With a company named The Investor's Edge, our team clearly believes in the value of hard money lending. But, real estate investors frequently ask me whether they should pursue this strategy. In other words, is hard money lending a good investment?
Hard money loans command higher interest rates than conventional mortgages. As such, hard money lending offers outstanding returns for investors. However, before doing this, investors need A) experience with real estate investing, in general, and B) enough cash to actually provide hard money loans.
I’ll use the following article to discuss some more considerations about hard money lending as an investment. Specifically, I’ll dive into these topics:
- An Overview of Hard Money Lending
- When to Use Hard Money Loans
- Gaining Real Estate Investing Experience
- How to Invest in Hard Money Lending
- Finding Hard Money Lending Deals
- Is Hard Money Lending a Good Investment?
- Final Thoughts
An Overview of Hard Money Lending
Before discussing hard money as an investment, I want to first provide an overview. People frequently—and incorrectly—assume hard money loans are so named because they’re hard to get. The opposite is true. Borrowers can typically receive hard money loans more easily than conventional mortgages.
Rather, lenders provide hard money loans primarily against the hard asset—the property. With a traditional mortgage, lenders base their lending criteria largely on the borrower’s “soft assets.” That is, lenders assess a borrower’s income, credit score, debt-to-income ratio, and other personal financial information to make a loan decision. Basically, lenders want to confirm you can make your monthly debt service payments. If you’ve applied for a home mortgage before, you understand the cumbersome nature of this soft asset review process for borrowers.
On the other hand, hard money lenders base their decision on the quality of the deal itself—not the borrower’s personal financial profile. Generally speaking, these lenders provide loans for distressed properties that would not qualify for traditional financing. Real estate investors—often using fix & flip strategies—use these loans to purchase and rehab properties to bring them to traditional mortgage lending standards. As a result, hard money lenders look at the future value of these distressed properties, known as the after-rehab value (ARV). Lenders assess a deal’s ARV, and they base the amount they’ll lend off of that future value. As long as borrowers don’t have bankruptcies or judgments, their credit doesn’t impact hard money lending decisions.
The reason hard money lenders can focus solely on the deal—rather than the broader borrower profile—comes down to equity. With a traditional mortgage, lenders frequently provide 100% LTV (VA loans) to 96.5% LTV (FHA loans) terms. As such, if the borrower defaults and they need to foreclose and sell the property, they’ll likely lose money because not enough equity exists in the property.
Hard money lenders typically provide far lower LTV terms. While each lender differs, we offer 70% LTV terms—based on the property’s ARV. This means that if hard money lenders need to foreclose on a completed property, they’ll likely recoup their funds, as far more equity exists in the property.
But, as stated, hard money lenders base their LTV calculations on the ARV, or future value. Whereas habitable properties back traditional loans, distressed properties back hard money loans. This means that hard money lenders assume far more risk. More precisely, they assume the risk that A) the borrower fails to rehab the property as planned, and B) that market price comes in significantly below the projected ARV.
If a borrower fails to rehab a property and the hard money lender needs to foreclose, the lender now owns a distressed property—not the fully rehabbed property. This means that, to recoup funds, the lender needs to either continue the rehab or sell the property to another fix & flip investor, as it won’t qualify for traditional financing.
Less risk exists for the second scenario, that is, market price coming in significantly below the projected ARV. This directly results from the lower LTV. By lending 70% LTV based on the ARV, the actual sale price would need to drop more than 30% from ARV for the borrower to not cover his or her loan. This provides hard money lenders a significant buffer against market volatility, assuming the borrower completes the rehab as planned.
When to Use Hard Money Loans
Now that I’ve provided a general overview, I’ll cover when real estate investors should use hard money loans. Simply put, as an investor, you’ll use hard money loans all the time. Any time a property requires major repair or renovation work, it won’t qualify for traditional financing. Instead, you’ll use hard money loans. And, while plenty more exist, here are the primary situations when real estate investors will use hard money loans:
- Wholesaling: The beauty of wholesaling centers on its simplicity. You don’t need to actually buy and rehab a property. Instead, you find deals on distressed properties, put them under contract, then assign those contracts to other investors so they can close the deals. However, some deals will require wholesalers to bring cash prior to contract assignment. In these situations, hard money loans provide a quick, reliable source of short-term funds.
