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Nikhil Raheja
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Work in the Healthcare Industry. I have an interest in small and mid cap stocks, and buy them for the long term. Been at it for a couple of years.
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  • Hard Money Lending  0 comments
    Mar 31, 2010 2:48 PM
    Introduction
    Hard Money loans are short term asset based loans extended mostly to real estate developers. These developers use the funds in the rehabilitation of real estate assets, in an attempt to sell the finished properties at much higher prices. Over the last several years, the hard money lending industry has grown exponentially, filling up a widening gap in the supply and demand for loans caused by a reduction in conventional bank lending. Due to the high interest rates and the safety measures used in the loans, the industry has become an extremely safe and profitable alternative for investors, disillusioned with the charm of the regular market based investments.
     
    Hard Money Loans
                    Hard money loans are short term loans made to businesses for their operational needs. These loans are made primarily against property based collateral that is usually over 200% of the loan amount. These loans are can be for any duration between 3 months to a few years. However, most loans in the industry are made for a period of 6 months or less.
    Hard money loans are originated against the collateral, primarily the real estate being purchased, or renovated. The loan to value ratios(LTV) demanded in such transactions is usually between the range of 30-65%, ensuring that the borrower has enough equity in the property, thus creating a large safety net for the lender in the event of a decline in property values. In addition, some lenders also lend based on the After Repair Value of the property (ARV), allowing the borrower to borrow a higher amount against the property at hand. In these instances, the loan value against the current price for the collateral might be higher; however the risk is minimized through several special assurances such as the personal guarantee, which is explained later.   
    In addition, the Hard Money Lenders do not preoccupy themselves with the incomes, employment, or the credit histories of the borrowing companies; instead, they direct their focus towards ensuring that they have enough collateral to claim even if there is a default or a massive decline in the property prices. Due to a decline in lending through the conventional channels, demand for such private short term loans has been soaring over the last few years. As a result, Hard Money Lenders face a shortage of funds against the increase in demand from the developers, who are seeking to profit from a decline in property values. Also, these loans are quicker to get approved and close, as opposed to loans from banks, which would take a bureaucratic route and take at least 4 weeks, as opposed to a week with the Hard Money loans.
    Despite the growth in the industry, the default rates remain much lower than that of the banking industry. An average hard money lender suffered a default rate of less than 1% in 2008-09. Most of these hard money lenders are registered privately, and thus are protected from the vagaries of the sentiment based market. The investors in the hard money lending firms depend only on the profits/interest generated by these firms, and not the capital gains/losses on the stocks of these firms.
     
    Process of lending
    Once the funds have been secured by the lender, a borrower with a viable business strategy is located. There are 4 other key steps involved in the qualification of the borrower.
    Underwriting is the gathering and assessing of information about the borrower and the property to determine if the loan is viable.
    Processingincludes the work with the Title Company (to obtain title insurance), with the Escrow agent, Realtors, Insurance agents, Appraisers, etc.
    Document preparation is the preparation of all loan documents.
    Lender inspectionis that part of the due diligence where the lender makes a visit to the property in question and determines the viability of the loan based upon the strategy, neighborhood, etc.
    Once the above process is over, the loan terms are finalized with the borrower. These include the duration of the loan, the interest rate to be charged, personal guarantees from the borrower, an audit of the borrower`s personal assets. Other steps might include a deed in lieu of foreclosure, and a confession of judgment, these two safety measures have been explained in a lower section. Also, some cautious lenders might demand to know the exit strategy of the borrower, which the lender would use to complete the project if the property is foreclosed upon due to a default. 
    Once the terms of the loan have been settled, the loan is extended to the borrower through the escrow agent. Some lenders may loan out the money in stages, thus keeping an eye on the progress of the renovation. Each further loan segment is issued at the completion of a particular stage in the development of the property. This is done to ensure that the lender can proactively take possession of the collateral in case the borrower has misappropriated the funds or the construction is not progressing as per the initial plans.  
    Most properties chosen by the borrowers are dilapidated and have huge potential for value addition at low costs of improvement. Ideally, the lenders give loans for projects in the surrounding areas, so they can be supervised. Some lenders even arrange the stock of building materials needed by the borrower, so as to precipitate the process of closing the loan and the start of the development. These lenders keep in constant touch with the borrowers to gain a better estimate of the date of the completion of the project. Also, it helps them know in real time if the loan amount needs to be increased due to previously unforeseen events. These lenders develop good relations with their borrowers, causing these borrowers to become repeat clients.  
    Most of these loans are non-amortized balloon loans or Interest only loans, requiring the borrower to pay the principal only at maturity. Once the principal and the interest are paid in full, a new loan is issued to the next borrower within a few days, ensuring that the capital does not stay idle. A successful hard money lender attempts to create at least 2 loans with the same money each year, with each loan yielding high rates of return.
    Some other borrowers also use Hard Money loans as Bridge financing to fund their ongoing, long term construction projects. These Bridge loans are described below.
     
