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.

No, I’m not writing about NASCAR or the IndyCar Series. And no it is not the video game.

I’m talking about those rare occasions where you need money and you need it fast.

If you are a commercial real estate sales agent or commercial loan broker, what do you do? Do you know who to turn to in a pinch?

In baseball many teams have the left-handed specialist who will come into the game to get one batter out.

Basketball teams have their specialists as well. The Chicago Bulls had Michael Jordan. The Lakers, Kobe Bryant. Who is your “Go-To-Guy” when time is short and you need a “sure thing”?

“Clutch”

Coaches depend on “clutch” players that will perform when the game is on the line.

Do you have a lender you can depend on when there are 10 seconds left and you are down by two? Do you have a “clutch” lender that understands real estate and can salvage a deal when your client’s deposit is on the line and close of escrow is days away?

Built for Speed

Most hard money lenders are built for speed. Some models of business are faster than others, but in general this is one of the advantages of hard money.

Because most private money lenders don’t have FDIC and state banking guidelines to follow they can underwrite and make a decision much faster than a bank. This allows them to fund deals much faster than a bank.

Always Be Prepared

No one plans on a deal going sour at the last minute, but it is good to have a plan for a “what if” scenario.

Like the Boy Scouts’ motto Be Prepared, commercial real estate specialists should have a tool for every situation. Having a relationship with a hard money lender for deals that require them is just another tool in the commercial real estate professional’s belt.

The Essence of a Professional

Which do you think sounds more reassuring to a client and more professional?

“I never have seen this situation happen before. I’m not sure what to tell you Mr. Borrower. I will have to get back to you on our options.”

Or

“Mrs. Borrower this situation rarely happens. However, I have developed a relationship with a lender that specializes in closing loans quickly. They are a more expensive than bank financing, but they will allow us time to find a more permanent solution.”

Quick Close Scenarios

Mr. O’Skool Mr. O'Skool is an experienced real estate investor. He is very "old school" and doesn't like much leverage. He speaks slowly and always has interesting anecdotes about life. He drives a late model station wagon and brags that he has a second matching station wagon at home in the garage. You are not sure you have seen him without a sweater on.

Mr. O'Skool owns a variety of properties He owns two apartment buildings free and clear. Through his network he learns that another apartment house is available for purchase. He knows that he can purchase it from the current owner if he closes in 15 days time at a 15% capitalization rate, otherwise the owner is going to list it on the market.

Can you get Mr. O'Skool the money he needs to purchase the property in 15 days?

Ms. Forshewnat

Ms. Forshewnat is a very successful real estate investor. She began with a few properties her late husband left to her and has parlayed that into a multi-million dollar real estate empire.

Through the grapevine you have heard that she is not extremely pleased with the service she has received from her previous lender. You have been courting her business for a while and she has finally agreed to allow you a chance at winning her business. She tells you that she is has other notes coming due in the coming months.

She has asked you to finance an office building she owns as the note is coming due in 120 days. You take Ms. Forshewnat to one of your lenders that has a great program for office buildings.

Everything is moving along without a hitch until the lender runs a new credit report 20 days before closing. It seems that Ms. Forshewnat co-signed a loan with her 23-year old son who has missed two of his payments. Now her credit score has dropped and the lender is unable to extend financing.

Can you find a lender to close in 20 days in order to keep Ms. Forshewnat from having a default and jeopardizing future loans?

Buying Time

In general, hard money is not a long-term solution. But it can buy you time to find that permanent solution.

Having a reliable, direct hard money lender can be invaluable to commercial real estate professionals.

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.

Michael Stoler of the New York Sun has written an article about our industry. (HT: The Dirt Lawyer)

Mr. Stoler accurately states that for new or inexperienced developers the sources of capital are few and far between. He writes:

“The answer for a growing number of these borrowers is alternative, or specialty, lenders that provide financing at higher rates and with stricter conditions.”

Still Lending

While the credit crunch has decreased the supply of funds, specialty lenders are still willing to lend on the right deal. Specialty lenders can be hard money lenders or hedge funds.

In order to obtain a loan from these specialty lenders, borrowers should have lots of cash and a solid project grounded in reality, not the past boom market. Mezzanine lenders and joint venture funds help borrowers with limited cash acquire the necessary equity to gain financing.

