Think Hard Money Lending is Easy? Think Again!

Real estate investors who need funds to jump on a deal quickly often turn to a hard money lender. For a number of reasons, it’s just easier all-around than trying to secure a traditional loan. Banks and other traditional lenders often have a lot of hoops for applicants to jump through, in terms of requirements. But that can result in a long and tedious process. And when an investor finds that “sweet deal,” he or she needs the money now—not 90 days from now.

Hard money lenders typically offer short-term loans or “bridge loans” backed by the value of the property instead of the creditworthiness of the borrower. Hard money loans may have higher loan-to-value (LTV) ratios than traditional loans and typically require that a borrower pay between 2 and 5 “points” (a point is a fee equal to 1 percent of the loan amount) and interest in excess of traditional subprime loans (ranging from 10 percent to 18 percent per annum).

But don’t get the idea that being a hard money lender is “easy money.” There is hard work involved here, as in any successful business. Let’s look at some points to consider in structuring and operating a hard money lending business.

The first question is: Are you using your own or investor funds? If you are using funds from private investors to fund a hard money lending program, you will need to make some fundamental structuring decisions about what you will give investors in exchange for their investment.

3 Common Hard Money Loan Structures

Here are some common hard money loan structures:

1. Matching Service: The hard money lender provides a matching service (matching private lenders with borrowers).

• Investors would be given a promissory note as evidence of the loan, signed by the borrower.
• These types of loans are typically secured (recorded) by a specific collateral property, and investors are given a fixed return (interest) for their investment. Or less commonly, they may be given a share of equity generated by the borrower (as in a shared appreciation loan or participation loan).
• The hard money lender earns fees for its matching service.

2. Lender is a Borrowing Entity: The hard money lender borrows money from private investors, pools it with its manager’s funds or the funds of other investors, and then loans the collective funds to others in the hard money lender’s name.

• Investors would be given a promissory note as evidence of the loan, with the hard money lender as the borrower.
• These types of loans are typically unsecured (not collateralized against a specific property).
• The borrowers would also sign a promissory note with the hard money lender, but with different terms (higher interest and points) than what the hard money lender pays to its investors.
• The hard money lender would earn all or part of the points generated from loan origination plus the difference between the interest rates (spread) earned from borrowers and paid to investors.

The hard money lender in this scenario is “in the business” of issuing promissory notes to private investors. Because promissory notes are securities, the hard money lender would need to raise funds from private investors under a securities exemption such as Regulation D, Rule 506 or an intrastate private offering exemption. (You can read more about this in our article titled “506(b) or 506 (c)—That is the Question” on our website. Investors would be given a private placement memorandum (disclosure document) explaining the risks of the offering, and sign a subscription agreement. The hard money lender would issue a promissory note to the investor in exchange for his or her money. Securities legal counsel should be sought for this option.

3. Pooled Fund Structure: The hard money lender pools money from private individuals by selling interests in a legal entity such as a limited liability company, usually called a “Fund,” where the Fund makes the loans to borrowers.

• Investors may be given a fixed (or “preferred”) return for their investment and/or a share of equity that the Fund earns on its loans.
• The Fund would make loans to borrowers, and it would record its interest against the property serving as collateral for the loan. The Fund is the hard money lender in this case.
• The “Fund Manager” would earn fees and a share of profits that the Fund generates from loaning its capital to others. This scenario would require the Fund Manager to raise funds under a securities exemption, such as Regulation D, Rule 506 or an intrastate private offering exemption.
• By selling interests in a limited liability company, the Fund Manager is issuing “investment contracts” to private investors. Because investment contracts are securities, the Fund Manager would need to raise funds from private investors under a securities offering such as Regulation D, Rule 506 or an intrastate securities exemption. Investors would be given a private placement memorandum explaining the risks of the offering, and sign a subscription agreement and the operating agreement to invest in the Fund. Securities legal counsel should be sought for this option.

Once you decide your hard money lending business model, you have to answer additional questions regarding both raising the money and loaning the money.

