Banks and other conventional lenders evaluate and underwrite loans based on a borrower’s ability to repay, the sufficiency of the collateral, and a project’s prospect for success. These and other considerations are mandated by federal and state regulations as well as policies of the Federal Reserve. However, no such constraints hamper the operations of hard-money lenders who, more often than not, are individuals with substantial cash looking for an aggressive return on investment. It is a largely unregulated, wild-west kind of market that may work to the benefit of the careful investor-or result in disaster. A central point to keep in mind is that hard-money lenders are not in business to be charities, or seminar promoters, or mentors. Their goal is to make a no-risk, high ROI loan to the investor-borrower and frankly-in spite of pious claims to the contrary-could not care less if the investor-borrower makes a dime or even survives in the real estate business. So caveat emptor.
What is a hard-money loan?
This term has come to refer to short-term non-standard financing that is available based on the deal itself. The borrower’s credit is not a factor. It is simply a question of numbers, including a loan-to-value ratio that effectively makes the transaction a sure bet for the lender whether or not the investor-borrower is successful in his objectives. Hard-money lending is an important part of the universe of potential financing sources, but it should be utilized only when appropriate safeguards are built into the loan documentation. Otherwise, it can swiftly turn into a “heads I win, tails you lose” scenario in favor of the lender. A pernicious example of this can be found among hard-money lenders who masquerade as gurus or mentors for newbie investors, offering seminars and “training” to those aspiring to financial independence in the world of real estate. Wealth is all but inevitable if the participants will only use the promoter’s “system.” Some of these seminars are really fantasy-based marketing tools designed to discover good borrower prospects for the gurus and link them to deals upon which hard-money financing can be offered.
There’s an old saying in the car business: “Sell the financing, not the car.” Why? Because that’s where most of the profit is, at least in the long term, which is not so different in the world of real estate. Hard-money financing, particularly when accompanied by up-front points plus an equity participation interest (the lender keeps a percentage of the action in addition to collecting interest on the note), can often be far more profitable than directly investing in the underlying “dirt.” Do you see how this would be an attractive proposition for someone with available cash? Let those newbie investors take the deal risk. A hard-money lender is all but assured of a positive return either way, with very little exposure.
“Just sign these standard forms-and don’t show them to your lawyer!”
Firstly, there are no “standard forms” in real estate investing, even though seminar gurus and hard-money lenders often claim otherwise. Even forms promulgated by TREC or published by TAR contain multiple opportunities for slanting the transaction in favor of buyer or seller. Every good broker and real estate lawyer knows this. For example, a lawyer’s documentary templates have multiple selections that need to be made throughout the text depending on whether the client is a seller or buyer, lender or borrower. The original template may be 30 pages long; however, once narrowed down to suit the client and focused to the client’s advantage, the result may be less than 10 pages. That’s how lawyers produce precision documents in favor of their clients. Conclusion? If a document is fill-in-the-blank, it is almost certainly over-simplified junk. Buy your supplies at Office Depot, not your legal documents.
Secondly, many seminar forms are derived from other states and have since undergone all sorts of evolution and amateur modification. They may be less than fully enforceable in Texas and may in fact get an investor in legal trouble. Many real estate lawyers (including this author) refuse to even attempt to make such guru packages Texas-compliant. What sensible lawyer would want the liability for trying to do that?
Thirdly, anytime you are told you do not need to consult your attorney, run-don’t walk-to the door. If the door is locked, jump out of the nearest window and flee for refuge. It is a monumental failure of due diligence to sign any loan documents, particularly hard-money docs, without talking to your real estate lawyer. He or she will have all sorts of constructive comments and suggested improvements designed to avoid disaster. Some lenders will respond that the golden rule applies (he who has the gold rules) and no changes to their documents are permitted. Nonsense. Everything is negotiable. And if the documents cannot be written so they fairly balance the interests of lender and borrower, then your lawyer will likely advise you to walk away from that loan. We have said elsewhere that not every deal can or should be made. The same is true for loans.
The Mechanics of Hard-Money Loans
Loans of this type typically come with higher interest rates-often up to 20% or so. Borrowers are also often called upon to pay several up-front points in order to get the loan (a “point” is equal to 1% of the loan). For example, on a $100,000 loan, the lender might require three points at funding ($3,000) which is netted out of the amount advanced, so the borrower in this case actually receives only $97,000.
Hard-money loan documents generally consist of a short-term promissory note (often with a term of 6, 9, or 12 months), a commercial-style deed of trust and security agreement that includes a statement that the property is not the borrower’s homestead; and a loan agreement to cover miscellaneous details such as representations and warranties and a provision for alternative dispute resolution (something that should always be included if you are the lender). Occasionally, there may be a participation agreement (sometimes called an equity participation agreement, a profit-sharing agreement, or joint venture agreement), which provides for payment of part of the net profits to the lender when the property is sold. In such cases, the lender is not only collecting fees and interest but also a piece of the action. This is common in the case of “fix and flip loans,” which are usually just another example of hard-money lending.