Borrowers should expect a rate in the double digits and higher fees to pay for the speed that specialty lenders provide.

If you need specialty financing, please feel free to call me at (925) 280-5388.

When I am reviewing a loan file one of the first things I look at and look for is the executive summary or loan summary. A well written executive summary speaks to the quality of the borrower and the value of the project. The goal of well written loan summary is to give the underwriter enough information to understand the commercial loan and to determine if the loan will fit within the lender’s lending guidelines.

Below are items that should be included in a well written and complete executive summary.

Salient Facts

Lenders want to know the details of the commercial real estate loan. Property location, property type, number of units, lot size, and the square footage are all important in the underwriting process.

Also include the loan amount and property value. I am always amazed when a loan summary is missing the loan amount or the property value. If the property is being acquired, include the purchase price.

You might also include useful ratios such as loan-to-value (LTV), loan-to-cost (LTC), and the debt-service coverage ratio (DSCR). Rounding these ratios to the nearest 5 or 10 integer can appear deceiving. I personally prefer that these ratios be expressed to two decimal places.

Project History

Include a project history for commercial property that is currently owned by the borrower. This should include the date of acquisition, acquisition costs, and any improvements or monies spent on the project.

Exit Strategy

Owens Financial Group is a bridge lender. Consequently, we are looking to see what the borrower’s strategy is to repay our loan at the end of the loan’s term. The exit strategy may be less important to permanent lenders than to short-term sources of capital.

Sponsor Summary

The sponsor or borrower summary should give relevant facts about the sponsor, but should not be their life story. A more detailed description of the borrower or borrowing entity can be include in a borrower’s resume.

A good summary might look like this:

Fictitious Development Company was started in 1989. Since it’s inception it has developed 32 properties with over 1,000,000 square feet of retail space. With combined sales of $120 million.

Or:

Fictitious Properties Group began acquiring multi-family properties in 1993. Fictitious currently owns in excess of 4,000 units in 7 states with rental revenue of in excess of $3,000,000.

Sources and Uses

This section details the utilization of the loan proceeds as well as the source of any other funds needed for the project. A table or spreadsheet format is most helpful and looks cleaner. If you are seeking a construction loan, this section is vital for the underwriting process. Cost information should only be a summary, because this is the executive summary and not the supporting detail, . The detailed costs should be included with the rest of the packet.

Property Financials

Relevant information regarding the current or projected rental income of a building should be included. The value of income property is determined by dividing the property’s net operating income by a capitalization rate suitable for the market location. Gross Income, total expenses, and vacancy are needed to determine net operating income.

Conclusion

Keep an executive summary short, no more than two pages. Include enough detail for the underwriter to understand the deal and to determine if it will fit in the lender’s parameters. Never mislead or lie on an executive summary. A well written commercial loan summary is often a reflection of the professionalism of the commercial mortgage broker submitting the loan.

What is a Daisy Chain?

I field phone calls from commercial loan brokers all day long discussing the different loan scenarios that come across their desks. Our company advertises in the Scotsman Guide and this generates some “cold” incoming calls.

Frequently, we will get a phone call from a Broker A that received a loan file from Broker B. Broker B received the file from Broker C who received it from Broker D who knows the borrower. This is what we call a broker “daisy chain”.

Merriam-Webster defines a “daisy chain” as “1) a string of daisies with stems linked to form a chain, 2) an interlinked series”. One broker linked to another broker linked to the next broker, etc.

Problems with Daisy Chains

Human nature dictates that every broker involved in the transaction feels entitled to a piece of the pie. Each will often demand their own “fee” for services rendered. Often this is a deal breaker. If there are four brokers in the deal each charging a 1% fee the borrower is now paying a fee of 4% just to brokers! As Brian Brady writes , “what value does the agent bring to a transaction” to demand a fee?

If the borrower balks at the fee, Broker A is likely to say to Broker D, “I know the lender, you know the borrower, if we cut out B & C the fee is only two points and the borrower gets his loan closed.” Now Broker D is in an ethical dilemma, because he plays golf with Broker C on Wednesdays. Does he get the loan closed and burn Broker C to earn the commission?