    Bridge Loans    
    Several real estate borrowers take out short term intermediate loans from Private loan firms to pay for real estate projects, until low interest bank financing is secured. As they receive financing from the bank, they pay off the loan and the high interest rates charged on it.  Bridge Loans are quite common in the real estate industry, as they are sometimes used to start new projects until a current property is sold and funds become available. These funds are then used to pay off the loan.
    Hard Money Lenders initiate these bridge loans along with conventional short term development loans. While the duration and interest rates charged on these loans remain the same, the key difference lies in the purpose for which these loans are taken, with bridge loans being taken mostly to “bridge” the gap between current needs and future availability of financing.
    These bridge loans, like hard money loans, may be taken out for any operational projects besides real estate development. Private equity firms along with several large Hard Money lenders issue these bridge loans in large amounts. For instance, NBC Universal used $6.1 billion worth of Bridge financing to pay off its current parent, General Electric Co. as compensation for the stake that GE would sell back to NBC.
    These Bridge loans are structurally similar to Payday loans, where an individual borrows a small amount, to be paid back on the receipt of the salary at the end of the month. Here the borrower may issue a post-dated check to the lender, cashable at the end of the loan term. Bridge Loan financing is a multi trillion Dollar industry with growing prospects, concomitant with a decline in bank financing.
     
    Interest Rates and Fees
                    Hard money lenders usually charge annual rates of more than 10%, sometimes going up as high as 30%. Some lenders may charge a higher rate in the case of a default, a “Default Rate”. In addition, some other lenders may also charge a “prepayment penalty”, compensating themselves for a lower interest amount received due to payment of the loan before the end of the loan term.
                    A borrower is also required to pay loan fees that cover everything from the origination expenses, escrow account fees, and title insurance. These fees are expressed in % points and can be as high as 10%. A lot of Hard Money lenders return most of the profits generated through interest and fees to the investor, keeping for themselves a small profit, and thus generating a need to increase the funds under management.   
                    Usury laws in most states limit the amount of interest rate that can be charged from a borrower. However, these laws do not apply to loans extended to corporations. As a result, Hard Money loans are exempt from usury laws. Not surprisingly, the high interest rates charged on the loans by these borrowers give a false impression of usury; however the rates in question are annual, while most borrowers borrow for 3-6 months, thus paying an interest in proportion to the duration of the loan. So a Hard money firm that charges 19% annually from its borrowers would only charge 19/4, or 4.75%, from a borrower who borrows for 3 months. So, in effect, this borrower would be liable for just that small interest charge and the loan fee applicable.
     