Questions regarding raising the money

• What terms will you offer investors?
• What fees will the Fund Manager earn? Will you offer a preferred return (where investors get paid a specified return before the Fund Manager earns something), or will you simply split profits?
• Will you have more than one class of investors? For instance, you could offer a higher preferred return or a higher interest rate to investors who invest more than a certain dollar amount.
• How long will you keep the Fund open to new investors or will you keep the fund open indefinitely (evergreen)? If so, will you offer a redemption program where investors can request their initial investment paid back if they want to get out of the fund?
• Will you establish a maximum dollar amount you will raise, or perhaps a minimum that you must raise before you use investors’ funds? If you establish a maximum, once you have raised the maximum dollar amount, you will close the Fund to new investors, and as loans are repaid (unless you have a specified reinvestment period), you will begin to repay your investors their initial investment.
• When will investors get their money back? You must decide how long you plan to operate the company; will it have an end date? If so, you will typically have a reinvestment period where the proceeds of loans that are repaid within a specified period (e.g., three years) can be used to originate new loans, followed by a liquidation period where investors are paid back their investment as loans are repaid by borrowers.

Questions regarding lending the money

In addition to the choices described above, you will need to decide on the loan terms you will offer to borrowers:

• Will you require that borrowers pay straight interest, shared appreciation or a combination? A shared appreciation loan is where the borrower splits profits with the lender that it generates from the collateral property.
• Will you require that points be paid on origination or periodic payments prior to maturation of the loan? Or will you allow the borrower to pay the entire loan balance plus points and interest on repayment of the final principal repayment?
• Will you charge points plus interest? If so, how much? Is it the same for every borrower, or is it determined case-by-case?
• How will you underwrite the properties? Will you use a broker’s price opinion? An appraisal? Who pays for it?
• Will all loans you originate be first-position, or will you offer second-position loans?
• What is your underwriting process to determine the sufficiency of the borrower’s collateral property? What methods will you use to determine it?
• What is the loan-to-value ratio for loans you will originate?
• Will you underwrite the borrowers themselves? What kind of qualifications must they have?
• Will you allow borrowing by individuals (which may trigger the Dodd-Frank Act or SAFE Act) or will you require that they borrow via a legal entity?
• Will you require a loan application, and will you run the borrower’s credit?
• Is there a minimum FICO score requirement? Will you verify income?
• Will you require borrowers to give personal guarantees?
• Will you use MLOs or loan brokers to qualify borrowers?
• What duration are your loans? Will you offer extensions? If so, on what terms?
• Will you sell your loans to secondary note buyers or hold them for repayment?
• Who services the loans? (The manager or an affiliate of the manager, or a third-party loan servicing company?) Who pays the cost of loan servicing? (The hard money lender or the borrower?)
• Will you obtain a lender’s title insurance policy on every loan?

Is a license needed?

Any of the above options may require the hard money lender or Fund Manager to have a mortgage loan originator’s (MLO) license to lend the money. Lending is largely governed by state law, so you must check with a mortgage brokerage attorney licensed in each state where you will originate loans.

Although there are some exceptions from licensure for lending to non-owner-occupants who do not use the funds for personal, family or household use, some states (e.g., Florida) have taken the position that loans originated on residential property (even to non-owner-occupants) may be considered residential loans that require a mortgage loan originator’s license. Further, in some states (e.g., California), a real estate broker must make or arrange the transaction or all loans will be subject to the state’s Usury limit of 10 percent.

A hard money lender should check with a real estate attorney or the real estate regulatory agency in the states where the money will be loaned to determine what licensing, if any, may be required.

Further, all of the options will require a sophisticated accounting system to keep track of loans on behalf of investors and borrowers. There are third-party fund managers and loan administrators who can help with this. Various private lending associations can also refer resources for private lenders.

Chances of success

The answers to the following questions will determine the Fund Manager’s likelihood of success in raising money for the Fund:

• Do you have a track record originating and servicing similar loans?
• Have you ever raised money in a securities offering before?
• Do you have a network of existing investors who might invest in your loan program?

Seeking experienced counsel may be in order

As you can see, hard money lending is a complicated business and should not be undertaken without proper training and planning. And in some cases, experienced securities and licensing attorneys will be required to help guide you through the process.

NOTE: This information is of a general, educational nature and may not be construed as legal advice pertaining to your specific offering, exemption or situation. Any such advice must be sought from your own attorney pursuant to an attorney-client relationship, after consideration of your specific facts or questions. At Syndication Attorneys, PLLC, we will be happy to discuss your investing goals with you. You can schedule a free, 30-minute consultation by clicking this link.