Owners of commercial properties have capital needs for varied purposes such as purchases and renovations. In a perfect world, the owners of the property would seek out conventional lenders such as banks and credit unions since they would most likely offer the lowest cost of money. Sometimes traditional financing is not available to the borrower or perhaps the borrower does not want to tie up personal funds to finance the project at hand.

In today’s more complex borrowing world, traditional lenders cannot fulfill all of the needs of commercial borrowers. Often these borrowers look to private lenders to move their projects along. On the surface, one may question why a borrower would be willing to pay much higher interest rates to private lenders (hard money lenders) and may instead elect not to pursue their project until traditional financing could be found.

Hard money loans are typically short in duration and come with higher interest rates and fees when compared to traditional financing. For borrowers, the analysis is about their end goal and the planned realization of profit from the completion of the project. Hard money loans play an increasingly important part in the commercial real estate world. Here are some instances where these loans may make sense for borrowers.

Capital Improvements

If a capital improvement, repairs, or renovations are needed to the property which if completed would enhance the value of the property from both a valuation or rental income standpoint, a borrower may look to the shorter duration of higher interest loans as a wise move to achieve the enhancements to their properties. Often in these situations, once the work is complete and the increased value or rental income is realized, the borrowers can look for more traditional financing, pay off the hard money lender, and replace the loan with lower cost financing. Or they may look to sell the property, take the profit, and move onto their next project.

Development

If a borrower owns a piece of raw land and wishes to proceed with a “ground-up” development, hard money loans may be a source of financing that they cannot find in the traditional marketplace. Lenders will look at a host of variables when assessing the credit worthiness of the project including the borrower’s development experience, collateral, timeline, borrower’s equity in the project, project presentation, and the financial reserves of the borrower. Weakness in one or more of these factors will cause a traditional lender to decline the project financing.

Hard money lenders will consider the same factors but often weigh them differently when making their final decision. Conventional lenders will often put caps on the construction loans that they make as a percentage of the total development costs. In contrast, hard money lenders may lend up to 100% (or more) of the construction costs if the analysis of the project warrants such. In other words, where conventional lenders are limited in the scope of the loans they are willing to make, hard money lenders with experience in development may weigh the attractiveness of the overall project in their determination and ultimate decision.

Purchase of a Property

When borrowers are interested in purchasing a property, often the timing of the purchase is critical. Private lenders service this market and provide an effective tool in the buying process. Attractive real estate opportunities and strategic property purchases are often time sensitive. Traditional lenders are typically not able to provide financing quickly and therefore are often not a good alternative in these types of real estate deals. Hard money lenders are nimbler and able to evaluate, approve, and close loans quicker than traditional lenders.

Undervaluing/Underperforming Properties

Undervalued properties or properties that are performing below market efficiency are good candidates for private lenders. Traditional lenders shy away from these loans due to the underwriting guidelines related to income statements and current expenses. In contrast, hard money lenders focus primarily on the value of the underlying property. With a properly constructed loan, a real estate investor can obtain the required financing to provide time to improve the property, fill vacancies, increase rental income, and get expenses in line. Once the property is stabilized, the investor can seek traditional financing to lower interest costs going forward.

Loan Underwriting

It is understood the credit worthiness of the borrower is a primary focus in the underwriting of a traditional real estate loan. Conventional lenders are also restricted by regulatory guidelines which limit how creative they can be in the loan approval process. Factors such as late payments, tax liens, mechanic liens, bankruptcies, foreclosures, and high debt levels all play a part in the underwriting of a loan.

Hard money lenders set their own standards concerning the level of risk they are willing to accept. These lenders can establish asset-based loans whereby the cornerstone of the loan is the property itself.

Current restrictions in the traditional financing marketplace for those real estate investors that own more than ten single family rental residences make it difficult to borrower additional funds. Hard money lenders are not as concerned about the number of properties that an investor owns; rather, they analyze the property itself and its attractiveness as an investment.

There are tons of loans available for real estate investors. One type of loan commonly used by investors is the hard money loan. These loans allow investors to buy and fix investment property. If used correctly it can definitely put money in your pocket right away. But, be aware because there are some pitfalls you will need to avoid in order to be successful. Below explains how a hard money loan works and what to look out for.

Scope of Work

For these specific types of loans, lenders will require the investor to provide a scope of work worksheet. Every repair you plan to make needs to be written down on this sheet. The scope of work worksheet is what the hard money lender will use as a guide, in order to pay for the project. If repairs are done that are not on the worksheet, then you may have trouble getting reimbursed by the private lender. The lender will want to see everything written down to be sure everyone is on the same page. Lenders will normally allow investors to change the scope of work in the middle of the project if able and necessary.

Requirements

Most hard money lenders now want 20% down from the investor on all projects. The lender will also want to see reserve money sitting in a bank somewhere. The investor’s monthly income will play a big role with the lender in approving the loan. Credit score is a factor, but they do not require a stellar score to be approved for a loan. The last hard money lender I used did not even pull my FICO score; they just wanted to see a copy of my credit report, which I was able to order for free. There will be requirements for a loan to value, but each lender will have their own set of guidelines.

Overestimating Repairs

Repairs on an investment property are always just an estimate. When rehabbing property nothing ever goes as planned. Overestimate the repair that needs to be done to cover you if any repairs are added later in the rehab. If you did a good job with the initial inspection, and no additional repairs were needed, then you can return the money or keep it. If you decide to keep it, do not spend the extra funds. Keep the extra money as an additional reserve.

Process

The process of receiving money for repairs is called a draw. After your contractor finishes a percentage of the work you will call your Hard Money lender, and tell them that you are ready for an inspection. The lender will send an inspector out to verify the work has been done and completed within code guidelines. Once the inspector gives the lender the o.k., the lender will release the funds that equal to the amount stated for the cost of work. For example, if you listed carpet repair $1500, paint $1200, and new light fixtures $100, when the inspector checks all the items off the lender will cut you a check for $2800.

Now you can understand why it is important to have all repairs and cost listed on the worksheet. If the repairs are not listed then they will not pay you. Normally the lender will give you three to seven inspection dates depending on how large the project is. Unless you can convince the contractor to start working without putting money down, you will have to put the money up to get things started. Expect to get reimbursed from the hard money lender through your draw checks.

Refinancing

This is the most important part in rehabbing property using a private lender. Hard money loans are short-term loans with high interest rates. These interest-only loans will have an interest rate of somewhere around 9-12%. That may seem high, but these types of lenders understand how important it is to make their money and get out. We need these companies in order to rehab properties if we cannot fund our own projects. Hard money lenders realize the risk they are taking, so lenders ask themselves “WIIFM” (What’s in it for me?). They compensate with a high interest rate for the risk they take. Hard money lenders expect you to either sell the property quick for a profit or refinance into a long-term loan and rent it out to a tenant. Whatever your exit strategy is, be sure to do it quick. Hard money loans are normally due in full 6-12 months after their origination.

Hard money lenders have allowed many investors to make money in real estate. These types of lenders are more flexible when compared to traditional ones. They allow investors to make things happen when no other lenders want to take the chance on them. Their guidelines are looser and allow an investor to spread their wings. These types of loans are expensive, but they can allow more deals to be done due to the amount of money they have access to.

Hard money lenders can be looked at negatively because they charge higher interest rates to their borrowers. However, hard money loans play a necessary role in the real estate investment marketplace as they fill a need that is created by the lack of traditional financing sources. Often the higher costs of the loan are well worth the purpose it serves. This provides investors the opportunity to participate in these loans and earn attractive yields with the security of a first position lien status.