Peter Pays Paul

Most of the time serious real estate investors do not want to think of calling a hard money lender. The interest rate and fees are likely to give many an investor a heart attack or at least cause them to faint.

However, there are times when a hard money loan makes sense, a lot of sense.

“We’re Out of Time”

Hard money loans are the most effective when time is short. Borrowers or real estate investors that don’t have time to wait for the conventional loan approval should consider a hard money lender.

This situation most often arises when another lender is unable to come through on their promise and a transaction is in danger of falling out of contract. Sometimes this can arise when an opportunity to purchase arises and a discount is offered if the property is closed on by a certain date. This can also arise in the situation of a 1031 exchange, where the purchaser needs to close prior to a looming deadline.

Because hard money lenders use private capital to fund their loans, their organizations are usually much flatter. This means that loans get approved much quicker. So a deal that might take weeks to get approved at a bank, can be closed in a matter of days for a direct private lender.

A Diamond in the Rough

Many real estate investors look for properties that are in need of a little TLC (tender loving care). They need work. Maybe the building is in need of repair or it needs to be reconfigured to maximize the value of the property.

However, with a little bit of vision and a lot of elbow grease this property will be worth significantly more than what the investor paid for it. These are value add deals. The investor adds value to the property and is able to realize the gain through either higher rents or a greater sales price after repairs or upgrades are performed.

These deals too are a good fit for hard money lenders.

Most hard moey lenders are “real estate guys”. They understand real estate and have a good handle on it’s value.

If a deal makes sense and the lender can see the properties future value, then the deal is likely to be approved. However, don’t expect to do many 100% financing deals with hard money lenders.

Cross-Collateralized Properties

Sometimes a borrower does not have enough equity in a single property to get the financing necessary for his needs. Many real estate investors own multiple properties and some of those properties may have a significant amount of equity.

A hard money lender can use one property as the primary collateral and a second property as additional collateral to secure the loan. The properties are said to be “cross-collateralized”.

Because most private money lenders understand commercial real estate value, they are able to be creative and provide these types of solutions.

Getting Deals Done

Hard money lenders are not a good fit for every deal. But in some cases they can provide the best solution to get a difficult deal financed. Borrowers that are facing a huge tax liability for a 1031 exchange gone sour may think a hard money loan fee a small price to pay  in comparison to Uncle Sam’s bill.

Commercial mortgage brokers would do well to take 15 minutes to get acquainted with the lenders on their lender list. While a rate sheet and lending matrix can be helpful, nothing beats a phone or face-to-face interview.

Here are nine questions that will allow a commercial broker to focus their efforts and to target properties to the right lenders.

1. What are your minimum and maximum loan amounts? - Calling a lender with a deal that is either too big or too small is a waste of your time and theirs.
2. Do you have a geographical limitation? – Some lenders can only lend in certain metropolitan areas. A loan outside of these areas is an automatic “No”.
3. What property types do you prefer? – You don’t want to take a loan on an auto body shop to a company that only finances apartments.
4. How long does your average loan take to close? What is the shortest amount of time you have personally seen a deal close? – This is very important to ask if you are dealing with 1031 exchange properties. It can help you weed out lenders for deals that need to close quickly.
5. What is your maximum loan-to-value ratio? – This helps you to eliminate lenders that cannot provide the leverage your borrower needs.
6. What is your minimum debt-service coverage ratio? – Along with the question above this helps you to determine the amount your client can borrow based on the properties income.
7. What information do you require from the borrower in a loan package? – It is frustrating for a lender to receive a trickle of information about a loan over a period of days, weeks, or months. Knowing beforehand what a lender needs, you can  assembled all the necessary documents before you send it to the lender for review and hopefully a quick answer or LOI.
8. What is the best way to contact you if I have a deal? – Contacting the lender through their preferred method shows a deference to working on the lender’s terms. It shows that you want to make things easy for them, not yourself.
9. What loans are you the most competitive on? – Sometimes lenders will tell you that they will lend on a certain type of property, and they probably will. However, the rate, LTV, or DSCR will make it practically impossible to get a loan from them. This question helps to narrow the scope to only the properties they can offer competitive financing for.

