The goal of taking out a hard money loan is to get financing quickly and with good terms. But hard money lenders have secrets they will keep from you to maximize their profits. We discuss these hard money lender secrets here and how you an use them to get better financing terms.
SECRET #1: The Hard Money Lender’s Cost of Capital
Most hard money lenders loan money they have either borrowed or received from equity investors.
A lender will always keep his / her cost of capital secret to prevent borrowers from trying to negotiate down interest rates and fees.
The lender makes money from the spread between the costs of capital and the revenue earned from hard money loans.
But calculating the lender’s profit not as simple as just subtracting the capital from the expected revenue on a loan. This profit margin must be adjusted down by an estimated borrower default rate.
To do this, the lender will multiplies the expected profit by the expected recovery rate of the loan. Recovery rate is never 100% due to occasional borrower defaults.
The expected recovery rate of a hard money loan can vary, and depends on many factors. Some of these include:
- The terms and length of the loan
- Geographic location of the property
- The type of property (low income apartments, upscale condo, suburban house)
- Experience and quality of the borrower
- Economic conditions
- How much liquid collateral is put up by the borrower
- After-repair marketability of the property
SECRET #2: How the Lender Plans to Recover Its Money if You Default
Hard money lenders will move fast to recover their money when a borrower defaults. These hard money lender secrets are kept hidden from the borrower to prevent them from maneuvering around them.
A lender needs to take quick steps to recover the property and collateral and liquidate it because their own business solvency is on the line. This is especially true if the hard money lender borrowed the funds.
Lender Recovery Tactics
Tactic #1: An aggressive hard money lender adds big late fees, jacks up the interest rate, and calls the loan in for immediate repayment if the borrower has a minor default or payment delay. This is more common in low income property markets because borrowers are more likely to walk away from a difficult rehab project.
Tactic #2: In a booming real estate market the lender may profit by making an unreasonably short-term loans. If the borrower isn’t able to finish the rehab or flip the house in time, the lender will call the loan for immediate repayment. If the borrower does not pay, the lender may foreclose and sell it for a big profit. Essentially, the lender is using the investor to find the property, do all the legwork, and put up cash collateral, then take the property (and the profit opportunity) quickly.
Tactic #3: A plunging real estate market can lead a hard money lender to foreclose on the property. They will then seek to sell it off as quickly as possible to avoid taking a heavy loss.
How Lenders Convert the Assets Back Into Cash
The ways hard money lenders recover cash from the real estate and collateral assets include:
1. Liquidating collateral that was used to back the hard money loan. This may include other cash-producing properties pledged by the borrower as security.
2. Selling the property in a foreclosure auction. Depending on the state, this can be easy or arduous. See below.
3. Foreclosing and renting out the property (if it’s habitable).
4. Recovering from the borrower(s) directly if a personal guarantee was required to get the loan.
Realities of Hard Money Lender Foreclosures
Depending on the state, recovering hard money loan proceeds may require the lender to go through a full foreclosure process.
Certain states like California have “non-judicial foreclosure” processes. Here the lender can foreclose and sell the property without having to obtain permission from a court first. These states are favored by hard money lenders because they can foreclose and recover their money fairly quickly.
“Judicial foreclosure” states tend to take longer to recover because a court order is required prior to foreclosing on a property. These states are less appealing for hard money lenders because time delays and court proceedings can cost a lot.
Some states have long waiting periods from the first foreclosure notice to the day the property can be sold. Other states have strong right of redemption where the borrower can default then “buy back” their property even if it has been foreclosed and auctioned.
The more difficult and complicated it is for a hard money lender to recover its capital when a borrower defaults, the higher the cost of the loan will be.
Holding the Property Title in Escrow
One hard money lender secret is to require the property title be held in a separate escrow account until the loan is paid back in full. This lets the hard money lender repossess the property without having to go through a legal foreclosure process.
This can only occur if the hard money lender is the “first in line” lender (i.e. not a second mortgage holder behind a bank loan) AND the loan is made to a company (LLC or corp) NOT an individual. Loaning to a business exempts the property from most states’ mortgage foreclosure processes for individual homeowners.
SECRET #3: Loan Terms Depend on the Lender’s Confidence in the Borrower (Not Credit History)
Hard money lenders base their loan decisions on the potential return of the deal, the value of the collateral, and their confidence in the borrower. They care less about the borrower’s ability to pay the loan back out of their income.
An experienced rehabber or flipper will likely get better terms than a rookie. If the hard money lender knows the borrower from past deals, then they are more likely to make a loan with less delay and favorable rates.
Successful Flipping and Rehab Experience Matters
Can you complete the project on time and on budget? Getting the project done is the key. Interest compounds quickly on hard money loans, and the clock is ticking. If you have a good history of sucessful fix & flips then hard money lenders will work with you to get the best terms.
A hard money lender will likely get involved with the project to some degree. They may go over the housing plan to understand the rehab details for each room in the house. The lender may make recommendations or require changes to the construction plan based on their experience. They will want to know the overall cost per square foot of the project.
Hard money lenders will also want to see a balance sheet and related financial documents for proof the borrower has their own funds to cover costs. They don’t want to lend to someone who says they can do the rehab job but actually cannot pay for it.
A hard money lender will not want to lend to investors that have lost money frequently. This means they may not be good at managing real estate renovations, are higher risk and may not pay back the loan.
Hard money lenders will not hesitate to say “no” to borrowers and deals that bring too much financial risk. If they are experienced lenders, they will have seen many good and bad deals, and gone through market ups and downs. They will navigate the process accordingly.
SECRET #4: Good Contractors Are Essential
The rehabber or flipper should have high-quality, trustworthy, and honest contractors to work with. However, these are usually the ones who are the busiest.
Hard money lenders know a good contractor can save a huge amount of time and headaches down the line. A hard money lender will not lend you money if he suspects your contractors are not going to be able to do the work the way it needs to be done.
There are many smooth-talking contractors who can convince a new flipper they can do the job, but will not be able to do the work. Having good subcontractors is also important, including plumbers and electricians. Most hard money lenders will dig into these details as part of the loan due diligence process. To mitigate risk your lender will want the contractor names and references for the project before making the loan.
In a worst case scenario poor quality contractors can lead to liens on the property. This is fairly common with short term real estate projects. This can mean the flipper loses the property, and the lender ends up with a bunch of mechanics liends to deal with. Both can lead to a significant loss on their investment.
SECRET #5: Hard Money Lenders Know How Much the Property Is Worth
Hard money lenders are experts at pricing real estate projects and can estimate what the after-repair value of the property will be.
They can accurately judge the region, the neighborhood, and the market growth rate using their own tools and techniques. They will judge the the location in terms of traffic, school system quality, local amenities, nightlife, etc.
Lenders will not fall for a borrower who insists their property is worth more than it really is.
Most lenders want to see that the neighborhood is growing in value and the local economy is growing. If they suspect the neighborhood is not good for a rehab or fix & flip project, they will say “no” to the borrower.
Know these 5 Hard Money Lender Secrets!
Understanding these hard money lender secrets can help you negotiate better financing terms and develop stronger relationships. By taking these hard money lender secrets into account, you will be poised to make more profit from your real estate deals.