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Laying Out The Myths And Facts Of Hard Money Loans

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The hard money or private loan can, under the right circumstances, provide borrowers with an easy to obtain loan. Unsurprisingly, it is getting increasingly popular, with the lending environment in banks remaining very unfriendly to borrowers. Indeed, there are numerous reasons as to why these loans are now so common.

Recent years have seen major growth in the private capital market with more lenders offering hard money loans and more borrowers seeking them out as alternative financing. While there are many reasons for the growth in this segment of the real estate market, here are four main ones: Mutually beneficial to borrower and lender. Credit availability. Asset-based underwriting. Higher returns on investments.

Yet, despite the fact that there are so many clear benefits, people are still skeptical about these types of loans. One of the reasons for that is perhaps because these loans can be quite a bit riskier because they don’t have a standard application and acceptance process. They also have much higher rates of interest. Nevertheless, everything has its pros and cons and it is all about weighing these up. Let’s review some of the most common myths about hard money loans.

Myth 1 – A Private Loan Is an Expensive Loan

The fact is that these loans indeed have a higher price tag, but a loan is taken out for a purpose, which means that what really matters is the return on investment. When you consider that a traditional bank will only finance up to 65% of the total cost of the project, it means a borrower must still be able to raise at least 35%. This is known as the loan-to-cost (LTC) ratio.

The loan-to-cost (LTC) ratio is a metric used in commercial real estate construction used to compare the financing of a project as offered by a loan to the cost of building the project. The LTC ratio allows commercial real estate lenders to determine the risk of offering a construction loan.

With a hard money loan, borrowers could raise as much as 90% of the total cost of the project. This means that they have more disposable capital to work with. And although the interest rate is higher for a private loan, many have found that the return on investment is also higher.

Myth 2 – Hard Money Borrowers Lose a Lot of Control of the Property

It is quite common for those who decide to go the traditional lending route to have to bring in a partner in order to be able to finance their project, leading to them having to give up at least partial ownership of the property. Some, in fact, will require full ownership to be given up. With a hard money loan, the lender owns part of the project, not the actual property.

Myth 3 – It Is Much Easier to Deal with a Bank

This myth stems from the fact that banks have a standardized process. While this may be true, this also makes them highly rigid. Banks also generally do not provide any finance for development or construction loans at all.

The implementation of HVCRE (High Velocity Commercial Real Estate) rules that went into effect for the banks at the beginning of 2016 has made a large impact in the space. This causes acquisition, development and construction loans to be reported separately from other CRE loans and to be assigned higher risk weighting by the banks.

Banks have to stick to the HVCRE regulations and they are only allowed to provide loans according to the rules of the Federal Deposit Insurance Corp. Additionally, they underwrite based on the borrower’s income. Finally, they are concerned about exposure and will therefore often only work with borrowers they already know.

A hard money loan does not have to deal with this, which is one of the reasons why even residential borrowers are now considering these types of loans. They have a quick, streamlined process and generally complete the transaction within 30 days. In fact, underwriting often only takes 48 hours. Private loans are also far more flexible as their terms and conditions can be modified or altered as a project progresses.

Lenders Are Becoming More Creative As A Result Of Bank Tightening

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At present, everybody seems to be watching what the big banks are doing. This is mainly because the third quarter results will be unveiled by Wall Street today. This will tell us a lot about the national economy and whether the pledges made by Donald Trump are starting to pay off. However, by only watching the likes of Citigroup and JPMorgan, investors are missing the more creative lenders. What happens on Wall Street is important, but so is everything else that happens in New York.

Credit Growth in Private Capital

Credit growth, it seems, is no longer in the banking sector. While banks still play a role, the real growth is in private capital. And it is also here that we are seeing the greatest innovation. Consider, as an example, HPS Investment Partners.

HPS Investment Partners, LLC (“HPS”) is a leading global investment firm with a focus on non-investment grade credit. Established in 2007, HPS has approximately 100 investment professionals and over 200 total employees, and is headquartered in New York with ten additional offices globally.

HPS has some $39 billion in investment capital. It was once part of JPMorgan Asset Management but it is now completely independent. It is also no longer simply a hedge fund, having morphed into something else. They have announced, for instance, that they will now lend some $6.5 billion to other companies, offering private debt and specialty loans. The money comes through limited partners’ equity investments as well as the bank debt.

Banks Borrow from Investment Firms to Provide Loans

What this basically means is that big banks will borrow HPS money, and this money will be used to create corporate loans. This is a new construction, as corporate loans would, in the past, simply be supplied directly by banks.

That said, the HPS example is the biggest of its kind and it is hard to tell whether others are using similar constructions. This is due to the opacity of the private market as a whole. However, similar tools have now been created by BlueBay and Apollo. Then again, consultants such as Preqin have seen significant increases in levels of private debt as well.

2017 is certainly off to a strong start, specifically bolstered by the highly active direct lending segment in the US. Fund managers across strategies are seeing increased and sustained investor appetite for access to all parts of the market at this point in the credit cycle, when a hybrid of private debt strategies are poised to return strong results. Finally, with 284 private debt funds in market globally targeting more than $112bn, competition for investor allocations will remain fierce for the remainder of 2017.