These are my nine suggested questions to ask your commercial lender. Do you have any others that you would recommend?

CoStar.com is reporting:

In a real estate alert to its clients, the law firm of DLA Piper in Atlanta, GA, wrote, “For taxpayers who have exchange funds at LandAmerica 1031 Exchange, the automatic stay imposed by the Bankruptcy Court in connection with the Chapter 11 filing will require Court approval of the release of any funds.”

“Accordingly, it is highly unlikely that those funds will be immediately available, and they may not be available in time for the scheduled exchange closings, if any.”

Another Blow to Faltering 1031 Real Estate Industry – CoStar Group.

CoStar reports that there are 450 exchange customers with transactions pending.

It is likely that some of these exchanges may fall out of contract because those in the “upleg” of their transaction will not be able to purchase the property.

If the bankruptcy court does not move quickly to free the funds, some of the exchanges may incur tax consequences if they do not close within the IRS mandated time frame. This could be a terrible mess for commercial real estate investors.

Real estate investors that are seeking to grow their invested capital commonly use 1031 Tax-Deferred Exchanges.

These exchanges allow the borrower to apply more of the proceeds from the sale of an existing investment property to the purchase of a new investment property.

1031 Exchanges Defined

This is an explanation of an 1031 exchange according to the IRS website:

Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031.

My explanation in a nutshell: a real estate investor can sell a piece of investment property, defer the capital gains tax until a later date, and roll the entire gain into the purchase of a new piece of investment real estate. The taxes are deferred (postponed) until the investment property is sold the final time.

Benefits of 1031 Exchanges

Deferring the taxes due on capital gains (appreciation) can reap huge rewards over time. Deferring payment of capital gain tax allows the savvy investor to apply more capital towards the purchase.

Leverage should allow the investor to generate a higher return through appreciation and/or cash flow.

1031 Exchange Hurdles

Now of course the government doesn’t make it an easy process and sets limits and restrictions on how a 1031 Exchange must be executed.

One of the main restrictions is the timing on completion of a 1031 Exchange. The exchange must be completed within 180 days of the transfer of the exchanged property. This deadline can put pressure on all involved to complete the deal within the 180 day period.

The costs of missing this deadline can be large. The borrower will be forced to pay capital gains tax on any gain as well as any penalties that might be incurred if the contract date is not met.

Most exchangers will typically qualify for standard financing. However, on occasion an institutional lender will be unable to provide financing within the mandated 180 days.

Using a Hard Money Loan to Execute a 1031 Exchange

If the primary lender is unable to close on time, what is the investor to do?

One of the benefits of using hard money is the speed that hard money lenders provide. A hard money lender that lends their own funds and is well operated can provide commercial financing within 14 days of receiving a complete package.

Another benefit is that most lenders offer loans on a short term basis. The hard money loan can help an investor close the transaction while a more permanent loan is arranged.

While the fees associated with hard money may be higher than a traditional source, the benefits of completing the transaction within the mandated time may outweigh the costs.

1031 Example

The following example should help demonstrate my point. Below are the assumptions we will use for our example.

Below are the costs that would be associated with a failure to execute the contract on time. I have only included what I would cite as the most basic and immediate costs. (There would be the potential loss of future returns as a result of cash flow and/or appreciation.)

The current capital gains rate is 15% but is set to increase in 2010. By including the deposit I am assuming that the deposit became non-refundable at some point.

Below I have computed the after tax costs of a hard money loan. The pricing below is on the high side for a short-term, conservative LTV loan.

Conclusion

As you can see from the example the after-tax cost of hard money may be less than the cost of not executing the 1031 exchange on time.

Hard money is not the best option for all scenarios. When a deal is on the line and speed is needed, hard money is a good alternative to institutional financing.

For more information head on over to Jeff Brown’s blog to find out more about 1031 exchanges and when to execute them.