Banks and other traditional lenders evaluate and underwrite real estate loans based on a borrower’s credit and ability to repay, the sufficiency of the collateral, and the project’s prospects for success. The objective is to make conforming loans, mostly to consumers, that can be packaged and sold to Fannie Mae, Freddie Mac, and Wall Street. Federal and state regulation, along with policies of the Federal Reserve, are primary guiding factors in the process.
Few such constraints hamper the operations of private hard-money lenders, who are largely unregulated, and who usually do not intend to sell their loans. These lenders are individuals or small companies with substantial cash who are looking for an aggressive return on secured short-term investments. The target borrower is not the consumer-homeowner but investor-borrowers who are engaged in their own real estate ventures and are far more tolerant of risk.
The goal for the hard-money lender is to implement a no-risk, over-collateralized, high ROI loan, preferably with profitable upfront fees, that resolves quickly either by full payment or by fast seizure and disposition of the security property. Acquiring a percentage profit participation in the borrower’s venture is a plus. Such loans become valuable financial assets in their own right.
Typical hard-money loan characteristics include:
Loans up to $1M
Streamlined loan application process
May require minimum FICO of 600 to 650
LTV up to 70% of after-repaired value (ARV)
Quick funding (one week)
No formal survey required
No formal appraisal required
Up to 100% financing of rebab projects
Origination points from 1.5% to 3.5%
Above-market interest rate (12.5%+)
Interest-only loans available
Typical loan terms of 6 to 18 months
Some longer terms (up to 30 years) available
Available for short-term rental properties
Prepayment penalty may or may not apply
Aggressive lenders may include a profit participation
Lending Based on the Asset
Hard-money lending is short-term non-traditional financing for investors (not consumers buying a primary residence) that is usually offered by individuals or small companies. The word “hard” refers to the hard asset, the real property that is pledged as security. The loan is offered based on the deal itself, principally the collateral, which is why this is sometimes called asset-based financing. The borrower’s creditworthiness and good character are not priorities.
Typical hard-money loans include the ordinary fix-and-flip loan; bridge loans that span the gap between quick cash to seize an opportunity before later transitioning to traditional institutional financing; and capital to engage in a joint venture with other real estate investors. In all such cases, the purpose of the loan is less important to the lender than the collateral being offered by the borrower.
The collateral is most often a single-family rental property or several of them); small multifamily properties (duplexes, triplexes, and quadplexes); and perhaps the occasional strip center. Hard money for new construction and commercial projects is less common but occasionally occurs. The latter instance, referred to as small-balance commercial financing, revolves around not only the market value of the collateral but also the income it spins off.
Security for the loan may either be a first or second lien on the property plus (of course) an assignment of rents. Second liens are common, especially when the property was purchased “subject to” by the hard-money borrower and sufficient equity exists.
Higher Rates and Avoiding the Deal Risk
Hard-money loans 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.
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 (allowing the lender to keep a percentage of the action in addition to collecting interest), can often be far more profitable than investing directly in the underlying dirt. Do you see how this business would be an attractive proposition for someone with available cash to lend? Let those newbie investors take the deal risk. A hard-money lender is all but assured a positive return either way.
Underwriting a Hard-Money Loan
Hard-money lending is a matter of hard numbers combined with high loan-to-value ratios and quick default remedies. The process increasingly involves up-front fees in the range of 1% to 5% with the borrower paying the document preparation and recording fees as well. Fees are ubiquitous. Even a letter of intent from a hard-money lender can incur a fee; release from such a letter (to the extent that it was binding) can incur a break-up fee.
Done correctly, a hard-money loan should never result in a loss for the lender. In fact, borrower default is sometimes the ideal outcome.
Hard-money lending is an important, even essential part of the universe of potential funding sources for real estate investors—particularly as traditional institutional financing tightens—but it should be sought only when minimal safeguards for the borrower can be built into the loan documentation. Otherwise, hard-money lending (if done competently) is a “heads I win, tails you lose” scenario in the lender’s favor—every time. It is hard to escape the comparison to payday lending.
Given the foregoing, if one is a potential borrower shopping for funds in the hard-money market, caveat emptor is good policy.
