” part is the loan itself — a difficult borrower, a difficult project or difficult circumstances surrounding the transaction. We refer to these difficulties as “hair.” Every request is unique and requires understanding, dissection and reconstruction to make it workable. The hair encountered often is incredible and sometimes even comical. It can be handwritten loan requests from prison, requests from ostrich and catfish farms and independent nations seeking to secede from Texas. There are, however, several consistent themes running through the typical request. One or more of the following usually are present:

  • Money is needed quickly, often within a week and almost always within a month.
  • The borrower has little or no cash equity and is unable to raise a reasonable amount or is unwilling to sacrifice a substantial equity interest to an equity investor. The borrower could have a troubled credit history, including personal and corporate bankruptcies, other litigation or even a criminal past. The borrower also may not be bankable.
  • The borrower has been trying to arrange the loan for several months and has been close two or three times. Sometimes, a disreputable lender or broker simply misled the borrower. Usually, the borrower stubbornly held out for an unrealistically cheap loan. 
  • The project has problems or is full of questions. The issues could be dealing with environmental issues, zoning and/or approvals, location, litigation, feasibility and valuation.
  • There is no obvious exit strategy for the loan.

Myth No. 2: Hard-money loans are too expensive.

Hard-money loans are priced to market like any other loan. If the same deal was priced by Wall Street, it would be priced similarly but not labeled as hard money simply because of the status of the institution quoting the price.

What make these loans “hard-money” are the circumstances surrounding the request, not the lender or the loan terms. If the loan was easy or qualified for cheaper pricing, the borrower would not have sought a hard-money loan in the first place. The typical hard-money borrower has explored and exhausted all other debt and equity sources. The pricing quoted by a hard-money lender usually is appropriate for the particular circumstances and properly matches the real risk.

Hard-money loans are usually a blend of debt and equity risk but are priced higher than conventional debt and cheaper than the cost of equity. Relatively few transactions actually fit, but hard-money lenders are trained to identify those that do and competitively price them. Once borrowers recognize that they are candidates for a hard-money loan, they will seek additional quotes. Inevitably, competitive proposals will be priced similarly. Therefore, borrowers’ final decisions are based upon:

  • The lender’s reputation and ability to close.
  • The conditions of each proposal (for example, recourse vs. nonrecourse).
  • The chemistry between the principals.

Myth No. 3: Hard-money lenders are fly-by-nights.

For the most part, hard-money lenders are experienced, trustworthy financial concerns. Principals of most hard-money-lending firms have successful backgrounds as investment bankers, developers, accountants or lawyers. They recognize that they can only make money by closing loans, and a bad reputation will not help them do so.

Finesse, however, may not necessarily be their strong suit. As time is their most valuable commodity, hard-money lenders will lay their business on the line quickly and bluntly. Savvy borrowers appreciate this approach and use it to better focus their financing search.

Horror stories are out there, though. Applicants have lost money and time, sometimes a substantial amount, during the qualification process. Occasionally, the lender may be at fault. More often, borrowers are unrealistic in their expectations, misrepresent the facts or misunderstand the conditions and obligations in the executed-commitment letter.

In summary, reputable hard-money lenders are tough but fair and experienced in assessing risk and closing loans. Prudent borrowers still should perform their own due diligence on the lender at an early stage of their relationship to avoid potential problems.

Pricing of hard-money loans warrants explanation. All hard-money loans include:

  • Monthly interest (or preferred return, in the case of preferred equity) at rates that usually range from 10 percent to 15 percent.
  • Closing fees. 
  • Sometimes, exit fees and/or a profit kicker.

If the project cannot support monthly interest payments, the lender can include in the loan amount an adequate reserve or prepayment for interest. The combination of interest and fees quoted by a hard-money lender will reflect the lender’s perceived risk of the transaction. This risk perception is based on factors such as borrower qualifications, experience and credibility, borrower equity, level and quality of personal guaranties, loan-to-value and loan-to-cost ratios, market strength, entitlement status, an exit strategy, the project’s track record, development risks and speed of closing.

The types and amount of fees charged can vary greatly. The following are some of the various fees which may be charged. One or more will be included in any loan proposal.

  • Application fee: Payable upon signing a letter of intent or conditional-commitment letter, typically $5,000 to $25,000. In addition, the borrower always will be required to advance a good-faith deposit for lender’s third-party costs of due diligence and closing. These costs include legal, appraisal, market/feasibility study, travel, engineering and environmental fees. 
  • Commitment fee or break-up fee: Payable at the loan closing or borrower’s default of obligations to close, whichever is earlier. It ranges from 2 percent to 5 percent. Usually, the lender includes and funds it as part of the loan.
  • Extension fee: Payable by borrower upon notice of maturity extension. Amount will depend on extension length and general fee structure.
  • Exit fees or profit kicker: At higher levels of risk, an exit fee of 1 percent to 10 percent — either levied on the loan amount or on gross sales — or a share of profits.

Most hard-money loans have short-term maturities, ranging from six to 36 months. Some lenders will extend them. Most loans have prepayment penalties if paid back before a minimum-hold period.

In addition, most hard-money loans also require a personal guaranty for repayment of the loan. Some lenders will limit personal recourse, which is required for construction completion and standard carve-outs, such as fraud, misrepresentation and bankruptcy filing.

The commitment also will refer to:

  • Exclusivity: The borrower must agree to not solicit other financing.
  • Brokerage: The lender will agree to fund the procuring broker’s agreed commission as part of the loan. To protect against unforeseen brokerage claims, the borrower must indemnify the lender against any claims for additional brokerage commissions. 
  • Legal issues: These include governing law and opinions.

Hard-money lenders comprise a niche between conventional lending and private-equity capital. Conventional-institutional lenders will not finance hard, hairy loans, while equity investors can demand high returns and shares of profits. Hard-money lenders do not equate hard deals with bad deals. Rather, they use practical experience and flexible-capital sources to see through the hair and help developers seize opportunities or add value to their existing projects. Their funding is best-suited for opportunistic, undervalued or other special situations that are short on time or capital or have conditions that impair financing them conventionally.

With their cost, hard-money loans work best as short-term fixes. They help developers get from point A to point B, rather than as permanent financing. Often, hard-money loans bridge the equity gap that might be temporarily missing from a deal. In turn, they help developers avoid giving away a substantial share of their profits.


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