- Robert G. Allen
Two weeks ago, we asked in a post about Alternative Investments: “If not the stock market, then what?” Indeed, it is a question many investors are asking themselves. Specifically, where can you earn reliable rates of return with manageable risk?
We have recommended to some clients to discover how to work with private lenders to invest in “hard money” loans such as bridge loans and rehab projects. What are hard money loans, exactly? Here’s a brief summary:
A Bridge Loan is a short-term loan to “bridge” the interval between buying one property and selling another. A typical bridge loan is for a short-term loan of 6 months or less, though time frames vary.
A Rehab Loan is a short-term loan made to improve a property. Construction funds are held in escrow until needed, and paperwork must be completed to show progress. Borrowers typically sell or refinance the property after improvements are made.
“Hard Money” Loans are the opposite of “soft money,” which is easily obtained. Hard money loans are made when either the borrower (often a contractor or investor) or the property (perhaps a rehab project) does not fit the typical bank lending qualifications. Hard money loans are secured by the value and saleability of the property more so than the borrower’s qualifications (though that has changed somewhat), and loan-to-value ratios are kept low to protect the lender.
By definition, bridge loans are generally considered hard money loans (even when borrowers have good credit), but not all hard money loans are bridge loans. Hard money loans are often short-term loans, but can be long-term mortgages for people who don’t qualify for more typical Fannie Mae/Freddie Mac/FHA/VA loans. Rehab loans can be hard money loans, though not all rehab loans are considered hard money, with some homeowners qualifying for FHA 203k rehab loans.
How Private Lending Deals Work:
The lenders examine the deals, analyze the properties and qualify the buyers. They charge fees plus interest. Some lenders look to private investors who can provide the capital in exchange for the interest. Depending on the type of loan, investors can be paid interest in a lump sum when their principal is returned at the end of the loan term, or they can receive regular monthly payments.
Bridge Loans and other hard money loans can be safe, reliable investments when properly vetted and executed. These loans have been offered by mortgage brokerages and even some banks for years, but now it is easier than ever for individuals to “be the bank” and enjoy the benefits of helping qualified borrowers. The key is finding a private lender who will carefully screen borrowers and properties.
The Pros and the Cons of Investing in Hard Money
While bridge loans are a non-traditional investment, the advantages of being an investor with a private lender are noteworthy:
- Diversification: Private real estate lending offers true diversification for the investor. The rate of return is not affected by stock market whims, global politics, or even long-term real estate trends.
- Collateralization: Investment funds are secured against freshly appraised real estate without requiring investor to purchase or manage rental properties. Typically a maximum of about 65% is loaned on the current or improved value of the property.
- Profitability: Investors can earn proven, predictable rates without tying up their money for years (or decades) at a time. (Investors are typically offered a set rate of 12-14% annualized with no fee, though terms vary according to lender and individual deals.)
- Control: Unlike the investments that caused the subprime meltdown, these are not loans that have been sold, re-sold, converted into stocks other investment instruments, and then packaged in bulk to hide deficiencies. These are simple, direct, secured loans that have been individually evaluated to protect both the investor and the company structuring the loan. Private lending borrowers are individually assessed and qualified, and investors are essential business partners that the private lender wishes to keep satisfied.
There are also potential disadvantages of becoming a bridge loan or hard money investor:
Research required. While putting money in a certificate of deposit or even an index fund mirroring a certain index may be somewhat simple, doing your due diligence is especially important with bridge loans.
While some investors put deals together and lend the money directly, we only recommend using the services of a proven, reputable company who finds, analyses, and puts together the deals. To find one, get referrals and recommendations, check references, and ask questions, such as:
- What position would your loan be in? (First position is preferred, because that means you’re the first to get paid in a sale.)
- How much do they lend on the value of the home, or anticipated value, if improvements are being made? (Our preferred provider only lends a conservative 65% of value.)
- What happens if borrower defaults?
- Can you check references? (Don’t skip this step.)
- Do they offer “too good to be true” results? (Run, don’t walk, if they say you can earn 20% per month, 2% per day, or some such nonsense, even if your brother-in-law swears its real.)
If you are not already a professional real estate investor, we don’t suggest attempting making private loans yourself. To loan directly to a homeowner or contractor, you need to have an excellent understanding of real estate law (or a good lawyer) and property values (or a good appraiser). And the devil surely is in the details. For instance, if you discover that there are unrecorded liens or notes and your loan is forth in line on an already over-mortgaged property, you’ll end up with nothing.
Time frame. We wish we could get this rate of return year-in and year out, but bridge loans are, by nature, a shorter-term strategy. (Of course, that may work perfectly for some investors!) Then you’ve got to wait for another bridge loan or find someplace else to put your money. Ideally, you’ll be working with a company that you can do many transactions with over time.
Risk. As with almost any investment, there is an element of risk, especially if “Murphy” shows up. What happens if something drastic happens to the house, the market, or the owner/contractor making the improvements on the home? In that case, the private lender goes to plan B. They have a lien on the home and are in an excellent position to collect on it. If necessary, they foreclose on the property and sell it to recoup the investment.
Every effort is made to guard the investor’s original investment, and if possible, the interest owed as well. However, it may take longer than anticipated, and the only real guarantee you have is the value of the home. While that may sound like less-than-a-sure thing, consider these facts to put the risk in perspective:
First, there is no insurance policy for a stock market crash, and in any economy, a company like Enron can go from riding high to crawling on the ground before you can say, “Sell my stock!” However, in real estate, a “worst case scenario” might look like a house burning down – and you’re insured for that!
Secondly, your mutual fund or stock investments are speculative in value. They are not collateralized with real property, nor are they considered to be collateral of equal quality and value to real estate. Ask your bank manager how much they’re willing to lend on a piece of residential real estate, and the answer will be at least 80%, even up to 100%, in some situations. Now, ask the same bank manager how much they will loan you against your mutual funds. Hmm…
Is real estate investing through private lenders for you? We think that investing in hard money loans such as bridge loans can be a great way to diversify your portfolio and raise your returns, while keeping your investments collateralized. Many of our clients have used this strategy over the years, with favorable results.
Want to know more? Contact us if you are interested in working with us to find bridge loans or appropriate alternative investments for your portfolio. Our preferred provider has limited bridge loans available to investors, so clients are given priority.