Written by Asset Based Lending’s Managing Partner Paul Ullman, this article previously appeared in the Scotsman Guide .
Private lenders offer rapid solutions to residential funding questions
Private lenders, frequently known as hard-money lenders, have become a prominent funding source for many non-owner-occupied residential real estate purchases and rehabilitations. At the same time, these private capital lenders are also a go-to funding source for investment-property owners with negative credit histories who need, for any number of reasons, to take out cash. Increasingly, private capital is also used to fund new residential construction because local community and smaller regional banks, which had previously supplied investment financing to that industry, remain under pressure from regulators and are often reluctant to loan.
Although it may seem that hard-money lending is everywhere, many borrowers choose not to use private lenders because of the higher costs or negative preconceptions they associate with this type of lending. Unfortunately, some borrowers and even brokers have also had bad experiences with hard-money lenders.
These experiences generally fall into two categories: First, when a loan didn’t close when promised for reasons that were not made entirely clear, and second, when relatively large fees were paid upfront but the loan was not approved. These types of situations are an unfortunate blot on the private lending industry, but can be avoided when mortgage originators know the right attributes to look for in identifying a reputable lender for their clients.
As experienced investors know, hard money is a great tool to use in funding investment deals. Understanding its many attributes will help mortgage professionals convince potential borrowers that loans from private lenders make good business sense.
Professional investors don’t need to be convinced about why it makes sense to pay a private lender a higher interest rate than a bank would charge. These professionals know that closing quickly is the only way they can consistently buy residential properties at, say, a 30 percent discount over current market value, a discount that they need to turn a profit.
“Good private lenders can and should be another set of eyes to assess the profitability of a deal.”
And the one thing that many banks do not do — regardless of whether or not they make investment loans — is close quickly. Many successful investors who borrow hard money are traditionally bankable. These investors know, however, that whether or not they are bankable is not really relevant. What matters is doing the deal quickly, making an acceptable return and then moving on to the next deal. Obviously, this is vastly preferable to not doing the deal at all.
Math that works
When considering a hard-money loan, borrowers who carefully track a deal’s particular expenses often realize how beneficial these loans can be. After doing the math and factoring the loan and property’s costs into the bid price of the target property, a return on capital of 20 percent to 25 percent should broadly be your goal.
Hard-money borrowers may not make as much money on an investment as investors who have their own cash, but again, making the deal is what matters. The most important thing when considering a hard-money loan is to take out the spreadsheet and factor in all of the deal’s costs — even the small ones — because they add up fast.
Good private lenders can and should be another set of eyes to assess the profitability of a deal. No lender doing fix-and-flip deals wants to finance ones that cannot make money.
Therefore, running your deal past an experienced private lender as part of the due-diligence process can be an invaluable step toward profitability. In reality, newer borrowers are frequently overly optimistic about many aspects of a deal, including the time it takes to rehabilitate a house and then close the sale on the back end.
A good private lender knows from experience what a deal’s realistic timeline and construction expenses will be, and that lender will factor these into a reasonable estimate of total costs. Further, that same lender may be able to recommend a general contractor or other service provider that could be the difference between making and losing money on a deal.
Building a relationship with a local private lender can pay off in many other ways for mortgage originators. If a deal goes well — meaning that the work quality is high and the turnover is quick — the lender may seek out the originator in the future to do additional deals. Regardless, when working with a private lender, the borrower or the borrower’s representative should provide the following information in the initial presentation to make the deal simpler to fund:
- A standard loan application and free credit report so the lender can quickly gauge the balance sheet and income statement of the prospective borrower.
- A certificate of formation and taxpayer identification number of the business entity that the borrower may be using.
- An initial scope of work for the rehabilitation so the lender can gauge the stated rehab budget with specific estimated costs.
- Sales comparisons for the target house so the lender knows that the prospective borrower has done the necessary homework on the property’s value.
- A statement of profit expectations including purchase price, estimated closing costs, rehabilitation and interest expenses and expected selling price. If possible, an estimate of the amount of cash the borrower is willing to invest in the deal should also be provided.
When private lenders have the necessary information about a deal from a prospective borrower, they can often move faster than banks because there are fewer regulatory and institutional constraints affecting or hindering their ability to make a decision on whether or not to fund the loan. Mortgage professionals must be vigilant, however, to make sure that they aren’t working with a so-called lender that moves quickly but delivers nothing.
It’s an unfortunate reality of the business that there are many individuals who call themselves private lenders but may have only enough money to fund one or two loans. Others may be intermediaries who claim to be lenders, but in reality are not. With this in mind, it pays to understand how to distinguish between legitimate lenders that are operating reputable businesses from those that are only out to take a borrower’s fee, deny the loan and move on to the next victim. Mortgage originators and their clients should therefore consider the following five attributes when evaluating lenders.
1. Direct lender
Is the candidate an actual lender — i.e., do they have real investors or a permanent source of capital that they are using to fund their loans? Your clients’ interests are too important to neglect performing due diligence about how a lender funds its deals. If you’re unfamiliar with a particular private lender, the most important question to ask is a simple one: Are you a direct lender? A reputable lender will close a deal when it says it will. Don’t be afraid to ask for references — and don’t be put off if the lender asks for the same from you and your client. If anything, doing so indicates the lender’s professionalism.
2. No money down?
Be wary of a lender that prominently advertises its willingness to make no-money-down loans. Many private lenders have learned that no-money-down loans are the most dangerous kind to make, and as a result will reserve them for their repeat borrowers who have demonstrated their worthiness. A company or website that prominently touts 100 percent financing as a selling point should be viewed with suspicion, as there is a possibility that it is a less-than legitimate enterprise.
3. Matching terms
Legitimate lenders understand how long it takes to rehabilitate a project or repair someone’s personal credit. Trustworthy lenders should be willing to offer mortgage terms that match the probable term of the project or will be upfront about why they will not. Legitimate lenders are not in the business of providing unrealistic loan terms to borrowers with the ultimate intent of defaulting them to take their real estate.
4. No large upfront fees
A private lender worth doing business with will not request a large upfront fee to “expedite” the deal, nor will a quality lender demand a large fee before any preliminary due diligence on the project. Perhaps the biggest complaint against the private lending industry is the willingness of some of its lenders to take fees when they know that there is no way that they’ll fund the given loan. Potential borrowers should request a term sheet listing loan terms prior to paying a fee, and also ask very specific questions about considerations that might result in the lender not making the loan after taking a fee.
5. Fast closings
A good hard-money lender should be able to close a loan within one to two weeks of the first phone call, assuming that all loan documents are in order. This lender should be able to convey exactly what information and documents are necessary to close and in what sequence they are needed. That lender also should be able to explain what fees are expected and when they need to be paid. Additionally, the fees should not all be front-end loaded. The largest fees should be the points paid by the borrower, and they should be paid at the close of the loan.
The attributes of quality private lenders — rapid decision making, fast closings, industry expertise, professional connections and more — are uniquely suited to the needs of residential real estate investors who are looking to grow their businesses by moving quickly. Mortgage originators who understand hard-money loans and what to look for in lenders will help those investors take full advantage of the many benefits these lenders have to offer.