- Fix & flip deals: As stated, properties in need of major repairs will not qualify for a traditional mortgage. Unless investors can purchase these with cash, they’ll need a hard money loan to finance the purchase and repair. Upon selling the rehabbed property, fix & flip investors use the proceeds to pay off their hard money loan and pocket the difference as profit.
- BRRR investors: These investors follow essentially the same steps as fix & flip ones. Therefore, they need hard money loans to pay for a property’s purchase and rehab. However, rather than selling a property to pay off their hard money loan, they rent it out and refinance with a traditional mortgage. These refinance proceeds pay off the hard money loan, and the remainder can either be pocketed as profit or left in the property as equity.
Gaining Real Estate Investing Experience
Now that you’ve seen all the scenarios when investors use hard money, you’re likely thinking that hard money lending represents a great investing opportunity. It does. That’s why our company lives and breathes hard money loans! But, before diving head first into lending, you need to gain significant real estate experience. In other words, hard money lending may seem easy, but successfully analyzing and executing deals requires tremendous experience in what I call the “real estate investor lifecycle.”
If you work through the below steps, you’ll gain experience in all facets of residential real estate investing, and you’ll be well positioned to begin investing in hard money loans.
- Step 1, Bird Dogging: With this strategy, investors search for potential fix & flip deals. They try to find distressed properties with equity in them that owners need to sell. Once they find these leads, bird doggers typically bring them to wholesalers to put under contract. By bird dogging for a period of time, you learn the critical elements to look for in a good deal.
- Step 2, Wholesaling: As discussed above, wholesalers don’t purchase properties. They put deals under contract then assign them to fix & flip investors. In addition to providing investors further experience in finding and vetting deals, wholesaling provides critical experiences in how real estate contracts work.
- Step 3, Fix & Flip: Next, investors need to gain experience in the fix & flip process. In addition to requiring in-depth knowledge of how to analyze potential deals, these investors must understand the actual rehab process. They need to do more than back-of-the-napkin rehab budgets. Fix & flip investors must develop, implement, and supervise a detailed rehab period. This provides significant investing experience in working with contractors, sticking to budgets, and, ultimately, selling properties.
- Step 4, BRRR: This represents the final step in the investor lifecycle prior to hard money lending. BRRR stands for buy, rehab, rent, and refinance. With this strategy, you need all the skills gained in the above steps. But, you now need to gain experience in both A) property marketing and management, and B) long-term financing. Understanding these facets of real estate investing will provide key insight as a hard money lender in assessing a deal’s potential.
When you intimately understand the above steps, you have the experience foundation to begin hard money lending. You still need to learn how to structure deals from the lender’s perspective and how to administer and collect loans. But, you’ll largely have the real estate background knowledge to make the jump into hard money lending. Or, you can also become a lender with us and we’ll send you vetted deals as well as manage the loan ourselves!
How to Invest in Hard Money Lending
In addition to gaining the experience necessary for hard money lending, you also need enough money to actually issue loans. And, that’s a secondary benefit to working through the above investor lifecycle. You not only gain experience, but you can set money aside during the process. While I firmly believe in rolling funds into future deals, I also believe a portion of all profits should be set aside as cash. This gives you tremendous flexibility, and it allows you to slowly build up the funds necessary to become a successful hard money lender.
But having a savings account full of cash isn’t the only way to put together the capital for investing in hard money lending. Here are a few other options available to investors:
Self-directed Individual Retirement Account (SDIRA)
This particular IRA provides an alternative to an employer-sponsored retirement account (e.g. 401(k) plan) or a regular IRA (e.g. traditional or Roth IRA). Investors can convert any of these plans into an SDIRA (NOTE: talk to a CPA about the tax implications of any traditional to Roth conversion). Whereas these standard retirement plans limit investment options, SDIRAs allow investors to pursue alternative asset classes like real estate. A custodian or trustee administers these accounts, but, as the name suggests, the account holder directs the investment decisions.