Hard-Money Loan Documents
Hard-money loan documents consist of a shorter-term promissory note; 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 one is the lender).
Occasionally, there may be a participation agreement (also 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 frequently the case in fix-and-flip projects which rely on hard-money lending.
Where can hard-money lenders be found?
Hard-money lenders are available online, of course, but also in proximity to real estate investing clubs. Some clubs located in major Texas cities have thousands of members who are prime candidates as hard-money borrowers. Lenders in this niche will occasionally present themselves as gurus or mentors at these clubs, offering seminars and training to newbie investors who aspire to financial independence. Wealth is declared to be all but inevitable if the participants will only use the promoter’s system. One of the true purposes of this strategy is to discover and draw in borrower prospects who will then be put into hard-money deals. After all, one of the better ways to get rich quick is to manipulate and exploit others who believe they are going to get rich quick.
Advice for Hard-Money Borrowers
What specific protective measures can an investor-borrower take when negotiating a hard-money scenario? Here are some examples:
1. Recognize that there are no standard forms in real estate investing. Scrutinize the loan documents carefully. Even forms promulgated by TREC or by Texas Realtors contain multiple opportunities for tilting the transaction in favor of buyer or seller. Every good broker and real estate lawyer knows this; so if says to just sign a such-and-such standard form and don’t talk to your lawyer, a certain level of caution is warranted.
A borrower should never sign such documents without first consulting an attorney knowledgeable in this area. Because the market is private and largely unregulated, hard-money loan documents vary widely. They can be derived from dubious sources, even other states, and may have undergone all sorts of amateur modifications. Some lenders will assert that the golden rule applies (he who has the gold rules) and no changes to their documents are permitted. Nonsense. Everything is negotiable in real estate, even if not every negotiation is successful. If the loan documents cannot be written or re-written so they fairly balance the interests of lender and borrower, then it may be best for a prospective borrower to walk away.
2. Never ever 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 (for example) the fix-and-flip 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 perhaps one should reconsider the project.
3. 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 induce him or her into putting an entire investment portfolio at risk.
4. Cap any potential equity participation by the hard-money lender. It is of course preferable if the lender gets no participation interest at all; however, if equity participation by the lender is inevitable, it should be reasonable and limited in duration and dollar amount. It should be effective up to but not exceeding a certain 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 include 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. An investor-borrower should beware of these. Such clauses are often unreasonable, even outrageous on their face and they 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 loan pro forma.
5. Provide for up to two extensions. 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 either complete the project or secure traditional financing.
6. 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. It goes without saying that there should always be an ample notice-and-opportunity-to-cure period after written notice of default is given—certainly no less than 10 days. Reinstatement procedures (i.e., after a default) should be addressed as well. The phrase “at lender’s sole discretion” should, to the extent possible, be removed from the loan documents.
7. Examine any relevant 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 level of restriction should be unacceptable to an investor-borrower. Read the lender’s deed of trust carefully. Make sure there are notice and cure periods. Know when the lender can call a loan due and when it cannot.
8. Preserve profit. The borrower should ensure that a hard-money lender does not (by means of its documents or policies) crowd out the possibility of a reasonable profit. Returning to the automobile example: car dealers routinely make (at least) $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 $50,000 to $75,000 on a single-family investment property. Investors who settle for less are generally on a high-speed exit ramp out of the real estate investment business.
9. Beware of fee factories and other fraudsters masquerading as lenders. It should come as no surprise that fraudsters exist in the mostly unregulated world of hard-money lending. We live in a fee-based economy now, so fees are going to happen; still, there is a point at which they become oppressive and even fraudulent. We are aware of at least one case currently being prosecuted under Chapter 31 of the Penal Code (theft) in which a hard-money lender charged over $100,000 in up-front fees with no apparent intention of ever making a promised $1.5 million dollar loan. It was all a scam to collect fees.
Scammers and fraudsters have always found a home in the real estate lending business and the rise of AI is accelerating this trend. The need for a potential investor-borrower to investigate and perform adequate due diligence before engaging with a hard-money lender cannot be understated.
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. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. 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.
Copyright © 2023 by David J. Willis. All rights reserved. Mr. 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.