The banks are keen to say that this is not healthy. However, financiers disagree. They believe that, since banks are so reluctant to provide loans nowadays, hard money lenders are a necessity to ensure the economy can grow. While certain borrowers are certainly high risk, they are also necessary to the economy.

Outlook on Private Loans

Private debt, clearly, is a demonstration of creativity in the entrepreneurial market. It is a main driver of economic growth. It also does not offer such a huge systemic threat, since the credit risk is shared across different banks rather than a singe one. Should the loan turn sour, the limited partners are those most affected. Furthermore, there is no chance of capital flight, because the loans are locked for up to seven years.

However, some are worried that the sector is growing too soon and too fast. The Great Recession of 2007 was caused by loans being provided too quickly, with too few securities. There is a risk that hard money lenders are going the same way, unless proper lessons have been learned.

How Important Is Private Lending In Commercial Real Estate?

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It was almost ten years ago when the global financial market crashed. Since then, a lot of things appear to have changed. Among those that have been affected the most is commercial real estate (CRE) lending, with loans now coming primarily from private lenders. Every quarter, people the world over continue to feel the effects of the Great Recession, despite it supposedly being behind us. And, as 2017 comes to an end, commercial borrowers continue to have to manage some significant financial complexities. Those include uncertain world affairs, a changing regulatory climate, and higher interest rates. What all of that means is that it remains difficult to secure commercial credit. Today’s lending standards are also tighter than they have ever been.

Well-established borrowers with long track records can still go to their banks and get financing. Regulations have made it more challenging, but if they have sufficient equity and well designed and capitalized projects, there are financing sources for the project.

However, financial investors are resourceful if nothing else. They are now in a unique position, and it is one that sees to have attracted private lenders to the commercial real estate market. The options offered by traditional banks simply aren’t realistic anymore, and this means investors have to look elsewhere. The result is that a range of new institutions have formed as well, including real estate developers, venture funds, insurers, and hard money lenders.

There are some key advantages to taking out a private money loan, not in the least that it provides a lot more room for movement in the CRE market. In addition, borrowers have found that a lot of these lenders are trustworthy and beneficial to them. The result is a significant impact on the CRE market as a whole, and it now looks as if private money is filling the gap left behind by the financial crash of 10 years ago.

How Is Private Money Helping?

It is quite obvious that there has been a significant increase in the number of private lenders that are becoming involved in the CRE market, and the existing statistics show this, too.

The silver lining for U.S. commercial properties came from the comparative strength of the U.S. economy and higher yields of U.S. assets. With global economies having slowed down in 2016, U.S. property markets remained a favorite destination for cross-border investors. While top-tier markets in gateway cities continued as major targets of investor activity, the higher yields and advancing economies of secondary and tertiary markets offered viable alternatives to investors looking for stronger returns.

That being said, it is very important to understand the impact of this on overall market activity. As such, the first key issue that is obvious, is that CRE investors and CRE developers continue to be heavily involved in the overall real estate market. However, they no longer have as much access to traditional lenders as they did in the past. This is due to traditional lenders choosing to be more cautious and also by new regulations, such as the Dodd-Frank Act.

The Dodd-Frank Wall Street Reform and Consumer Protection Act is a massive piece of financial reform legislation passed by the Obama administration in 2010 as a response to the financial crisis of 2008. The act established a number of new government agencies tasked with overseeing various components of the act and by extension various aspects of the banking system.

Of course, the Dodd-Frank Act is now in question again, as President Donald Trump has, so far unsuccessfully, attempted to repeal it in its entirety, to be replaced with the Financial CHOICE Act.

If we want strong economic growth and more freedom, we must empower Americans, not Washington bureaucrats.

However, much of the Dodd-Frank Act will stay in place and while the Financial CHOICE Act will be implemented, the reality is that investors will have to continue to look towards alternative lenders if they want to fund their CRE investment projects.

The Potential Pros and Cons of Private Lending in CRE

Lending always comes with risks. However, with private lenders, there is a different systemic risk associated with it. This was, in fact, a key lesson learned from the 2008 crash. Large lending organizations were classed as “too big to fail”, and this caused the Big Bank Bailout.

The Special Inspector General for TARP summary of the bailout says that the total commitment of government is $16.8 trillion dollars with the $4.6 trillion already paid out. Yes, it was trillions not billions and the banks are now larger and still too big to fail.

Private capital, if there is another burst of the real estate bubble, can quite easily absorb this. Only two players will be affected: the private lender and the investor. This is very different from an entire bank going under.

Yet, at the same time, there are some negative issues as well, one of those being that a lot of private investors are foreign investors. In fact, many of them come from China, as well as Canada and Europe. Clearly, the US market is seen as a safe market, but there will come a time when these investors start to see their own domestic market as safe again. This could have a significant impact on real estate investment trusts (REITs) further down the line, and the overall impact this could have on the market itself would be significant, albeit in theory.

What’s in Store for Private Money Lenders?

To date, the fact that the economy has strengthened has not resulted in more commercial credit becoming available from traditional lending sources. Hence, it is feasible that the last quarter of this year could see some real changes to what the lending environment looks like. There continue to be significant changes in financial regulations, and it is now also seen that interest rates are finally rising again. This means that, perhaps, traditional lenders will become friendlier to investors once again. Whatever happens, however, it is vital that the lessons learned from the financial crash and the benefits offered through private money since then continue to be at the foreground of their work.