When you are a real estate owner or investor – the ownership, purchase and/or upkeep of a property requires capital. Ideally, a borrower might work with a conventional lender and receive a low interest rate loan with attractive financing terms. However, because of circumstances, access to needed money may not be available. Or, perhaps borrowing money, rather than tying up personal funds, is a more fitting financial strategy.
In today’s real estate market, conventional lenders cannot fill the needs of every borrower and there is a definitive place for the Hard Money Loan Industry.
There is even a commercial bridge loan fund opportunity for those seeking higher returns on their money as a lender.
On a face value comparison between conventional loans and hard money loans, some might wonder why anyone would even consider obtaining interim financing. Hard money loans are short term loans that typically have higher interest rates and upfront fees than conventional loans. However, hard money loans do have an important place in the real estate market. When traditional financing options are not available, utilizing a short-term hard money loan can help achieve a borrower’s end goal.
Here are the top situations where obtaining a commercial real estate hard money loan makes sense.
(1) Completion of Task – capital improvements, repairs, renovation
When buying a real estate property, an investor may see hidden value in a property that has not been maintained and is looking to maximize that property’s potential. The investor believes that with a combination of capital improvements, renovations, repairs, and aesthetic upgrades, the property value will increase and be more market appealing. In the future, after work is completed, the property owner would look to flip the property for a higher price or possibly attract higher rents and better tenants.
But right now, the property could really use some TLC. In the property’s current condition, traditional lenders would generally pass on offering financing. They want to lend on properties that fit within their guidelines and are “market ready.” The buyer’s vision is not their reality. A conventional lender’s thought process is three-fold.
- One, they want assurance that the real estate property follows their underwriting, environmental, health and safety, and occupancy standards.
- Two, if the subject property is commercial real estate, a traditional lender wants the property to be performing similar to comparable properties around its geographic area.
- Three, should they have to take back the property, conventional lenders want to have the least amount of work and cost to get the property ready for a sale. Banks do not want to be in the business of owning real estate.
The “as-is” condition of a property does not pose the same barrier for hard money loan providers, who are generally willing to take on more lending risks. Their lending standards are usually more asset value driven. As such, private money lenders can offer greater flexibility in their lending practices. However, the future value of the property, after work is completed is considered in their decision to lend.
Whether a property is in need of major capital improvements, repairs/rehab work, or exterior and interior renovations, a hard money loan can be the financial source to get the work completed.
(2) Property Construction
A property owner who is also a developer could look to build a ground-up project. Although, there are many lenders who offer construction financing, each one has their particular niche and lending guidelines. A borrower’s development experience, credit worthiness, collateral, project presentation, timeline, equity in the project, and financial reserves are just some of the factors a traditional lender considers in their construction loan evaluation. Weakness in any one, or combination of these factors, can cause a conventional lender to decline a construction loan application.
Although hard money lenders also consider these factors in evaluating a real estate construction project, the weight they put on them can be significantly different. Whereas a conventional lender can deny an application outright if anything is outside their lending parameters, hard money lenders are often willing to explore compensating factors a developer brings to the table.
Furthermore, when it comes to construction projects, a borrower may be focused on Return on Investment, profit margin and the opportunity cost of using their own monies. Conventional lenders who offer construction loans may place a cap of sixty, seventy, or eighty percent loan-to-costs. In contrast, some hard money lenders who specialize in development projects have been known to offer one hundred percent financing (and sometimes more) for attractive projects. Companies offering hard money loans for construction projects are able to tailor loan terms that fit a borrower’s needs. As mentioned, hard money lenders typically charge higher upfront costs and interest rates for their loans. But if a developer’s Return on Investment requirements and profit margin are satisfied, it can be in their interest to accept the costs of money and forgo the risk of using their own funds.