Let’s imagine that this is a perfect world and all of the brokers in the deal lower their fee to an amount acceptable to the borrower. However, they are unwilling to give up their contact in the chain for fear of a future “circumvention”. So every piece of information needs to be passed from the borrower to Broker D to Broker C to Broker B to Broker A to the lender. (Did you ever play the game Telephone as a kid?)

How to Avoid Daisy Chains

Ask if the hard money lender lends their funds. Or you may ask if the hard money lender brokers their deals. Both of these questions should give you a better insight into the lender’s business model and how they make loans. If a “lender” brokers all of their deals, you may get caught in a daisy chain. Ask enough questions to get a straight answer and to understand the lender.

Remedies for a Daisy Chain

The smart broker that finds herself in a daisy chain situation will take control of the situation and work as the main point of contact for both the lender and the borrower. For example the chain of brokers lowers their fee to 2% of the loan amount. Broker D volunteers to coordinate between the lender and the borrower for a larger share of the commission, say 1%, allowing the other three lenders to split the remaining 1% without having to do any additional work.

Cutting out a broker from a deal, because they do not have a “signed agreement”, is a bad idea. This is a quick way to ruin a reputation and to never receive a referral again.

Summary

Daisy chains should be avoided at all costs. However, if you find yourself in the midst of this situation, take control and work to bring the deal to completion. This is an opportunity to gain a reputation as a broker that gets things done in the eyes of the borrower, other brokers, and the lender.

I get at least one phone call a day requesting construction financing. (Owens Financial Group does fund commercial construction projects on a limited basis.) Underwriting a construction loan is handled differently than a typical commercial loan.

Lenders desire to know that a developer has enough money invested in the project to motivate the developer to overcome the headaches and hassles that are bound to arise during development. A developer with too little invested, is likely to cut their losses and run, if construction problems arise, permits are not obtained, or weather is not favorable. Many lenders will underwrite a construction loan on a Loan-to-Cost (LTC) basis, as well as a Loan-to-Value (LTV) basis.

Loan-to-Cost

LTC is a ratio of the loan amount to the total project cost. Included in total project cost are all of the costs from the time of acquisition to the close of escrow.

Cost Categories

Costs can be divided into two general categories Pre-Development and Development costs. Pre-development costs are those costs incurred before any actual construction work has begun on the property. This includes architectural fees, engineering, survey, legal, entitlement, and permit fees. The property acquisition price, site work, and utility installation may also be included in this cost section. Development costs are those incurred during the actual development of the property. Development costs include site work, material costs, labor costs, overhead, loan fees and interest, landscaping, insurance, and taxes.

Sources and Use of Funds

Many lenders will ask for a spreadsheet or report that details where money was spent and the source of that money, borrower’s funds or loan proceeds. Again, this is used to determine the developer’s investment in the project.

The Devil is in the Details

Different developers account for costs differently and lenders might view developer “costs” differently. Commonly this occurs when a developer has little actual cash left in the project. The developer is trying to appear more invested in the project.

Below are some common cost “red flags” for underwriters:
Interest during the pre-development period. This is indeed an expense, however it has not added value to the land or property. Interest has no value to a future buyer, while entitlements, site work, or utility installation may.
Property acquisition price vs. property “value”. Borrowers on construction loans will often state the property cost based on a current market value. Asking when the property was purchased and the initial purchase price is a key to unraveling this knot. Value can be attributed if the borrower has taken the property through entitlement or assembled multiple parcels of land and is developing a larger project.
Management or supervision fees during development. Most lenders expect the developer to get paid upon completion and sale of the project, not before the construction lender’s risk is paid off.
Single builder/developer projects. If the developer is also acting as the builder, the cost figures might be lower than market costs for similar construction. Should the developer be unable to complete construction, the lender is going to incur a higher construction cost to bring the project to completion.

The Wrap Up

Lenders are always trying to mitigate their exposure to risk. A well capitalized developer, that is invested in the project is more likely to bring the project to completion and to mitigate the lender’s exposure to risk.

Funding construction projects requires gathering the proper detail from the borrower. It also takes an understanding of lender requirements. Different lenders will ask for different documents and schedules. Knowing in advance what they require and acquiring that information from the borrower will speed your loan approval process.