    Safety Measures
    Personal Guarantee
    Most loans in the country are recourse type, which implies that the lender has recourse in the event of a default by the borrower. In other words, the lender can take the borrower to courts to recover the money not paid back by the borrower, or not recovered from the collateral pledged. But, there are many states where only non-recourse mortgages are created. A lender has no judicial right to stake claim to a borrower`s personal assets in these states, and must be content with the collateral.
    Consequently, most Hard Money lenders have settled in states that allow recourse to a default. However, despite offering loans in a recourse state, a hard money lender may still not be able to recover the money if the borrower files for corporate bankruptcy (Chapter 11) or Personal bankruptcy (Chapter 13), or liquidation (Chapter 7). In this case, the lender must abide by the orders of the court and take its share.
    Some Lenders have come up with a brilliant way to escape the dread of bankruptcy by demanding Personal Guarantee from the borrower. This Personal Guarantee ensures that no form of bankruptcy overrules this guarantee and the borrower remains liable for every penny, including the interest and fees owed to the lender, plus extra interest for a delay in the payment. So if a default occurs, the lender could chase the individual`s personal assets to recover the money. This process has ensured that these Hard Money lenders do not lose their money to defaults except in the most unfortunate cases. In addition, the personal guarantee becomes a motivator for the borrower to be diligent in the repayment of the loan. As a result, the lenders that take a personal guarantee almost never see a default.
    This feature is the USP of the Hard Money Lending industry. This assurance drives a huge wedge of safety between the private lenders and the banking industry. So much so, that the banking industry has recognized its folly and now it demands a personal guarantee on some loans. Historically, these personal guarantees have been given by many famous enterprises, such as the personal guarantee pledged by Donald Trump`s company to Deutsche Bank AG for $40 million on a $640 million construction loan for the Trump International Hotel & Tower. Trump`s company defaulted on the debt in November 2009, and is now being sued by the bank for the amount not yet recovered.
    Find below the list of states with non-recourse debt requirement:
    Alaska, Arizona, California, Connecticut, Florida, Idaho, Minnesota, North Carolina, North Dakota, Texas, Utah, Washington
    All remaining states, with the exception of a few with more complicated laws, allow recourse debt.
     
    First Mortgage Positions
    Hard Money Lenders usually accept a first mortgage position on the loan, in other words, they hold the first right to the property in the case of default, irrespective of the number of loans that may have been taken on the collateral. This feature coupled with low LTV ratios ensures that the lender can remain indifferent to the operational risks taken by the borrower. The lender simply depends on the safety net created by a combination of low LTV ratio and a first lien on the property.
    This strategy is timely since the banks that have held the second mortgage positions during the current crisis have on an average recovered less than 10 cents on the Dollar. 
      
    Confession of Judgment
    Some states like New Jersey and Pennsylvania allow a special arrangement between the creditor and the debtor where the debtor trades away his right to protest a judgment against him if there is a default. So with a confession of judgment, a lender may simply approach the courts with the signed document and appeal for permission to foreclose upon the property. In this case, the borrower has no rights to a trial, unless if he can draw focus upon any impropriety in the framing of the document.
    The confession of Judgment allows a lender to gain access to the collateral within 24 hours of a default. This procedure is extremely rare in the country and is found in only a handful of states. Many Hard money lenders have thus relocated to PA and NJ in pursuit of this feature.
     
     
    Deed in lieu of Foreclosure
    A Deed in lieu of foreclosure is a tool to allow the lender to acquire the collateral from a delinquent borrower without the foreclosure proceedings. Several documents constitute the deed, such as the Agreement in lieu of foreclosure, which explains the terms and conditions of the deed-in-lieu, and the Warranty deed, which conveys legal ownership in the property to the lender. In addition, a Quitclaim deed and a grant deed may be signed by both the parties.
    Some Hard money lenders make use of this deed to ensure that the property in question is transferred to them quickly, so as to avoid the time and costs of foreclosure. Another benefit to the lender is that the property changes hands before the borrower can vandalize the property to get back at the lender.  
    The advantages to the borrower are numerous. The borrower avoids the harassment of a foreclosure. In addition, a deed-in-lieu eliminates all personal indebtedness and responsibility for the borrower, as regards that loan. In addition, the credit score of the borrower remains unaffected since the lender loses all rights to pursue the borrower for any amounts unrecovered.
    The lender must provide a letter that assures that the debt is “paid in full”, and must waive the right to a deficiency judgment, which prohibits the lender from seeking the borrower for any unpaid debts after the sale of the collateral recovered.
                    Hard money lenders may or may not use a deed dependent upon the proportion of the debt that could be paid off from the sale of the collateral. If the debts largely exceed the collateral, then the lender would hold off on the use of the deed and may proceed with the foreclosure, so as to maintain a claim on the borrower`s personal assets.
     