(3) Purchasing a Property
The phrase, “timing is everything,” also applies to real estate. Hard money loans have been an effective financing tool in the purchase of real estate. Good real estate opportunities and strategic property purchases can be time sensitive. The difference between taking ownership of a desired property and being out-of-luck sometimes come down to which buyer has the money to close quickly. In these circumstances, the lengthy lending process conventional lenders have would not work. Hard money lenders can typically evaluate, approve, and close a loan quicker than a bank.
After the borrower closes on the property with funds received from a hard money source, they now have the time to obtain replacement financing through a traditional lender. However, take note, as of 2011, conventional loans backed by Fannie Mae require a minimum of 120 days before they can be refinanced. A borrower should be prepared to carry the hard money loan for at least 3 to 4 months.
(4) Stabilizing Property
Similarly, a real estate buyer may need time to stabilize an underperforming property they own or recently purchased. This is not an uncommon situation with commercial real estate properties.
Conventional lenders shy away from providing financing for properties that are performing below market efficiency. The income a property brings in may be low or non-existent and/or expenses can be high relative to the income. These scenarios would fall outside a bank’s lending comfort zone.
Luckily, these are perfect situations to use a hard money loan. There are hard money sources that focus primarily on the value of the underlying property and don’t take into consideration a borrowers personal financials or the property financials. With bridge financing, a real estate investor can obtain a loan in order to have time to improve a property’s standing by filling vacancies, increasing rents and finding ways to lower expenses.
Once the property is stabilized, the investor can utilize a conventional lender for the permanent financing.
(5) Less than Perfect Credit
For better or worse, conventional lenders rely heavily on the credit worthiness of a borrower in their loan evaluation. The difference between a 575 credit score and a 625 score is greater than the mathematical value of fifty in the world of finance. Where a borrower stands on the credit scale determines the availability of funds, loan terms and cost of borrowing.
Conventional lenders make loans, but are restricted by regulatory guidelines. They can also be constrained by their desire to pool loans they issue into tradable instruments such as mortgage-backed securities. In both cases, a borrower’s credit is a cornerstone of a bank’s decision-making process.
30 day late’s, 60 day late’s, 90 day late’s, tax liens, mechanic liens, high debt levels, collection accounts, bankruptcy’s and foreclosures – are all credit score killers and reasons for a traditional lender to decline a loan application.
Hard money loans are not restricted to the same lending guidelines. These lenders set their own standards regarding the level of risk they accept and how they evaluate an application. Certain alternative lenders, who are asset-based evaluators, can take any level of credit history. A borrower having bad credit or no credit, can still obtain real estate financing through a Hard Money Lender.
(6) Ownership of too many Single Family properties
Depending on the type of real estate, the number of properties owned can affect a person’s ability to qualify for future real estate investment purchases. Owning too many single-family properties (SFR) that have a mortgage attached is a scenario where obtaining a hard money loan makes sense.
Today the maximum number of simultaneously financed single family residences allowed by Fannie Mae is 10 – which includes the primary residence. Despite Fannie Mae’s extension of the limit to 10, investors can find it challenging to find banks that offer SFR financing for people with more than 4 properties already financed.
Note: Commercial real estate, any property with no mortgage lien, multifamily properties of more than four units, warehouse, timeshares, vacant land, ownership of manufactured homes on a leasehold estate – are not subject to these financing limitations, even if a borrower is personally obligated for the mortgage on the property.
Conversely, those offering hard money loans are not as concerned about the number of properties a borrower may own. This is a great benefit for those investors who hold a portfolio of single family residences or those who are active in fixing and flipping multiple properties.
Hard Money Loans sometimes get a bad reputation because of course, hard money’s are not cheap money. But hard money has a necessary role in continuing the movement of the real estate market. When conventional lending products are not available, hard money sources fill a need that typically is well worth the cost for the purpose it serves.
Opportunity to Earn Higher Returns
Hard money loans are usually associated with borrowers paying higher interest rates in order to accomplish their real estate financing goal. Much like how conventional lenders are not the only source of real estate financing, there exists other opportunities for those looking to earn higher returns on their money.