Happy New Year and Success in 2008!

Not many mortgage brokers live consistently in the world of hard money. It is a subject despised by some and feared by others. When I call on brokers for the first time, many of them report, “We don’t do that here.”

I believe commercial mortgage brokers, often times, don’t understand the role hard money lenders can play in serving their clients. Anything new can be intimidating. Especially, something that if not handled carefully can injure your business. Hard money is like a sword: wielded by an experienced broker it is a valuable tool. Wielded recklessly by an amateur, the user is likely to lose a limb or a valuable client.

Below are some hard money hints to help you avoid cutting off a limb.

1. Beware of application fees. Most hard money lenders will require a good faith deposit or an application fee. This when used properly protects you the broker and the lender from a “window shopping” borrower. A good lender will refund this deposit if the loan is not funded, less any expenses incurred by the lender for legal fees, travel, appraisal, etc. However, there are some unscrupulous lenders that collect application fees as a source of revenue with no intention of refunding the fee. Others charge a due diligence fee to even review the loan scenario and underwrite the loan.
2. Beware of hard money brokers. Some hard money “lenders” are really hard money brokers. By this I mean that they do not personally or corporately directly lend the money. They have a list of investors that they broker deals for. These investors may have anywhere from $25,000 to millions to invest in trust deeds or mortgages secured by real estate. Each of the investors has a different appetite for property types and individual lending ability. The “lender” matches the loan request with the proper investor or investors. Sometimes a loan is too big for one of the investor and multiple investors must be sought.
   This may cause problems on larger deals or when time is of the essence. It takes time to match borrowers to investors. Investors may want to review the underwriting themselves. This can delay the loan process until the contract has expired and your client has lost their deal. You may have lost the client.
3. Beware of staged construction funding. “Staged” funding occurs when the “lender” cannot raise enough capital initially to fund the entire cost of the construction loan. The lender is betting that as construction is completed they can raise the additional capital to fund the balance of the construction loan. This tends to happen more frequently with hard money brokers described above. The danger arises when a “lender” cannot raise the additional capital required to complete construction. Your borrower is left with a half-finished project and no money to pay for the remaining construction.
   Often whatever the total amount of funds initially obtained by the “lender” is deposited into an account accruing interest at the borrower’s expense. The borrower has not used the funds, but the borrower is already paying interest on those funds. This is because the “lender” has promised a return to the investor and must start charging interest to maintain that return. Most banks and some hard money lenders only charge interest on the amount of funds used, not on the total loan amount.
4. Cheaper is not always better. I had a boss that consistently told me “Peter, you get what you pay for. You pay for quality, you get quality. You pay less, you get less quality.” This axiom, though not always true, is often true. Though, you may get the loan for a lower price or lower rate, what is being sacrificed to achieve a lower rate? Can the lender perform on time? What is the hard money lender’s reputation? Can they guarantee the funds will be there? Will they be true to their word when it comes to the closing table?
5. Make friends with a hard money lender. You never know when one of your clients is going to need money in a hurry or have a problem with their credit. If you can’t get the deal done for them, your client will look for someone that can. You may not need a hard money lender more than once a year, but it will be nice to know who to call. It never hurts to close one more deal a year.
6. Don’t charge an exorbitant fee, because it is “hard money”. Lenders have underwriting criteria and a risk tolerance level. If a client is willing to pay a broker 10 points to place a hard money deal, something might be wrong with the deal. We tend to raise our eyebrows a little. Please understand that in know way do lenders begrudge you making a commission. Understand that from the lender’s perspective you are not undertaking risk warranting 10 percent of the loan amount. You provide a valuable service and should get paid, just don’t be miffed if lender’s are turned off by a large broker fee.
7. Avoid daisy chain loans. A deal comes across your desk from another broker, who got it from another broker, who got it from another broker, so on and so forth. Usually, every commercial broker in the chain wants a fee and the borrower or lender gets cold feet. These deals can be extremely frustrating because there is a lack of control. If you are the last broker on the chain, you get whipped back and forth by the other end. It will save you a lot of stress and time to avoid the majority of these deals.

This list is by no means exhaustive. It is meant to be a useful tool to get you on the right track to using hard money wisely. I hope that it does.