    Third Party Escrow Account
    An independent third party, such as The Escrow Firm acts as the agent for the disbursal of funds to the Lender, borrower, and investors. As the Lending firm receives the money, it deposits the money in the Escrow account with a third party (mostly a bank). The Escrow agent then becomes responsible to disburse the money to the borrower as per the terms of the loan.
     The loan is paid back by the borrower into the Escrow account, which the lender has no access to, save for the interest portion, which may be drawn upon for working capital uses or dividend payments to the investors. If an amount must be redeemed to an investor, the amount is mailed/wired by the Escrow account on the directions of the lender.
    All Hard money firms are required by law to use the services of an Escrow account. The Escrow agent brings transparency to the operations and limits the amount of embezzlement, if any, perpetrated by a dishonest lender.   
     
    Demand for Hard Money Loans
                    Bank lending has fallen precipitously with the onset of the financial crisis, leaving the borrowers scrambling for the little credit available in the market. According toJack Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania, “The financial crisis has been good for the hard-money lenders because it has made loans with less than perfect credit very difficult to obtain from institutional lenders.”
                    The loan applications at an average hard money lender are up 50% since 2007. As a result, hard money lenders are turning down most applications and have been accepting only those with the most collateral and best credit histories. In addition, the interest rates charged by the borrowers along with the fees have also increased substantially. This is an anomaly since Hard Money lenders seldom change their fees or rates, which have remained immune to the changes in the underlying interbank lending rates over the years. 
                    During the housing bubble, most mortgages, residential and commercial, were being packaged into Mortgage backed securities (MBS) and sold off; but with the start of the bust, the MBS markets have remained seized for over 2 years. According to the Wall Street Journal, the first multiple borrower commercial MBS deal since 2008 would be completed in the 2nd quarter of 2010 by Deutsche Bank.  A multiple borrower deal is where a security is formed from mortgages issued to several borrowers. Consequently, the banks have had to hold on to their mortgages instead of selling them off, leading to lesser new creation of mortgages and other loans.
                    The current mortgage market is being supported by Federal funds, with Fannie Mae and Freddie Mac buying most of the residential mortgages from the banks. In total, the above two Federal agencies and FHA combined are backing 90% of the new residential mortgages created, as opposed to 30% before 2007. However, there is absolutely no federal support for Commercial Mortgages, and thus the Hard Money Lenders have gained the upper hand in dictating terms to the borrowers who approach them.
                    The volume of commercial mortgages outstanding in the United States fell by $99.1 billion in 2009, the largest-ever annual dollar decline, to $3.4 trillion, according to analysis by the Mortgage Bankers Association. Most of the decline was the result of a $44.3 billion drop in the volume of mortgages held by CMBS and other securitization vehicles, to $690.5 billion. But commercial banks, which hold the largest chunk of the mortgage universe, also saw a $37.4 billion drop, to $1.5 trillion, according to the trade group.
                    In Figure 1.1, a decline in the total real estate lending is depicted. The Real estate loans held by all commercial banks fell by 4% in the last 1 year.  
                   
