When developers seek to fund their projects there are numerous ways, beyond conventional bank loans, to secure the financing. One such option is to turn to private individuals or a group of individuals that lend money (Hard money) based on the project and not necessarily the credit-worthiness of the borrower.
These hard money loans typically cost (percentage-wise) significantly more than the conventional mortgage. Rates are often twice what a normal mortgage commands, and they often include additional costs in the form of origination fees.
Due to the higher cost and subsequent debt exposure, developers must be certain of a project’s timeline, costs, and ending value in order to maximize the return and mitigate the higher cost and fees of hard money loans.
Here are 5 scenarios where it makes sense for a developer to use hard money loans.
In cases where cash is needed to fund a purchase of a property that needs work completed in a shorter time period, a hard money lender is an excellent option. The ideal timeline is weeks to a month to get the work done, minimize expenses, and resell for a profit.
With a hard money loan, the cash is immediately available to fund the rehabilitation and repair projects. When the house is sold, the hard money loan is paid off after closing with the sale proceeds. Whatever remains after selling and paying off the loan would be considered profit. The obvious challenge here is keeping repair costs low, completion on time, and successfully evaluating the market and sale price once the project is finished.
The hard or private money lender will generally lend on the value of the property, its ARV (after repair value), or what it will rent for. Getting a bank to consider the ARV is a cumbersome and at times impossible task. Hard money lenders are flexible and often open to cover the costs of repairs and rehabilitation while focusing on the ending value of the property as security on their investment. This flexibility makes the hard money loan ideal for rehab properties.
Some hard money lenders may require money be accessed in the form of draw, or the ability to show physical progress on the repairs before accessing additional funds. This is a way for the lender to be certain the money is being well spent and the project managed appropriately.
New Construction in a Hot Market
An experienced developer or home builder who knows how to efficiently and effectively set up and complete a home build for a quick sale should consider hard money as an alternative to conventional financing. Hard money loans can cover the land purchase, as well as the build and closing costs, leaving the builder to pocket the profit after a quick sale in a hot neighborhood or market. An even better scenario is having a buyer already lined up for a quick close once the property is ready.
Properties at Auction
Purchasing a home at auction typically requires an immediate downpayment and the remaining balance of the winning bid be submitted in cash within 24 to 48 hours. Traditional mortgages are not an option here. If a property can be purchased at a significant discount at auction, a hard money loan becomes the ideal vehicle for someone who is unable to come up with such a large amount of cash at once. The shortened time-frame and little ability to inspect the property before bidding, however, add a much greater level of risk and all parties should be clear on the terms of the loan and how the proceeds are being used.
Any Rental or Investment Property with a Solid Plan to Replace Hard Money on the Front-end with Back-end Traditional Financing
In this scenario the borrower uses hard money upfront, funding nearly all of the upfront costs of the purchase and rehab or repairs. This can be a way for the buyer to control costs while getting the rehab done with little to no out-of-pocket money. Once the rehab is completed or the home is rented, the owner can coordinate a traditional mortgage with the new home value and proven income as collateral. The proceeds of the bank loan can then be used to pay off the hard money loan.
If a hard money loan fits well with one of the scenarios outlined above, then borrowers will want to begin by making sure that the property or project has the ability to generate future profits either in terms of income (rent) or proceeds from the sale.
The potential profits need to be outlined and presented at the time of investment. Borrowers should always have a sound repayment or exit strategy to present to the private lenders. This also informs everyone involved of the overall feasibility of the plan. money loans on longer-term projects are never a good idea due to the added cost and expenses, but for short-term rehabs, flips, or quick sales, they can be a powerful tool.
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