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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2011

How Well Do You Know Hard Money?

Nonconventional lending brings a world of opportunity for brokers and their clients

How Well Do You Know Hard Money?

These days, pushing a loan through underwriting at a commercial bank can be an exercise in futility. Commercial mortgage brokers have all had experiences submitting documents, getting preapprovals, having clients sign reams of paperwork and then waiting 60 to 90 days — only to find out the loan has been turned down because the applicant doesn’t meet some obscure guideline. Loan fallout is frustrating for clients and not so good for brokers’ bottom lines, either. It’s also the reason many brokers and borrowers are turning to hard money and finding a world of opportunity.

"Hard-money loans rarely require the reams of financial paperwork that conventional loans require. "

A hard-money loan is an asset-based loan for which the lender’s main concern is the collateral’s value. Hard-money loans are typically easier to get, quicker to underwrite and require much less documentation than conventional loans. They are the preferred loan type for many developers, builders and other real estate investors who choose to finance their projects outside traditional lending channels. Adding hard-money loans to your portfolio of services will expand your reach as a broker and open up opportunities you may have missed with just conventional loans.

There are many hard-money lenders from which to choose, but finding the right one for your clients’ projects takes research, planning, expanding your network and understanding the key terms.

Underwriting

The loan-to-value ratio (LTV) is the main underwriting ratio for hard money. Whereas conventional loans can feature LTVs as high as 96.5 percent, most hard-money loans cap out around 80-percent LTV, with the average hard-money loan somewhere between 50-percent and 60-percent LTV. This requires borrowers to bring more cash equity to the transaction or to purchase properties at steeper discounts.

In today’s market, most borrowers using hard money must finance rehab costs on their own or purchase the property at such a discount as to allow them to include the rehab costs in the purchase loan amount. For example, assume a borrower is purchasing a property valued at $100,000 for $45,000 as a foreclosure. The borrower estimates the property needs $15,000 in rehab costs. The total cost to the borrower is $60,000, which would be covered in the loan amount at 60-percent LTV. In this way, the borrower can get a loan at 100 percent of cost, paying nothing out-of-pocket, except perhaps assorted third-party fees, closing costs and the broker fee.

Some hard-money lenders prefer to lend off a percentage of cost rather than value. For instance, rather than using LTV, some lenders would offer 80-percent loan-to-cost (LTC). It’s common to get a hard-money loan at that level, and using the same example, the deal would look like this: a $100,000 property is being purchased for $45,000 with $15,000 in rehab costs. The total cost to the borrower is $60,000. The lender offering 80-percent LTC makes a loan for $48,000, and the borrower must bring the remaining $12,000 to close the deal.

A loan made as a percentage of cost requires borrowers to inject their own cash into a project. When borrowers submit their own cash equity into a transaction, they often are more likely to stick around when problems arise and fight to finish the project.

Advantages

There are two key advantages to using hard money over conventional loans: underwriting flexibility and quick underwriting.

Hard-money loans rarely require more than a clean title and an estimate of current value. Most lenders want to know what they can sell the property for in the event of a default, and they likely will price their loan below that amount to allow for default costs, selling costs and sometimes a small profit.

The key here is that hard-money loans rarely require the reams of financial paperwork that conventional loans require. Lenders will review corporate agreements to make sure they are in good standing, as well as any income or expense information that might be available. Cash-flowing properties will earn the best terms among hard-money lenders because, if the borrower defaults, lenders don’t necessarily have to sell the property. Rather, they could step in and continue to manage it, drawing on that positive cash flow to earn their return.

Because such few documents are required, the underwriting timeline typically is much quicker than with conventional loans. Larger commercial hard-money loans can take longer to underwrite — as many as 90 days — because loans made to businesses could require additional insurance, review of corporate-entity documents, personal and corporate guarantees, and substantial legal paperwork.

Disadvantages

There are a few disadvantages you’ll encounter when brokering hard-money transactions for your clients, primarily subjective underwriting and smaller terms with bigger fees.

Because these are asset-based loans, knowing the true property value is paramount when requesting funds. As such, quicker underwriting can be a disadvantage to the borrower because it can lead to less-reliable property valuations, which impact the final loan offer.

