By Ryan Stephens | www.Kepler.Properties
In the world of real estate investing, cash is king. Investors who can purchase properties with cash can close on deals quickly, potentially saving them thousands of dollars. On the flip side, investors utilizing the services of a traditional or conventional lender risk losing the deal due to the lengthy time it often takes to close on a property.
For those who want to compete with cash investors, but don’t have a lot of cash, and don’t have friends and family willing to back their investment ambitions, chances are they’ll need to utilize the services of a private lender. Furthermore, if the property is distressed and in need of substantial repair, the borrower may need a non-conforming loan due to the “unorthodox” nature of the use of funds, i.e. fix and flip. These non-conforming loans are typically issued by private investors or lending companies. Although not quite as good as cash, private lending can behave in a similar fashion due to its ability to fund a loan quickly. Private lenders can come in many different and exotic forms, but the most popular is the hard money lender.
Hard money lenders offer short term, high interest, asset based loans that are secured by real property. The interest rates are high in comparison to conventional property (commercial or residential) loans due to the short length of the term and the risk involved in the underlying asset.
Benefits of hard money lending include:
- Financing the acquisition and/or renovation of non-conforming property
- Ability to make a smaller down payment when compared to conventional financing
- Ability to close in 7-14 days (~3x quicker than a conventional lender)
- Unreported loans to credit agencies (unless the borrower defaults or goes into foreclosure)
There are many different factors that can influence the terms a hard money lender might offer a new or existing borrower. However, there are some basic pre-qualifications required to get the ball rolling. The average hard money lender will require the potential borrower to have a minimum credit score (typically in the low to mid 600s), experience in real estate investing, they will require 1st position (first lien), and the property cannot not be owner occupied. With these pre-qualifications in mind, the borrower can expect the following terms:
- 12 month term – Many lenders will offer an extension on this term length at a cost that is usually no less that 1% of the loan amount. Extensions range from 6 months to 24 months.
- Loan to Cost 75-90% – Lender will fund 75-90% of the total project cost (purchase and rehab). Often times the purchase is funded at a certain percentage and the rehab at another percentage (i.e. 75% purchase and 90% rehab). OR
- Loan to Value (LTV) of 65-75% of After Rehab Value (ARV) – LTV being the ratio of loan amount divided by the expected value of property after its rehabilitation.
- 3-6 Points (also known as origination fee) – This is an upfront interest fee charged at closing. If a borrower owes 4 points on a $100k loan, they will pay 4%, or $4k in this example, at closing.
- 10-16% Annual Interest – Hard money loans are interest only with payments made monthly. (Loan Amount x Annual Interest) / 12 months will give the borrower their monthly payment amount.
Experience can affect the terms dramatically. An experienced investor can save thousands of dollars in interest alone by enjoying 7-10% annual interest whereas a newbie investor may pay 16% or more. Additionally, an experienced investor may be offered fewer points upfront in addition to only paying interest on actual money borrowed. For example, if the rehab budget is $50k but the project is still in the first phase of construction, the borrower would only pay interest on the funds currently used in that initial phase of construction as opposed to the entire $50k. These benefits are extended to borrowers perceived to be less risky due to their experience.
As a rule of thumb hard money loans are only granted to entities (LLCs, corporations, etc.). All members of the entity are subject to a financial background check during the loans underwriting process. Anyone tied to the entity, either through the entity’s bank account, operating agreement, property purchase contract, etc. will go through the check. Before entering the loan process, it saves a lot of time and headache to have a general understanding of the financial status of all parties involved with the entity. This includes credit scores, defaults, judgements, and foreclosures that may be on any individual’s credit profile. For example, a lender may offer 90% Loan to Cost at 3.5 points and 10% annual in their pre-approval, but scale back to 75% Loan to Cost at 6 points and 14% annual due to one of the entity’s members having a weak credit profile. It pays to know who you’re in business with.
Finally, having all of your ducks in a row prior to entering the lending process can get you to the closing table days, if not weeks, ahead of someone scrambling to get their paperwork together. With the following list of documents and artifacts in-hand and ready to go, the borrower can easily close on a property within 7 days:
- Executed Purchase Contract
- Entity Documents (EIN, Articles of Incorporation, Operating Agreement) – Make sure the entity is set up prior to going under contract on a property.
- Driver’s License (scanned copy)
- Tax returns for last 2 years – Personal and business
- Bank statements for last 3 months – Personal and business
- Retirement Account statements – 401k, IRA, etc.
- General Contractor Information (License and Insurance) – Have a contractor lined up prior to going under contract on the property
- Itemized Construction Cost and Schedule from the General Contractor
- Attorney and Escrow Title Information
- Homeowner Property Insurance
- Survey – Establishes official land boundaries for the subject property
- Inspection Report – The lender will select the inspection company. The borrower must schedule the inspection appointment.
- Appraisal Report – The lender will select the appraisal company. The borrower must schedule the appraisal appointment.
- Pay Stubs – Many investors have regular 9-5 employment. Lenders request recent pay stubs as evidence of the borrower’s ability to fulfill the obligations of the loan.
- Real Estate Schedule – This is a document outlining all of the borrower’s current real estate holdings
- Photos and/or online listings of prior projects
Once all requirements are fulfilled and a closing date is scheduled, the borrower will submit a down payment on the loan (the difference between Loan to Cost and Actual Cost), and the lender will fund the project on the day of closing. The hard money loan lifecycle includes the monthly interest payments and construction draws. Construction draws will be expounded upon in a subsequent blog post, however, it is important that the borrower be fully cognizant of their obligation to fund construction upfront as is typically required by most hard money lenders. This upfront funding is then reimbursed after successful completion and inspection of each construction phase. The loan is complete once the investor has rehabbed and sold/refinanced the property and submitted the balloon payment to pay off the outstanding principal sum.
Investors who are cash-strapped, and even those with high liquidity, can benefit from adding hard money private lending to their tool chest. Real estate is a numbers game. Follow the guidance outlined in this post and start leveraging “other people’s” money to complete more projects, and get going on the road to fulfilling your real estate investment goals.