A variety of financing options exist for commercial real estate – both debt and equity. All of these options come with their own pros and cons, meaning some financing sources make more or less sense, depending on the specific deal. For developers and investors, financing speed and flexibility sometimes take priority over costs. In these situations, commercial real estate hard money loans can be useful, so we’ll use this article to provide an overview of these loans.
Specifically, we’ll cover the following topics:
- What is a Hard Money Loan?
- Hard Money Loan Pros and Cons
- Using Hard Money for Commercial Real Estate
- Final Thoughts
What is a Hard Money Loan?
Traditional Loan Underwriting
Traditional commercial lenders take a fairly holistic approach to loan underwriting (i.e. the lender’s vetting and approval process for a particular loan). Say, for instance, you apply with your local credit union for a commercial mortgage on an apartment building.
As part of the underwriting process, the lender will certainly look at the property’s financials and income-producing capacity, lease stability, value, and condition. But, that’s only one part of the review. Additionally, lenders will closely analyze your (i.e. the borrower’s) financial situation. Except for the most experienced real estate developers, the vast majority of commercial mortgages will require a personal guarantee, even though you’ll be borrowing in the name of a business entity – typically an LLC. As such, banks want to know that you can keep making your debt payments, regardless of what happens at the property.
At a minimum, this personal financial review will include a close inspection of:
- Personal tax returns
- Personal credit score, judgements, and bankruptcies
- Personal financial statements (essentially a personal balance sheet and income statement combined)
- Related business profit & loss statements
In addition to being an intrusive, detailed process, this underwriting takes time. Most traditional commercial loans don’t close before the two- to three-month mark.
Hard Money Loans as an Asset-Based Alternative
A common misconception exists that hard money loans are so named because of the difficulty in securing them. Rather, the name comes from the fact that approval for these loans rests solely on the hard asset, that is, the underlying commercial real estate.
With hard money loans, private lenders (e.g. high-net-worth individuals, family offices, etc.) review applications based on the value of the underlying real estate – not the borrower’s financial situation. Hard money lenders will commission a commercial real estate appraisal to determine the property’s value, and they’ll offer a loan based on this appraised value. Depending on the particular deal and lender, borrowers may secure a hard money loan for anywhere from 60 to 80% loan-to-value (LTV).
As part of this process, hard money lenders will secure a first-position lien on the real estate. That way, if the borrower defaults, the lender recoups its funds via the foreclosure process – seizing and, likely, reselling the property.
Unlike traditional commercial mortgages, hard money loans can close in as little time as a week. But, this speed and lack of personal financial review translates to increased lender risk, which means hard money loans have significantly higher rates than traditional mortgages.
Hard Money Loan Pros and Cons
Hard Money Pros
- Speed: If you need financing fast, hard money loans offer a potential solution. With limited document review and closing timelines as brief as a week, these loans make sense for investors looking to quickly seize a real estate opportunity.
- Deal flexibility: Hard money lenders also offer more flexibility in financing unique deals. For instance, a traditional lender will likely avoid deals involving retail centers with marijuana dispensary tenants. Hard money lenders may not worry about this type of tenant, so long as the property appraises.
- Personal credit flexibility: If you have a low credit score, judgements, or bankruptcies, you will likely not qualify for a traditional commercial mortgage. Due to the fact that hard money lenders focus solely on the value of the underlying asset, borrowers with troublesome financial histories can still qualify for one of these loans. (NOTE: However, borrowers with a criminal history likely will not qualify for a hard money loan).
Hard Money Cons
- Cost: Hard money lenders make you pay for their speed, flexibility, and lower underwriting standards. These loans typically come with large origination fees and interest rates several points (or more) higher than the market rate for commercial mortgages.
- Shorter terms: Hard money loans also come with significantly shorter terms than traditional mortgages, typically from the three-month to one-year range, depending on the deal. To avoid a default situation, investors should have an absolutely solid exit strategy before securing a hard money loan (e.g. refinancing into a long-term mortgage, selling the property, bringing in outside investors, etc.).
- Non-amortizing nature: Unlike traditional mortgages, hard money loans are non-amortizing (i.e. interest only). This means that, with each debt payment, the borrower doesn’t pay down the outstanding loan balance at all. Rather, these loans come with a final “balloon” payment, with the borrower curtailing the entire loan balance. This non-amortizing nature goes back to the importance of having a financing exit strategy before taking out a commercial hard money loan.
Using Hard Money for Commercial Real Estate
In this section, we’ve outlined three common situations that an investor may use a commercial hard money loan. But, these are by no means the only situations.
Situation #1: You Need Financing Quickly
In commercial real estate, some deals only present themselves for a limited window. If you have a time-sensitive investment opportunity, you may want to jump on it before you have time to raise outside equity capital and secure long-term debt financing. Hard money loans can let you seize opportunities before locking on more permanent financing options.
Situation #2: You Need a Short-term Loan Between Transactions
Some situations require cash to “bridge the gap” between separate transactions. For instance, an investor may need cash to buy one property while selling another. Or, a deal may require a certain amount of cash to close, and an investor capital call cannot be completed in the timeline. In both of these situations, hard money loans can serve as a bridge, providing short-term financing to make one deal happen while waiting on another transaction.
Situation #3: You or the Property Don’t Qualify for Traditional Financing
Due to poor credit or other financial history “black marks,” many borrowers won’t meet a traditional lender’s strict underwriting standards. Similarly, unique deals, property types, or “unconventional” tenants may also not qualify for traditional financing. In both cases, a commercial hard money loan may provide a reasonable financing alternative.
Hard money loans don’t make sense in every commercial real estate situation. Their higher costs and shorter terms may not appeal to some investors and developers. But, when you need flexible financing quickly, hard money may be the best option.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.