Local lenders know their market well enough to work off broker price opinions (BPOs) rather than longer appraisals.  BPOs often include a quick-sale value, and the lender likely will base its value on this number, which is usually more conservative than what a standard appraisal would show.

With more-specialized property types — such as gas stations, warehouses and land development — hard-money lenders tend to use the appraisal more as a guideline than a statement of value. Combined with lenders’ assessment of risk and their willingness to lend larger amounts on any one project, this can make the final loan offer more of a subjective calculation. The drawback is you may not be able to predict the loan amount before going into underwriting. In cases where upfront fees are involved before diligence is done, this can be too large a leap of faith for  some borrowers.

You’ll also find that most hard-money-loan terms are shorter than their conventional counterparts and more expensive. It’s uncommon to find a hard-money lender willing to extend a loan past three years. Most will be for six months to one year, with a few lenders offering loans with terms of as few as 24 hours for foreclosure- auction scenarios.

Expect hard-money lenders to charge higher-than-market interest rates and origination fees, sometimes 10 points or more. This is purely because their money is in short supply and high demand. For some, the higher cost also reflects higher risk. Borrowers may even see an exit fee attached to the loan, which is comparable to conventional loans’ prepayment penalties.

When the lender is putting in 100 percent of the project cost, you may see what some hard-money lenders call a fee in lieu of equity. The borrower pays a fee to have the lender not take an ownership interest in the property, which a mezzanine or equity provider would do in cases where the investor did not bring any cash to the close.

3 keys to choosing a lender

Choosing the right hard-money lender for your client’s project is the most important step, and with a little research and planning, you can narrow your choices to a few key players. Carefully consider the following three things when choosing a hard-money lender.

  1. Property location: Hard-money lenders are specific about the areas in which they lend. Most like to stay local, where they have a greater understanding of the market dynamics and can visit the borrower and property with relative ease. Other lenders offer nationwide or even international loans. Because of the diligence involved in loans outside the lender’s home area, expect higher fees and closing costs for these loans, as well as longer underwriting times.  Make sure the lender has a good understanding of values in the area where the property is located. The better the lender knows the market, the more leeway you have when it comes  to appraisals.
  2. Loan amount: Hard-money lenders are usually specific about how much they can lend on any one project. The amount of money requested may even knock a few lenders out of the running on your project. Local lenders will usually have a loan limit above which they can no longer participate. Some prefer to lend less than $100,000. Other lenders don’t even make a loan unless it is greater than $1 million.
  3. Lending ratios: Most hard-money lenders use the same ratios. You’ll likely be offered a loan between 50 percent and 65 percent of property value, or as much as 80 percent of project cost, no matter what the property type or location.

Pitfalls

Be aware of the two most-common pitfalls of hard-money lending: upfront fees and limitless property-type or loan-type combinations. 

Upfront fees are common on larger hard-money loans. On a loan request of $50 million, the lender likely will expect the borrower to put up some funds before undertaking any due diligence. If asked for money upfront, make sure to do your own due diligence. Ask the lender for references, and ask to speak with clients who have received loans. Check its licensing, if any, and make sure there are no pending lawsuits against the lender. Most upfront fees are nonrefundable, so make sure you have a good sense of the property’s value. When problems arise regarding upfront fees, it is usually because the client overestimates the property’s value. If the lender offers a lower loan that doesn’t allow the client to complete the purchase, the deal likely will fall apart and the client loses the upfront fee.

There is a hard-money lender out there for every conceivable property type and almost any required loan amount. You might be leery of a lender that claims it can fund a $500 million loan, however. Few banks and even fewer private individuals can fork over that kind of money for any one project.

Build business 

In 2010, 156 banks were closed, according the Federal Deposit Insurance Corp., and there were 140 bank failures in 2009. These banks represent thousands of loan programs that are no longer available. With so many banks closing, commercial property-owners and investors will need your help to find the funds they need to continue investing.

Increased demand for nonconventional loans likely will continue for the next several years, which presents an opportunity for mortgage brokers to expand their business into the hard-money niche.


 


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