Financing With ‘Hard Money’
- Jun 05, 2013
Seen in the past as a tool for ‘desperate’ borrowers, high-yield financing is gaining legitimacy today
By Brian Good, Eagle Group Finance
Hard money lending, arguably the oldest profession in the world, is typically misconstrued by all as a “bad thing.”
Just mentioning the phrase insinuates either a bad property or a bad borrower. Because of its heritage and history, the definition of what is hard money is subject to interpretation. Many real estate professionals characterize it as high-interest rate debt (over 10 percent per annum for example), basically a last-gasp money source for desperate borrowers.
Does it mean the borrower has to not only guaranty repayment of the debt, but also pledge immediate family members as collateral? Or does it symbolize the need for a quick close, for example in less than a week? Or does the word “hard” have a more simple meaning, such that a borrower needs this type of loan because it is “hard” to get? The reality is that all of these definitions of hard money are true. In fact, the definition has been so jumbled for so long that the industry now prefers to call itself “Alternative Private Lenders.”
The numbers show there is $3.5 trillion invested in commercial real estate in the U.S. Of that, 70 percent or $2.45 trillion is debt. Of the $2.45 trillion, 87 percent of the loans are made by banks, life companies, CMBS, and agencies. So that leaves 13 percent or $350 billion, to be sourced as private debt. This is a huge market.
So why so many bad connotations? Well, first of all it is true a bad apple doesn’t fall far from the tree. Early on, private lenders with significant funds could drive a pretty good deal when a borrower was in desperate need of cash. This is a simple rule of supply and demand where the one with the money can dictate egregious terms. Either the borrower is out of time or the borrower is not perceived as a good enough lending risk by traditional banks.
At that point the borrower is at the mercy of an egregious lender who has no problem exploiting their advantage and pounce. In a loan maturity scenario, a borrower would have no choice but to accept any terms because they could lose their property in a foreclosure. For the lender, this turned out to be another way to get to ownership of the property without buying it, and get it at a discount. With such high interest rates, borrowers would typically default, and with a personal guaranty, would prefer deed in lieu versus litigation.
Fast forward to today. New technologies have made it a lot easier for borrowers/owners to understand that they have many more choices available to them to solve a last minute debt dilemma. Stiffer competition means that lenders have to be more competitive, offering lower rates and non-recourse debt. Yes, rates are still higher than most banks, but the other terms that would let lenders take over the properties have gone away. No more personal guaranties, no more cross-collateralization, and the like. If anything, the hard money business is more legitimized and recognized.
So why? First, as a backlash against the subprime lending fiasco that took place over the last 10 years, there are many more protective laws out there that help the borrower. A lender in California for example may be subject to approval by the Department of Real Estate or even the Department of Corporations. Additionally, depending on what type of loan the lender is providing, a lender or its officers may be subject to SEC approval as it is providing a security. More regulatory scrutiny usually means the lender will tone down its historically egregious acts and comply or get out of the business altogether. It is now harder than ever for anyone to simply lend money secured by real estate.
The other reason causing tamer private lending is more nuanced and requires an understanding of the reasons for deploying private capital. Most private investors nowadays are simply searching for yield. The mindset is to try and find a return that exceeds the return they are getting for bonds or simply their money market accounts.
Yield has real meaning to these investors. When weighing the risks of investing, it appears to these investors that investing in real estate debt provides a return well in excess of the risk, especially when structured properly with a low leverage first trust deed protecting the investment. So when the money is lent, the investor simply wants the so-called coupon return the loan provides monthly. Yes, it is ordinary income, but even after tax it is a better yield than money markets or even most bonds provide. And, most importantly, it is secured by a real asset.
In real numbers, one-year treasury (the safest of investments backed by the US government) pays .05 percent, five-year treasury pays 1.95 percent, triple AAA 10 year CMBS pays 2.7 percent, and Class A core real estate pays 7 percent. Private lending pays 8-10 percent, with low leverage, and a security interest in the real estate.
It might be easier to illustrate these points by showing a few real-time hard money loan scenarios. A private investor in a multifamily property in a tertiary market has defaulted on a loan but worked out a deal with CMBS servicer for a discounted pay off. As part of the agreement, the servicer wanted to close by end of calendar year (10 business days). If not closed by then, the servicer was moving forward on sale date the following week and the borrower would forfeit a significant good faith deposit.
The investor went to several banks, one of which where he had been a customer for 20 years. The bank said maybe, but needed 45 days minimum to close despite the good relationship with the borrower and having a familiarity with the borrower’s financial condition. The borrower turned to a private lender as a last ditch effort, and the lender closed in a timely fashion and saved the borrower’s deposit and property.
Another illustration is from a surprising source. A mid-size fund had 10 investments in its portfolio. One of the investments was not able to service its debt, plus the debt was maturing shortly. Simultaneously, the Fund was out raising its follow up Fund 2, and could not risk having a deal in its previous fund show a loss. The Fund could not tap its existing investors in Fund 1 for more capital because they were targeted for Fund 2.
Additionally, the Fund had minimal cash on hand because it returned most of it to investors or had it tied up in the portfolio. The existing lender was not willing to extend the loan because it decided it had too much exposure in its lending portfolio and would require a personal guaranty which the fund would not offer. Seemingly out of options, the Fund turned to a private lender who closed quickly and salvaged the Fund, and allowed for a smoother transition to Fund 2.
As an indirect result, the private money lenders are driving the market right now. They are competitive and eager to place the money to provide a return. Everything is yield driven, and for these smart investors, they want the yield, not the property. This is good news for borrowers. Private lenders are more legitimized than ever because of the regulation, terms are fair, and the interest rates they are requiring are historically low.
If this holds true, the bad connotations may go away – for a little while at least.
Brian Good is president of Eagle Group Finance, an operating unit of Los Angeles-based Eagle Group LLC. Eagle Group Finance provides short- and long-term non-recourse financing secured by multifamily, office and retail assets.