    History of Hard money Loans
    The term “hard-money” lending can be traced to the Great Depression when private individuals started lending money because of the banking crisis, according to Leonard Rosen, who owns the La Jolla-based company, Pitbull Mortgage School. 
    Later, in the 1950s, Prospective borrowers’ credit applications began to be scored quantitatively.  As a result, people with lower credit scores could not obtain the credit that they needed. Therefore, a new market for Hard money loans was created. The higher risk with lending to less creditworthy applicants allowed higher rates and fees to be imposed by the lenders. People with money to invest saw this market as a potentially very lucrative one, and the service began in earnest in the late 1950s.  
    The industry was hurt considerably with the real estate crashes of the 1980s and early 1990s due to lenders overvaluing and funding properties at more than their market prices. When real estate values fell, lenders lost substantial amounts of their investments. This, in large part, explains the lower loan-to value ratios required by the Hard Money lenders today.  
    Hard-money lending has been around for decades but had been marginalized for residential borrowers in recent years. That is because of the rise of credit scores, and the ability of banks to bundle low-grade loans and sell them on Wall Street. This provided the traditional lenders with a way to offer mortgages to riskier consumers at interest rates lower than hard-money lenders charged. The subprime crisis has changed all that.   
     
    Non-tradable capital
                    Since most Money lending firms are registered privately, and are not traded publicly, they are not subject to the whims and fancies of investors. As a result, the investors’ success in these companies is only a factor of the profitability of these firms, and not that of the stock trading sentiment in the markets. Consequently, the returns of the investors from these companies were stable and predictable during the financial crisis.
     
    Similarity with Mortgage REITS
                    Mortgage Real estate investment trusts (Mortgage REITS) are almost the same as Hard money lending firms. These Mortgage REITS follow the same business model of lending money to short term developers, or of making bridge loans. However, Mortgage REITS are required by law to distribute 90% of their profits amongst the investors each quarter.  This rule helps them qualify for pass through taxation. Conversely, most Hard Money Lending firms qualify for pass through taxation owing to their registration as Limited Liability Corporations. The REITS, on the other hand, are registered as public corporations, which generally do not qualify for pass through taxation. So a REIT abides by the Dividend rule simply to provide the benefit of pass through taxation to its investors. Most REITS are publicly traded, but it is not uncommon to come across a private REIT.  
                    The benefit of registering as a private company was discussed under the previous heading, “Non-Traded Capital”. The same logic applies to the Mortgage REITS. It has been profitable to hold a Private REIT as opposed to a publicly traded REIT due to the immunity from undue fluctuations in the stock prices.  
     
    Industry size and statistics
                    There are no hard facts available on the size of the industry, but combined with the Bridge loans and Payday loans, the industry creates at least a Trillion Dollars worth of loans each year. There are hundreds of Hard Money lenders in each state, but mostly concentrated in a few states with favorable terms, like PA and NJ. The Hard money lenders market their loan services largely through word of mouth, and through some small media. Hence it is often difficult to locate a hard money firm for a new entrant in the development industry.
                    However, due to the decline in bank lending, the scope for the use of hard money loans has expanded considerably.
                      
    Legal structure and other Issues
                    Like most small firms, Hard Money lending companies register as Limited Liability Corporations (LLC). The chief benefit of registering as an LLC instead of as a corporation is the tax benefit. The incomes of an LLC firm are subject to pass through taxation, where the incomes are only taxable to the individual investors, but not taxable at the company level. This escapes the most common problem faced by all public corporations, which are taxed at both the corporate level and at the individual level, famously known as Double taxation. Even the mutual funds are maligned by the same issue since the public companies they buy are taxed at the corporate level and the dividends are then taxable to the mutual fund investor.
                    Another advantage of an LLC structure is that of limited liability. As opposed to a partnership, the owners of an LLC are not personally liable for any debts, or other damage. In addition, no annual meetings of shareholders are required. Also, the investors could be foreign citizens.  
    The Hard money lending industry is lightly regulated, though depending on how a mortgage is structured, lenders can be subject to state and federal caps on interest rates. The industry is monitored by the Federal Trade Commission. The Federal Trade Commission's Web site ( www.ftc.gov ) has links to consumer publications that explain high-rate, high-fee loans, a category into which hard-money mortgages fall. The agency says it hasn't received many consumer complaints about hard-money lenders.  



     


    Disclosure: None
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