Hard-Money Loans: Myth vs. Fact
Hard-money loans could provide an easy solution for borrowers in search of a simplified lending process.
This type of loan is growing in popularity as more people begin to realize its benefits, but some remain skeptical. There is more risk associated with hard-money loans than loans from banks or other conventional lenders. Unlike bank loans, hard-money loans lack standardized processes and require higher interest. But they also offer advantages that traditional lenders do not. Below are three common misconceptions about hard-money loans:
Myth: Hard-money loans are expensive.
Fact: While the price tag on a hard-money loan is much higher than a traditional loan, it can often lead to increased return on investment for the borrower.
The majority of big banks and traditional lenders are conservative with loan-to-cost ratios, lending between 50% and 65% of total project cost. This means developers may need to find additional equity to fund the remaining 35% to 50% of their project. On a large project, that additional cost can get expensive.
Alternatively, a hard-money loan covers between 80% and 90% of a borrower’s cost. This higher LTC ratio narrows the gap in a borrower’s capital stack. While interest rates are more expensive, several borrowers have found that this type of short-term loan pays off in ROI.
Hard-money lender Pyatt Broadmark recently loaned to a borrower in Portland who was originally considering using a conventional bank to fund his project, but it took some convincing.
"One client wanted to use a bank loan and raise equity because he thought it would provide a higher return for his initial investors,” Pyatt Broadmark partner Bryan Graf said. “But once he did the math and compared the price of a bank loan and the additional equity he needed to raise with the overall cost of a hard-money loan, he discovered that the hard-money loan was just as expensive as a traditional loan, and he would keep 100% ownership on all future cash flows.”
Myth: Hard-money loans give borrowers less control over their property.
Fact: Developers who take out traditional loans may decide to bring in a partner if they cannot afford to raise equity. This partner would contribute to the equity financing of the project, and a lender would invest in the ownership of the LLC as opposed to a piece of property.
But this alternative has its own set of consequences. Borrowers who opt to bring in external partners often forgo partial ownership of the property, or may need to give up ownership altogether. Meanwhile, hard-money loans use property as collateral, providing borrowers with complete ownership over a given property.
Myth: Banks are easier to deal with than private lenders.
Fact: While big banks and traditional lenders offer a standardized approach to lending, hard-money loans can provide a more streamlined and flexible option.
For new construction and development, hard-money loans are especially effective. It is difficult for banks and conventional lenders to fund new construction deals due to federal regulations. High volatility commercial real estate rules require banks to hold more reserves against construction loans, and the Federal Deposit Insurance Corp. regulates how much funding banks are allowed to provide borrowers. Banks underwrite based on income, so many construction professionals do not qualify for bank loans because they do not have the consistent tax returns or 1099 income required. The banks that do approve loan applications are conservative with the funding they provide. Many large banks have decreased activity in the construction arena due to exposure concerns. These lenders are focusing primarily on serving existing clients rather than opening the door for new opportunities.
Hard-money loans can also be conservative, but they are not bound by federal regulation. They have fewer processes than conventional lenders and banks, so the process is often faster and more streamlined. Lenders like Pyatt Broadmark offer loan closings within a 30-day period. Since hard-money lenders are not beholden to regulations and outside committees, underwriting can sometimes be compressed to 48 hours after receipt of the lending package.
When it comes to project timelines, hard-money lenders are also more flexible than their more traditional counterparts.
“During a construction project, we have the flexibility to modify the loan,” Graf said. “If there is a design change or the borrower needs more funds, we can underwrite additional advances.”
Hard-money lenders like Pyatt Broadmark examine loans with the same level of detail as a conventional lender, but are generally more open to risk. In addition to general modifications, Pyatt Broadmark’s underwriters grant extensions on virtually all of their projects.
"As an unleveraged, all-cash fund, we have no other outside pressure that would discourage an extension," Graf said.
As more construction projects break ground, developers have begun to consider hard-money loans as an increasingly viable option.
“Once a borrower understands the benefits of a hard-money loan, they can decide whether or not it makes sense for them,” Graf said.
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