What are the risks of hard money lending?

[webguy]

I'm interested in learning more about hard money lending and what the risks involved are. I have a friend from college who runs a property company and one of the things they offer are loans to real estate investors:

"Due to the large number of properties that we buy and sell, we are always looking for short-term private lenders who are excited to loan money at attractive rates, and which will be secured by a mortgage or deed of trust."

It seems like if you have capital then hard money lending can be a good way to generate income as the interest rates are pretty attractive. But I'm interested to learn more about the risks or potential downsides to this kind of investment.  If the loan is backed by the property then that seems like a pretty good insurance policy if the investor defaults or goes bankrupt and can't pay back the loan.

[sokoloff]

You need to understand the seniority of your note. If you're not the most senior lender, then you're not first in line to get paid or foreclose on the property.

I have a few friends who dabble in this and they seem very happy with their returns and have urged me to get into it. For me, it doesn't match the liquidity and "I am certain that I understand it fully" demands that I have, so I haven't (and likely won't) pulled the trigger.

Many books and websites available to educate you on the basics. I'd start there.

[trollwithamustache]

What exactly is the "hard money" loan for? A lot of developers and/or flippers use this kind of financing at a higher rate because a traditional bank won't fund them. That's maybe OK, but you need to understand the developers plan for the property and believe the guy or gal can make it happen.  Otherwise you might be foreclosing on a half build something.  This is a do your homework first investment.

And as others have mentioned you need to be absolutely certain of what seniority your debt has.

[MicheleCooper90]

The main disadvantage with hard money lending  will be a down payment or equity of at least 25-30% . Though lenders will overlook various shortcomings and issues on a borrower’s record, but they to ensure that the borrower has enough equity or down payment in the property.

The hard loan terms are for 1 or 2 years. Terms of up to 3 to 5 years may be available in some cases but these loans are intended to be short term only.

Also, Interest rates on hard money loans are higher than traditional bank loans.  They are usually in the range from 9-14%.

[sammybiker]

A couple guidelines...

- Accept 1st and ONLY lien position

- Lend only in markets/neighborhoods/streets that you know well and maintain conservative LTV ratios (don't exceed 65-70%)

- Lend only to experienced investors with a proven track record. 

I'm processing my first private money loan right now - young investor but experienced, engineer with a good W2 income and we've walked the flip property together and agreed on the scope of work, budget, exit, time frame and worse case situations.  He's excited to generate a return with quick private money at a very reasonable 12% APR (and no points) and I'm excited to receive a 12% APR without dealing with tenants.

[mr_orange]

A couple guidelines...

- Accept 1st and ONLY lien position

- Lend only in markets/neighborhoods/streets that you know well and maintain conservative LTV ratios (don't exceed 65-70%)

- Lend only to experienced investors with a proven track record. 

I'm processing my first private money loan right now - young investor but experienced, engineer with a good W2 income and we've walked the flip property together and agreed on the scope of work, budget, exit, time frame and worse case situations.  He's excited to generate a return with quick private money at a very reasonable 12% APR (and no points) and I'm excited to receive a 12% APR without dealing with tenants.

This is sound advice.  You also need to understand how much other debt the investor has outstanding and possibly have convenants that prevent too much borrowing.  If your LTC is low enough this matters less because you're really lending based on the property's collateral and not on the creditworthiness of the sponsor.

Beginners would be well-served to find a local fund manager to place their money with if they can handle less liquidity.  This will spread your investment over more loans and may also give you more favorable tax benefits.  If you find the right manager it will also give you someone with a track record of sourcing quality loans to good sponsors so you don't have to do this work on your own. 

[RWD]

I've done a couple real estate hard money loans through a company that my dad used a lot. They only did first trust deed loans so there was no risk of another lender being paid first. Both were 2-year interest-only loans at 11.5%. The first loan defaulted after about a year when the guy's wife died. Fortunately there was a lot of equity in the property so we were paid back in full plus interest (eventually). The second loan was paid back in full early after only three payments, so we didn't make much on that.

