Hard Money Lending - Why, When, & How

mod (Andy) note: "Blast from the past - Best of Eddie" - This one is originally from November 2011. If there's an old post from Eddie you'd like to see up again shoot me a message.

I've written the following at a reader's request (yes, I take requests as long as it's a subject on which I'm knowledgeable and experienced). It's about a fairly esoteric aspect of real estate investing. If you have an interest in real estate investing, you'll probably enjoy it and might even learn something. If not, I'll see you tomorrow.

I owned a property management company from early 2002 to late 2006. If those dates seem conveniently aligned to the explosion in residential real estate prices in the United States, I assure you it's no coincidence. Bubbles are great for making money as long as you're not the last one out turning out the lights.

Real estate investing (or speculation, as the case may be) can take a lifetime to master, so in my experience it's best to learn how to do one thing and do that very well rather than try a dozen different approaches. For some people this means buying rental property and being a landlord. For others it might be discount paper, private mortgages, foreclosures, short sales, whatever. In my particular case, I was a rehabber - more commonly known as a "flipper". I would buy a property, fix it up, and sell it for a profit. It's a little more complicated than that, but essentially that was the strategy.

I further specialized by concentrating on two relatively unpopular aspects of the market at the time: HUD foreclosures and bank short sales. A lot of folks didn't like dealing with HUD foreclosures because there was additional paperwork involved, you had to deal with specific real estate agents who were approved to work with HUD, and a number of other small hassles that turned your average real estate investor off. I found the extra hurdles to be worth the effort, because once you became known as an experienced HUD investor you could get HUD to agree to almost anything to get a property off their books.

The places I bought were generally in a shambles. For HUD to be in possession of a property, it had to have been an FHA-financed property (which means the former owners had no skin in the game and therefore very little to lose in foreclosure) and most of these places were cosmetically hideous. I bought a lot of these and my average turnaround time was less than 90 days. I got to the point where I would leave the closing table with a key to the place, drive to the property, and my contracting crew would be there waiting to be let in to gut the place and get to work.

Conventional financing doesn't always work with such an investment strategy. Conventional lenders like to see owner-occupied properties. They like properties with white picket fences and flower beds in the front yard. They generally shy away from former crackhouses and scenes of triple homicides. So in the absence of conventional financing options, you have to get a little creative.

Enter the hard money lender.

These guys have a terrible reputation and, in my experience, it is wholly undeserved. They've tried to church up their image a little bit by ditching the term "hard money" lending and replacing it with "asset-based" lending, but it hasn't caught on thus far. In a nutshell, these guys lend where banks would never even consider it. Because of that, hard money lenders are able to charge BIG interest rates and fees on their loans, and their loans are very short term in nature.

Unlike a conventional lender who is concerned with your ability to perform on the loan, and therefore analyzes your credit rating, your employment history, your ratios, etc., a hard money lender focuses on the wholesale value of the property in question. In other words, a hard money lender doesn't care about you, he cares about whether he can sell the property quickly in foreclosure if/when you default.

Because of the increased risk in these loans, hard money lenders typically charge double-digit interest rates, multiple origination points, and sometimes pre-payment penalties. Some people consider it loan sharking, but that's not the case at all.

Let's say you've found a four-plex that is an absolute mess. There's no way a conventional lender will give you the money in the property's current state. On top of that, you don't have the money to fix it up. But you've analyzed the market and know that in pristine condition the property is worth three times what you could buy it for in its present state. So you get in touch with a hard money lender. He provides a loan to you for not just the purchase price, but also the cost of all the repairs. He might not even require a down payment. So you go to closing to buy the place and you not only walk away with the keys, you walk away with a check to fix the place up. And you don't make any payments on the loan for the first six months, or even the first 12 months on larger projects.

The money to repair the place is usually doled out to you in three tranches, known as draws. You get the first draw at closing, you use the money to get one-third of the repairs done, the hard money lender checks your progress and then releases the second draw, then the third and final draw. Once the property is completely repaired you either sell it for the enhanced market value and pay off the hard money lender (and pocket a nice profit for yourself) or you refinance it with a conventional loan now that the property qualifies for conventional financing (and you pay off the hard money lender with the proceeds of the new loan).

Why would you use a hard money lender? Because:

• Your credit sucks
• The property you want to buy is a disaster and no bank will lend against it
• You can get a conventional loan but have no money to make improvements
• You need to move quickly - most hard money lenders can turn the entire process around in 24 hours once they know you
• Your bank thinks you're over-leveraged (I'll go into this next)

If you're an active real estate investor, you're going to discover your bank's personal comfort level with you rather quickly. In my particular case, I used a local community bank and had a great relationship with bank management. I could literally call the president's cell and get a deal approved. Likewise, he'd sometimes call me out of the blue and ask me to value a yacht a customer wanted to pledge as collateral (I owned a yacht services company at the time as well). So we knew each other pretty well.

Once I got to ten properties or so, I could sense a shift in the bank's willingness to go much further. It was clear that they were comfortable lending against a portfolio of five or six investment properties, and more than 100 investment properties, but weren't comfortable in between.

So I started using hard money lenders. Since my turnaround time was short and predictable, hard money was the ideal solution. Did I pay a little more than I had to in interest and fees? Sure. But it was worth it to me to be able to pick up the phone and have the cash the next day with no hassles.

There are times when hard money does not make sense to use, however. For example, you should not use hard money:

• To purchase your primary residence
• For any property you suspect may be difficult to sell or refinance in less than a year
• For any long-term hold like a rental property

One instance I can remember in particular, and this will speak to the specific situation the reader in question asked me about, was a foreclosed condo I bought that was part of an association that had let their general liability insurance policy lapse. It was no problem to get insurance on this specific unit, but as long as there was no liability insurance on the common areas in the condo complex no bank would loan on individual units.

I considered this a short term problem, one that would easily be rectified with a new general liability policy, so I went ahead and bought the unit out of foreclosure using a hard money loan. As usual, I had the place fixed up and ready to sell in about 60 days. But there was still no general liability policy in place. So that meant that even if someone wanted to buy the condo, their bank wouldn't lend them the money to do so. That also meant I couldn't pay off my hard money loan against the place.

What I thought was going to be a short term problem took over a year to fix, and forced me to scramble to pay off the hard money loan without being able to sell or refinance the place. I was able to do it, but it was no fun. On top of that, I had to rent the place out for a year, and I hate being a landlord. After being rented out for a year, the condo I'd done such a nice job fixing up was trashed again. Tenants suck.

In conclusion, hard money is a great option for those with dodgy credit, those whose banks think they're over-leveraged, or those brave souls who can look at a hovel and see a palace. If you go into a hard money arrangement with your eyes wide open and you perform according to the terms of the loan, you can't find an easier more open-minded source of financing in the real estate market. If you use hard money where it's not appropriate just because it's easier to get, however, you can expect a lot of headaches.

Brookview Financial is probably the largest and most well established hard money lender in the US. I have dealt with them and they are very professional and helpful (I've never actually closed a loan through them, just because I had an abundance of local options available to me). Most communities have a real estate investors association of some kind, however, and you'll have no trouble finding a hard money lender there.

Hopefully this has answered any questions you guys might have about hard money lending. If you have any others, hit me with them in the comments and I'll do my best to answer them.