An Overview of Hard Money

A note from Justin:

Today’s guest post is from one of my favorite hard money lenders, Pivotal Capital Group.  In fact, they were the first hard money lenders I ever used!  Back when I first started I was going a lot of wholesaling.  Then I moved in to private money and some Joint Venture (JV) deals with private money, and then in to Hard Money with Brad and Joe at Pivotal. 

They are the reason I am able to do such a high volume of deals at higher price points.  Even today we use them for a lot of our deals and, unlike myself or private money lenders, they just never seem to run out of money! 😉 

When I look at hard money lenders I usually evaluate them based on three criteria: performance, terms and leverage.  Pivotal ranks high in all three areas and it’s one of the reasons I use them for so many deals. 

So, without further delay, take it away guys!

What is Hard Money?

Hard money lenders are really just gangsters that charge 100% interest per month, will break your legs if you don’t pay on time, want you to default so they can steal your property, and are really just lenders of last resort that you have to go to when no one else will make you a loan.

Well that may true in the movies, but in the real world, hard money lenders play a vital role in the financing of all kinds of real estate across the Country, and especially so with flipping houses.

What is a hard money loan? Broadly speaking, a hard money loan is a loan secured by real estate from a non-traditional lender (i.e. not a bank, credit union, etc.), the amount of which is based primarily on the value of the asset and less so on the borrower’s credit.

However, compared to traditional bank loans, hard money loans typically have higher interest rates, higher fees, and shorter terms. Given that, why would a house flipper use a hard money loan instead of a bank loan? Well, compared to a bank, hard money lenders typically:

  1. Can give you a quicker loan quote
  2. Can fund a loan much faster
  3. Don’t always require third party appraisals
  4. Make loans on distressed homes that need rehab. Many banks won’t touch
    this type of property
  5. Rely heavily on the value of the property. Banks typically rely heavily on the
    borrower’s credit
  6. Have much shorter approval process, less red tape, and less paperwork
  7. Don’t have maximum exposure limits to one borrower

Hard Money and House Flipping Deals

Let’s talk about how a typical hard money loan works in a house flipping deal. The first thing to understand is that there really is no typical hard money loan and every hard money lender looks at things a little different. They each have their own underwriting criteria, borrower requirements, and loan structures. However, most hard money lenders size their loans based on a percentage of the borrower’s After Repair Value (ARV), an independent appraiser’s ARV, in-house ARV, percentage of the purchase price, percentage of As-Is Value, percentage of total costs, and/or any combination thereof.

This being said, we can make some generalizations. For residential flip loans, most hard money lenders will provide roughly 80%+ of the purchase price or 60-65%+ of the ARV of the house. So by way of example, if you are buying a home for $250k, spending $50k on rehab, and expect to sell it for $375k, you will probably see loan quotes anywhere from $200k-$250k. Again, this is a generalization, and some lenders will do a loan outside of this range. However, note that this example assumes your lender agrees with your $250k purchase price and/or your $375k ARV.

In addition to the amount a hard money lender funds at the initial purchase, some may reserve a portion of the loan funds for future advances. This is what is commonly referred to as a “holdback”. The holdback may be funded at certain milestones during the rehab, or in a single amount at the end, just before the house is put on the market. The holdback can provide a flipper with cash flow sooner by allowing them to pull some of their equity out of the house, prior to the eventual sale, which can take 60 days or more complete. It’s important to know that most hard money lenders charge interest on the entire loan amount, including the holdback, starting from the initial funding.

The Cost of Hard Money

For loan pricing, most lenders charge between 10%-13% interest per year, plus a loan fee of 2%-4%, for a 6-12 month loan term. However, beware that in addition to quoted loan origination fees, some hard money lenders also charge fees for credit checks, appraisals, loan documentation, inspections, recordings, reconveyances, etc. (in industry jargon, these are typically called “junk” fees).

A tip when comparing loans: Do not just look at the rate and loan fee. If the lender has junk fees, they can have a substantial impact on the true cost of the financing.  [Tweet this]

When comparing loan proposals, be sure to look at ALL of the costs of the loan and compare them on an “apples to apples” basis. Just because a lender says they’ll do a “9% rate and a 2% fee”, if the lender is also charging you thousands of dollars junk fees, then that rate and fee quote is completely misleading.

Finding a Good Hard Money Lender

As you can see, there can be a pretty wide range in loan sizes and loan costs between different lenders. However, finding a good lender is more than just who has the lowest rate and fee.  [Tweet this]  It is just as important (perhaps even more so) to be sure you know who is lending you money, know what they stand for, and to be sure they will deliver and do what they say.

Unfortunately, anyone can call himself/herself a hard money lender. Hard money lenders can range from an individual with a few hundred thousand dollars, to a $5MM-$10MM mid-sized real estate fund with 20 or more members, to a large institutionally-backed real estate finance company with significant capital resources.

You must protect yourself (and your business) and be sure you are doing a deal with a reputable lender with a good track record. There are a lot of good lenders out there; but there are a lot of shady ones too.

Do your due diligence and ask questions. Remember, it is just as important that you are a good borrower for them, as it is that they are a good lender for you. It is a two way street.