For example, say you have a traditional IRA with $250,000 in stocks and bonds. You couldn’t normally cash out those investments and use the funds to invest in real estate. However, by rolling your account over to an SDIRA, you could sell a portion of those investments and use the cash to fund hard money loan investments.
Home Equity Line of Credit (HELOC)
HELOCs represent another great option for funding hard money loans. For example, let’s say you have $250,000 in equity in your primary residence. Most lenders will offer HELOCs up to 80% LTV, or $200,000 in this case. But, with a HELOC, you only pay interest on the funds you draw against the line of credit. As such, when you find a hard money lending investment opportunity, you can draw funds to use for the hard money loan.
At first glance, most people will discount this option—that can you make money by lending borrowed money. It comes down to taking advantage of the spread. A primary residence HELOC typically commands a very low interest rate. On the other hand, due to their risk and shorter time horizons, hard money loans generally have higher interest rates. If you can borrow against your HELOC at 3% and lend at 13%, you’re netting 10% profit (13% interest income – 3% interest expense) on the hard money loan you’ve issued.
Bring in a Partner
Alternatively, you can bring in a partner. Plenty of people have money they want to invest but don’t have the time or experience to find solid investment opportunities. As such, it’s not uncommon to see one partner provide the cash, and the other partner finds and manages the deals.
You can split the profits however you’d like. Typically, the partners providing the cash get a preferred return up to a certain point, then the managing partners get the upside. But, you can structure deals however you’d like. Bottom line – this offers a win-win situation. One partner finds great returns, and the other partner finds the capital necessary to invest in hard money loans (while profiting in the process).
Finding Hard Money Lending Deals
Once you have the experience and money, you now need to go find the deals. By working through the above investor lifecycle, you will absolutely have the ability to find solid deals. But, the better question is, do you have the time? Once investors get to this point, they often want to focus on other pursuits. And, even with a ton of experience, finding good hard money deals takes a lot of time and effort.
Fortunately, you can invest in hard money lending without needing to find the deals yourself. By partnering with a hard money lending company like ours, you can drastically reduce your time investment. Put simply, we find and vet the deals, and we then bring them to you. After you conduct your own analysis of a particular deal, you can decide whether or not to lend to a particular borrower. If you move forward with the deal, we can also administer the outstanding loan, saving you the headache of approving draw requests and collecting funds.
While hard money companies charge fees for these services, many hard money lending investors find the benefits far outweigh the costs. You can gain solid returns, but you save a tremendous amount of time by not needing to find and manage individual deals. However, as the lender, you retain foreclosure recourse. That is, if the borrower defaults, you have the ability to foreclose on the property and sell it to recoup your funds. If that happens with on of our private lenders, we manage taking back the property and foreclosure for you.
Is Hard Money Lending a Good Investment?
After providing all of this background, the question remains, is hard money lending a good investment? Absolutely! Occasionally, you’ll need to foreclose on a property. Or, you may just end up with a loser of a deal. But, the key is volume. If you invest in enough deals, you’ll earn outstanding returns.
Due to their increased risk (relative to traditional mortgages) and shorter time horizons, hard money loans command significantly higher interest rates. These higher rates translate directly into solid returns for hard money loan investors—so long as they pursue multiple deals. In that respect, hard money lending faces the same diversification risks as any investment. If you only own stock in a single company, your portfolio’s value will collapse if that company goes south. With multiple stocks, you limit risks through diversification. One company’s poor performance can be offset with the other companies’ solid performance.
When you invest in multiple hard money lending deals—with the proper vetting and experience—the winners will far outpace the losers. Hard money lending offers high returns, and you secure your investment with a property. If a stock’s value drops, you can’t go pick up some of the company’s machinery to sell. You can foreclose and sell the loan collateral as a hard money investor.
Learn how to make money flipping real estate with us by attending our next webinar.