Clearing up something about private lending...

[Alex Breshears]

Since I get these questions a lot - I thought going out to the BP community to see what they think might be educational.

As a private lender, I've discovered the term is very ambiguous and vague to borrowers. There are not unified terms within the lending space to differentiate a lender like myself that lends out their own capital in defined ways secured against real estate, a lender that is more synonymous with 'hard money' that has very strict underwriting criteria and documentation requirements, a friends and family lender that may give a borrower money for the downpayment or closing costs - or even DSCR lenders that will offer permanent debt on properties.

It gets confusing for borrowers. Before the pandemic of 2020, most borrowers didn't think about where the money came from to fund their deal, as long as it showed up on the closing day. Now, understanding the source of your capital and what can be done with that source will allow an investor to reach out for the right tool at the right time.

"Private Lender" as I am using it here denotes individuals (or their business entity) that are lending money they directly control and keep for the life of the loan. They are not turning around and selling it on the secondary market, so they have the freedom to be more flexible on underwriting and loan terms. Many have a business model of keeping the lights on with interest paid during the life of the loan. These lenders will want to have their capital backed by an asset - usually some piece of property. This will be done by filing a lien (mortgage vs deed of trust) in the municipality where the property is located.  A few smaller private lenders may offer 2nd lien products, but they will be under very specific criteria and with a combined loan to value usually below 75%.

"Hard money" as I'm using it here will be the large lenders you see advertising everywhere. They can usually lend in most, if not all, states in the US.  They have institutional backing from possibly a large fund, hedge fund, warehouse lines of credit, or large business lines of credit.  Usually these lenders are selling their loans on the secondary market and off to fund the next deal. Their business model relies on deal flow, and that requires some conformity to what the secondary market is willing to buy. That's why you see the very strict underwriting criteria and documentation requirements for these types of lenders.  These can be a great asset if you have a very standard deal, good credit, lots of experience, and potentially time for a more thorough underwriting to close your deal. They also have much higher maximums than some private lenders, so if you are looking to take down a luxury property or even a medium sized multifamily deal quickly - these types of lenders can be a great resource.  Some may also offer a short term bridge debt option that rolls into permanent financing at a certain benchmark, saving in refi costs.

DSCR lenders as I'm using it will be permanent debt financing for many investors because these loan products look heavily at the income the property produces. The underwriting may involve a credit check on the primary borrower, others do not but may require a personal guarantee signed by members of the business entity borrower. Terms can vary widely in this category from annual interest rates, prepayment penalties, income calculation, DSCR ratio, maximum loan to value, minimum and maximum loan size, amortization period, and requirements to escrow taxes and insurance. If the property is in a habitable condition at the time of purchase, and will have an income that can support the purchase price, these are a great option for many investors as long term permanent debt.

Where I think the waters get muddiest is with people seeking "gator lending".  These investors are looking for capital for anything and everything from earnest money deposits, renovation costs of the property, downpayment and closing cost assistance for acquisition of a new property, or help with holding costs while the property is undergoing renovation and not producing income.  Most of these requests have no ability to secure the capital against an asset, or if there is a 2nd lien placed on the property it may be behind a lender that doesn't allow junior liens.  While there can be ways to secure your capital in this type of lending, in many instances that I have seen these deals go bad because the borrower was undercapitalized to begin with, both borrower and lender are inexperienced, and neither understand the risk they are taking on. Yes, there is risk for the borrower doing this type of lending.  If you have a foreclosure notice or judgement pop up in public records, you will have a much harder time getting loans in the future to continue your real estate investing journey.

So what has your experience been with lenders?  Do you agree with this broad assessment? I realize these are highly generalized, but in order to provide a bit of clarity to investors on the sources of capital available to them I thought this would be a good starting point.

[Don Konipol]

Quote from @Alex Breshears:

Quote from @James Blair:

I totally agree. Being a private money lender who lends out my own money, the typical response I receive from potential borrowers is that it is hard money. Seems like there are a lot less private lenders out there relative to hard money lenders. Both have their advantages and disadvantages.

@ George Randall - I like your term "institutional" lenders and will use that when trying to explain the difference between private money and hard money on the next opportunity.

I agree with you! There probably are many
more private lenders like us than the institutional hard money lenders when you look at sheer number of each - but the “big guys” have the ability to market and advertise much more - they are placing a larger volume of deal flow - so they get a lot of attention. The little guys like us just quietly do our thing in our network. I really enjoy that aspect of my business - I work with some great people over and over. Everyone gets set up for a win - and we watch each other prosper. What I don’t think a lot of people realize is we are taking money back from Wall Street and putting it on Main Street. We are helping our communities, business owners in our communities etc. 

First, your original post is an excellent and well thought out analysis.  
I’m not sure that the term private lender and hard money lender are measuring exactly the same thing.

Private money refers to the source of  the capital, while hard money refers to the terms offered. 
so, by my definition one can be both a private lender and a hard money lender. 

In my experience "hard" money is used to describe an extreme section of what's referred to as asset based lending. So, hard money would encompass most if not all of the following characteristics: not credit based, loan amount based on the value of the hard asset offered as collateral, high interest rate and high points, short term loan, relatively low LTV, low documentation requirements, non cash flowing properties still considered.

Private lending is a little harder to define.  I’ve heard essentially 2 different definitions.  The more expansive definition is any lender that isn’t “conventional or institutional “.  On the other extreme is lending from an individual lending only his own or family money.  

In my case I started out 20 + years ago as a private hard money lender lending only my own capital. When I invested (lent) as much capital as I wanted to, I started lending out friends and referrals capital. About 2 years into lending I had so many investors I needed to formalize the business and formed my first "fund", whereby the investor were limited partners in a portfolio of hard money mortgage loans. When we got into larger loans, we decided to syndicate each loan into a separate Series LLC so that the passive investor could pick and choose if and how much he wanted to invest in each loan. Interestingly, our criteria and qualifications and terms have changed remarkably little in the ensuing 20 plus years. So, from the borrowers viewpoint not much has changed.

Under the definition of private lender you proffer we would not be included at this point, despite the fact that the borrower is getting almost exactly the same thing as when I was lending only my own money.  But, I probably had more stringent criteria even then than most private lenders as I always was aiming to scale this business. Interestingly, and providing support for your position, when I come across a deal I really like but doesn’t fit into our criteria for our fund, my partner and I often invest in it as individuals.  So I guess in this limited instance we are private lenders.   

Anyway, thanks for opening up this interesting discussion.  The major takeaway for the investor looking for funding is to understand different funding sources and figure out which provides the greatest benefits and they have a realistic chance of funding.