Here are some questions to ask prospective hard money lenders:

  1. Are they the actual lender, or are they just a broker for some other lender?
  2. Do they check your personal credit? If so, is there a minimum score needed?
  3. What project details and documentation do they need to make a quote? How long will it take to get a quote?
  4. How many fix and flip loans have they done in the last 12 months? Where does their money come from? Is the money they lend in their possession and in their control, or do they have to go raise it from a third party?
  5. How long does it take them to close a deal?
  6. What happens to your loan after funding? Do they sell it or keep it in- house?
  7. Who does the loan servicing? The lender or a third party servicer?
  8. Do they rely on 3rd party appraisals, or underwrite loans in-house? What kind of loan documentation is involved? And who prepares those loan documents?
  9. What happens with your loan if the project takes longer than expected? Can the loan be extended?
  10. How do you pay interest? All up front, monthly pre-paid, monthly in arrears, all at the end?
  11. If the lender provides you a quote, is that quote 100% firm on its terms? Have they ever quoted a loan, and then changed the quoted terms prior to closing?
  12. Does the lender only lend? Or do they also flip houses themselves? (If they also flip houses, are you comfortable with that as a borrower)?
  13. Have they ever foreclosed on a loan? If so, why?
  14. Have the lender provide you references to a few of their other borrowers so you can call and ask them questions.

The Power of Leveraged Returns

There are two important reasons and benefits to using hard money: leveraged returns and the ability to grow and do more deals with a fixed amount of capital. The concept of leveraged returns can get complex, so let’s just look at a simple example to help illustrate.

Assume you have a flip deal that has $250k in total costs. Further assume you have $250k in cash, don’t need a loan, and therefore are going to fund it all yourself. If you can sell the house for $300k, your projections show that you will make $50k in profit ($300k – $250k in total costs) on your $250k cash investment. That’s a 20% profit margin, which is not bad, right?

Now let’s assume you do the same deal but borrow $200k from a hard money lender (so you now only need to put in $50k of your own cash, versus $250k above). Since there is a cost for using a hard money lender (interest, points, etc.), your project expenses are going to increase from $250k to say $270k. So now your net profit is only $30k ($300k sales price, less $250k in project costs, less the $20k in lender costs) instead of $50k in the all cash example.

So if you had the cash, why would you use the hard money loan if you make less money by doing it?

Well, let’s look at what happens to your investment return when you use the hard money loan. You are making $30k on a $50k cash outlay (remember, the lender put in the other $200k). So your investment return is $30k/$50k, or 60%! That is 3 times the return you were getting compared to doing the project all cash. That is the power of leveraged returns.

The other significant benefit to using hard money is that it allows a flipper to diversify and do more deals. With that same $250k in cash, you could do one deal for $250k or 5 deals using hard money. If you make $30k net profit per deal, that’s $150k in total profit, 3 times what you would have made using all cash. The use of hard money in your business model can help you grow your business and diversify your risk across multiple projects.

Hard Money Risks

So now that you are thinking that hard money is even better than free house flipping advice or 75% off toilets at The Home Depot, you need to understand some of the risks.

Rest assured, whenever you use someone else’s money in a deal, there are always additional risks. [Tweet this]  Understand that the lender’s security is almost always a secured lien against your property. It is that lien and it’s priority over your cash equity, which provides the lender collateral for making the loan.

Putting it bluntly, if you mess things up with the project, do not make payments per the terms of the loan, or do not pay that loan back as agreed, the lender may call a default and ultimately get control of the property, thereby possibly leaving you with nothing. That is a big risk, but one that you somewhat control since you are driving the project. As long as you perform and do what you say you are going to do, this risk can be minimized.

Another important risk to consider when using hard money, or other people’s money for that matter, is your lender not performing. This is a real risk (sadly, one often overlooked by borrowers), and one in which you have very little control.

Say everything is going well, you have your lender all lined up, the project is getting ready to close, and it’s time for everyone to fund. What happens if your lender doesn’t fund? Well, unless you have the cash to close yourself, you could lose the deal. What if just before funding, your lender tells you that won’t fund unless they charge you a higher interest rate and/or more loan fees? It happens, and while you most certainly wouldn’t’ do another deal with that lender; you are still stuck on the deal in question.

Bottom line: it is your responsibility to do your due diligence on the lender [Tweet this] and as best you can, make sure they will do what they say they will do. This is crucially important in the world of hard money lending.

One additional thing to consider is how much your lender will be involved once you close the loan. Are they going to be calling you every few days asking for progress reports, inspections, paperwork, and generally bugging you? Be aware that some lenders are people with money just looking for you to educate them on flipping homes. Be sure your lender will do what they say, fund when they need to, and stay out of your way, and let you run your business.

Finding Hard Money Lenders

Where do you find hard money lenders? A simple Google search will get you all kinds of results. But as with most things, networking, word of mouth, and referrals are a much more effective means of finding a good lender.

Ask other flippers who they use. Go to real estate investment club meetings and ask around. Be sure to look for lenders that focus on, and have direct experience in, making fix and flip loans.

The use of hard money in your house flipping business can be a tremendous benefit, increase your margins, help you grow your business, and allow you to diversify your risk. However, don’t make the mistake of just doing business with any lender.

Do your homework, ask questions, and minimize the risks that come along with the use of outside capital.

Written by Brad Rust and Joe Gigliello, Co-Presidents of Pivotal Capital Group II, LLC. Pivotal is a hard money lender specializing in fix and flip loans in Southern California. For more information you can visit: www.pivotalcapitalgroup.com

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