Things I didn't like:
- Entire interest amount is taxable as normal income
- You have to have a lot of cash on hand sitting idle while waiting for an investment opportunity
- Investment is not liquid
- Lots of concentrated risk

My dad lost a lot of money on a loan once where the property was grossly overvalued so when the borrower defaulted he wasn't able to recover the original loan amount.

[sammybiker]

Good perspective RWD, thanks.

Do you have any long term data on your Dad's PnL?

[Midwest]

We do some hard money deals (am involved with one now).  The main risks are a dishonest partner and/or you end up owning the property.

Few rules we follow:

1)  Assume the deal is going to fall apart and only do deals up willing to own for the principal invested.

2)Have both a mortgage and a purchase option in the contract.  If the deal falls apart, purchase option avoids attorney fees and a protracted foreclosure (hopefully).

3) Typically the 1st lender and only lender, but willing do deals as 2nd if rules 1 & 2 are met).  If you can (and would like to) buy the house for your principal plus the first mortgage,

4) Require a minimum yield.  If they need money for 90 days, require a minimum fee for your time in evaluating the deal.  A 15% (annualized) deal isn't that great when it's a 60 day deal.

5) Pick your partners carefully, monitor the project and do draws for the construction.

Regarding liquidity. we  use Helocs and/or secured lines for our financing.  We haven't lost money (yet).  I prefer less expensive houses because the buyer pool is larger.  We are currently in a deal that is taking forever to close out.  Because we are willing to own the house for our investment, I'm not losing sleep over it.

[sammybiker]

@Midwest, what are you charging?  Any points?  Interest only with a balloon at project completion?

Thanks!

[RWD]

Good perspective RWD, thanks.

Do you have any long term data on your Dad's PnL?

My dad has always been very protective of financial specifics, so I don't have any useful data. Would be really interesting though. I'd especially love to compare it to the stock market and REITs for the same time period.

[Bicycle_B]

Curious about this topic for the future.  Listening!

[Midwest]

@Midwest, what are you charging?  Any points?  Interest only with a balloon at project completion?

Thanks!

We don't charge points, but we charge an application fee.  I (not an attorney) was concerned about usury laws.  It's not worth my effort to do a 3-6 month loan without an application fee.  Application fee is typically 6-10% of the principal depending on the size of the deal.  After 2-3 months, we charge 1% to 1.5% per month.

Our typical loans are balloon and interest when the property sells.

These deals are structured as loans, but they might as well be equity deals as we bear the risks of ownership.  Don't let the flippers convince you otherwise unless they are putting up substantial dollars.  If these deals were credit worthy, they would be borrowing at the bank.  There are some truly unsavory people trying to take your money, so remember the first rule is don't do bad deals.  I'd rather miss a good deal than take a bad one.

The other party in this finds the properties and fixes them up.  Typically they have little or no money in the game.  We have offered to do a split at 33% - 50% of the profits and they don't like that idea. 

We have one small deal where we loaned long term on a property.  We are in first position, amount is small, and the rest is owner financed.  For that deal, we charged a straight 10% or 12% payable monthly.

[sammybiker]

@Midwest - thanks for the info, interesting twist on the loan interest outlay but it makes sense.

[Midwest]

No problem.  Remember to consult an attorney if you have legal questions as I'm not one.  One other thing, the application fee is a smaller % in larger deals and vice versa and we don't write it up in % terms.

We really are charging for evaluating the deals and can take a smaller fixed fee when the deal is larger.

[RWD]

Good perspective RWD, thanks.

Do you have any long term data on your Dad's PnL?

My dad has always been very protective of financial specifics, so I don't have any useful data. Would be really interesting though. I'd especially love to compare it to the stock market and REITs for the same time period.

I'm home for Christmas and asked my dad about his loans. I don't have any specifics but he did say that he has never lost money on a loan with the company he has used the most.

[sammybiker]

Thanks for the follow-up RWD.

Haha and speaking of RWD, I just totaled my 997.2 (rwd & 6sp, of course) a few weeks ago...in the market for a 991.1 now. 

I dig your thread!  Alright, done with the derail.