If you’re like most people, you always buy or refinance with a traditional 30-year fixed rate mortgage. You've never considered using a hard money loan — and maybe aren't sure what it actually is. But, there is an entire group of people in the real estate profession who use these short-term private loans several times each year to buy, sell and renovate properties. This blog post will explain who these people are, and why they're a good fit for a hard money loan.
I will discuss how the following types of real estate professionals and self-employed entrepreneurs use hard money loans year in and year out:
Real estate investors with a portfolio of properties, commercial or residential, are usually real estate rich and cash poor. Most of their money is tied up in real estate, and they make their living off the monthly profit after paying their mortgages, taxes, insurance, management and maintenance expenses. I have several investors with many residential investment properties who make a great living from their real estate portfolio. However, they don’t necessarily have $1 million in the bank to quickly move on a new property that just hit the market.
Instead, they’ll call me for a hard money loan to make it happen fast.
We’ll usually use one of their existing properties, owned free and clear or with minimal debt, as additional collateral to acquire the next property using little or no cash of their own, known as a Blanket or Cross-Collateral Loan. The hard money loan will finance the new property for two to three months, then they'll refinance with long-term debt or a blanket loan secured against both properties.
Banks don't give loans to house flippers. The loans usually pay off within six months —and banks don’t make money on loans until about the seventh month, after paying employees and other costs of doing business. Thus, house flippers use hard money loans with costs of two to three points at 10-12% interest rates to purchase and renovate homes.
The house flipping industry is supported by hard money lending. In fact, some hard money lenders are 100 percent dependent on house flippers for their profits.
If the house flipper has a successful track record working with a hard money lender, they may get to the point where they just send a text to the lender with the address, purchase price, rehab budget and closing date, to be approved for financing. I’ve worked with an investor where I’d get a text message and start putting the loan in motion for a seven-day closing. The borrower would send the purchase contract and a detailed budget, and I’d take care of the rest. The partnership worked well for many years.
Many home builders use hard money loans rather than bank financing to fund their projects because hard money lenders usually move faster. FCTD has worked with several home builders who gave up on bank financing because the underwriting process for a construction loan on a 10-house subdivision or two spec homes took three to six months. During that time, they reasoned, they could have finished the homes if they’d just paid the extra costs and gone with a hard money lender.
Hard money construction lenders aren’t always faster, like in the cooling market of late 2022. Existing loans are taking longer to pay off, limiting the money available to fund new loans. For example, a hard money lender may have a $100 million fund that averages $8-10 million per month in payoffs, which immediately funds new loans. In Q4 2022, with payoffs taking longer, some lenders only have $2-3 million available to fund new loans. I frequently heard, “I want to fund this loan but won’t have funds available for another two to three months because payoffs are delayed due to the cooling market.” However, a hard money lender will generally be faster than bank construction financing.
Land developers often use hard money loans to acquire properties that they entitle, engineer, subdivide, develop infrastructure on and sell in lots to builders or end-user homeowners for custom homes. These hard money loans may have different structures. A lender may take an equity position with the developer rather than recording a deed of trust and collecting monthly payments. They could have a profit-sharing agreement where the lender (equity partner) gets a specified return (14 to 25%) on their money. The lender may also issue a two-year loan for a three points origination fee with a 12% interest rate to be paid regularly each month.
The hard money debt structure depends on the developer’s track record, the scope of work and estimated timeline, and the relationship the land developer has with their lender/equity partners.
Self-employed borrowers can sometimes experience financing challenges, and may need a hard money loan to acquire or pull equity from a property they own.
For example, ten years ago a business owner was buying an investment property in Newport Beach for $2.5 million. The previous year, he had acquired an existing business that created a paper loss of approximately $1 million on his personal income taxes. This prevented him from qualifying for a jumbo bank loan. NonQM (non-qualified mortgage) loans didn’t exist in 2013, so we got him a three-year hard money loan to acquire the property and provide him time to show two years of income taxes with positive income rather than million-dollar paper losses.
Another example is of a self-employed buyer in Los Angeles, whose jumbo loan was taking longer than expected to approve. The buyer received a "3-Day Notice to Perform" or else the seller would keep the $50,000 earnest money deposit and accept the all-cash offer in backup position. The buyer needed loan documents the next day and chose a hard money loan to close within that three-day window. He wound up having the hard money loan for fewer than 50 days. In fact, he made a single payment at the 9% note rate before refinancing into a 30-year fixed rate loan at 3.625%.
Conclusion
Hard money loans are used by a variety of real estate investors and professionals, as well as self-employed entrepreneurs who occasionally need hard money financing. Quick capital, short term hard money loans are well-suited for these individuals before they either sell the property or refinance into a long-term loan.
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Ted Spradlin