Protections for the Investor-Borrower
What specific documentary measures can an investor-borrower take when negotiating a hard-money scenario? Specific circumstances must always be considered in answering this question but here are some examples:
1. Never sign a personal guaranty of a hard-money loan. Hard-money loans are made based on the fundamentals of the deal itself and have very little to do with the borrower (who should, by the way, be an investor’s LLC or, in the case of series LLC, one of the LLC’s individual series). Signing a personal guaranty pointlessly adds to the potential damage if the purchase/rehab/resale does not work out as planned or within budget. If the deal is not strong enough in the lender’s eyes to stand on its own-that is actually useful information, incidentally- then walk away.
2. Always include a non-recourse provision in the note. Here’s an example: Notwithstanding any other provision of this Note or any instrument securing same, Lender may satisfy the debt evidenced by this Note only by the enforcement of Lender’s rights in, to, and against the Property and no other property, real or personal, of Borrower. Since the deal is supposed to stand on its own, it should do just that and extend only to the subject property. An investor-borrower should not allow a hard-money lender to con him or her into putting an entire investment portfolio at risk.
3. Cap any potential equity participation. If there is an equity participation agreement, it should be reasonable and not unlimited in dollar amount. It should be effective up to but not exceeding a figure. Sample wording: Borrower hereby irrevocably grants and conveys to Lender a 5% participatory interest in the net sales proceeds of the Property, not to exceed a maximum of $25,000.” Your lawyer will then want to carefully define the term “net sales proceeds” to account for all the investor-borrower’s out-of-pocket costs, including commissions and unforeseen expenses.
Certain participation agreements are worded in absolute dollar amounts rather than as a percentage of net sales proceeds. For example, if closing occurs by a certain date, then the amount due the lender is $15,000; if it closes a month later, the amount increases to $25,000. Beware of these. In the view of this author, they are unreasonable on their face and should be avoided. To the extent possible, the hard-money lender should be compelled to share in at least some of the risk that profit may not be as much as anticipated in the original pro forma.
4. Provide for an extension. Unfortunate timing, along with under-capitalization, are the causes of most financial loss in real estate investment. If pressed for time, it can be useful for a borrower have the option of falling back on an extension provision allowing payment of a predetermined fee (perhaps another point) in order to get an extra 30 or 60 days to complete the fix and flip.
5. Scrutinize default provisions. Remember, hard-money lending is an essentially unregulated market. Many hard-money documents are cobbled together from various sources and contain a maze of vague default provisions that fail to include a specifically-stated notice period and opportunity to cure without penalty. These are dangerous. Others are designed by very smart lenders’ lawyers to put the investor-borrower at every possible disadvantage. These are dangerous as well-particularly if the investor-borrower has bought the line that the loan documents are “standard” and cannot be changed, so he has not consulted a lawyer. General rule: A lender should never be permitted to have the ability to declare a borrower in default on a whim. Default parameters should be ascertainable and transparent, as should notice periods and the time in which any alleged default must be cured. Reinstatement procedures (i.e., after a default) should be addressed as well.
6. Scrutinize due-on-sale or transfer provisions. Not all due-on-sale clauses track the familiar language of the FNMA deed of trust. They can be custom-written to prohibit a borrower from even leasing a property prior to maturity of the loan. This is unacceptable in a hard-money case. Read the deed of trust carefully. Know when the lender can call a loan due and when it cannot.
7. Beware of Fee Factories. It should come as no surprise that fraudsters exist in the unregulated world of hard-money lending. We live in a fee-based economy now, so fees happen, but there is a point at which they become not only excessive but fraudulent. We are aware of at least one case currently being prosecuted under Chapter 31 of the Penal Code (theft) in which the “lender” charged over $100,000 in up-front fees with no apparent intention of making a promised $1.5 million dollar loan.
Lastly, make sure that the hard-money lender does not crowd out the possibility of a reasonable profit. Returning to the automobile example: car dealers routinely make (at least) $5,000 to $10,000 when flipping a luxury car. Shouldn’t an investor make more than that when locating, buying, rehabbing, and selling a house-particularly if he or she must incur a loan risk in order to do it? The minimum goal should be a net profit of $10,000 to $20,000. Investors who make only $1,500 here and $2,500 there are generally on a high-speed exit ramp out of the real estate investment business.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is expressly retained in writing to do so.
Copyright © 2019 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.