Hard Money Frequently Asked Questions

There have always been hard money lenders. It is termed “hard money” because the loan terms as well as the interest rate are “hard” on the Borrower. These lenders function in many markets serving the needs of borrowers who are unable, or for some reason, unwilling, to use regular (conventional) bank debt. The security for these loans varies depending upon which market the lender operates within. In the real estate hard money arena, the security is usually a first lien on a borrowers commercial real estate asset and the personal guarantee of the borrower to repay within the specified loan term.  Additional security is obtained where possible as the lender is aware that the type of loan he is providing has a far greater risk of defaulting and so he will over collateralize the loan as much as possible to increase his chances of a satisfactory pay off. 

Historically, real estate hard money lenders functioned within markets local to themselves, financing single family homes in areas “red-lined” by traditional banks (redlining is discriminatory credit practices against low and moderate income areas) They would provide 50%-60% of the homes value in the form of a high priced, short term mortgage. As conventional banks would not lend in these areas, demand for these mortgages from owners of homes was high and the private lenders required a never ending stream of cash to keep funding the loans. To find this money they turned to individuals who had available capital which they were looking to invest.

For many “Mom and Pop” investors, these types of investments were extremely attractive. The assets had good, simple and understandable security – a  first lien on a house. The loans were in local areas, the Lender wa a local firm and the returns were high. In time, a functioning business model was created whereby investors would own shares of mortgages on a fractionalized basis with other investors, their ownership percentage based upon the percentage of the mortgage they had funded. The lender who found and offered the mortgage to the investors was typically paid a fee at the funding of the loan as well as an ongoing fee to “service” the loan ( collect mortgage payments, ensure taxes and insurance were paid, make distributions to investors based upon their ownership percentage and take necessary actions on behalf of the investors in the event of problems arising). 

The ongoing success of this business model was significantly interrupted following the introduction of the Community Reinvestment Act (CRA) in 1977.  Local banks could no longer “red line” and were obligated to offer traditional, conventional mortgages to borrowers in these areas. The CRA as well as subsequent federal law related to protecting homeowners ( in particular RESPA, the Real Estate Settlement Procedure Act) effectively squeezed private lenders out of this market, leaving them with a large pool of capital available, a corporate infrastructure designed to make and manage real estate loans ..but nothing and no one to lend it to. It didn't take a genius leap for these lenders to turn their focus to the largely unregulated commercial real estate lending arena. It was not an ideal situation. It required far greater technical real estate knowledge, it forced them to look outside of their local “comfort zone” for loans and heavy reliance had to be placed upon third party professionals (appraisers, engineers, attorneys, environmental specialists) In other words, the private real estate lending business became far more complex. Gone were the days of the simple homogeneity of home loans. One of the largest companies who developed along the above lines was a Company in Seattle, WA. It had several hundred individual investors. I use this firm as an example because the model they developed was copied by numerous other firms in the NW, as well as nationwide, all of whom have failed spectacularly in the recent recession. While the failures in the Northwest are particularly notable in that they invariably involved fraudulent behavior from the owners, the real failure was the failure of the fractionalized business model they followed.  Until the recent mortgage and general economic meltdown we witnessed an unprecedented boom in real estate values in parallel with abundant capital in the hands of private individuals. It was a great time to be in the real estate lending business. Hard money real estate lenders sprung up everywhere and a different, more sophisticated model of hard money lending developed in most of the country. 

The lenders who adopted this new model “pooled” investor cash together and then leveraged this capital by borrowing cheap money from banks and financial services companies (known as “re-discounting”), multiplying the amount of their capital three or four fold at a low cost, thereby dramatically increasing the return on their investors pooled cash.

The firms who did not do this continued with the old fashioned, un-leveraged, fractionalized model.  Having so many small investors was extremely cumbersome, expensive and time consuming to manage but the market was good, new investors were joining the firm every day and loans were plentiful. The firms flourished, making huge amounts of money in fees at the closing of every loan. Investors generally were fine with this as the loans routinely paid them a 12% or 13% return,paid off when they were supposed to, and the investors simply put it into a new loan which performed just as well. In a market such as this, everything worked and so long as that check dropped into the mail box every month investors rarely cared as to what was going on behind the scenes, whether an appraisal was good whether the firm was honest in its dealings, whether or not it was a good loan or a bad loan. The greater the number of investors, the larger the loans and the more loans they did. Fee income was at an all time high.

The booming real estate market was not all roses.  As was noted above, competition for loans became tough as cheap institutional capital flooded the market and in response most hard money lenders began lowering their interest rate expectations to maintain a good flow of loans. They were able to this and still achieve high returns thanks to their capital being leveraged which in practice meant a cheaper cost of funds. The Pacific Coast Investment Company model, adopted by the Seattle lenders and many others country-wide, couldn't do this as investor capital was not leveraged and the firms needed to maintain the double digit returns for its investors they had historically delivered. They started to look at areas in the market where they could guarantee a steady flow of loans and still generate the required returns for investors. They found it in smaller loans, loans on special use properties and loans to single tenant properties – all considered “unpopular” by real estate  lending professionals. It also forced them to start lending money to real estate developers. [ It is worth noting at this point that a hard money loan is a bridge loan.  Its purpose is to fulfill a defined event, the funds “bridging” the gap between the current situation and a better, future situation. This better, future situation is what allows the Borrower to pay off. The timeline for this event to take place is crucial as the hard money debt is so expensive on a real estate assets operation that it cannot bear the cost of it for too long.] Development loans however should never be hard money “bridge” loans and hard money lenders should never make loans such as these. There are already issues in place if a borrower is willing to pay a high interest rate and high fees for his loan so why would a lender add to these existing risks by taking the additional risk of construction, and the complex, lengthy timetables to repayment?

The answer was two -fold:

They felt they had no choice if they wanted to guarantee high yielding returns and a steady flow of loans.

This “old fashioned” model of lending, selling fractionalized shares to small investors, was slow and in a bull market every borrower needs his money yesterday.  Construction loans actually suited this lending model as they require an initial funding and then a series of subsequent fundings as the project advances. Lenders would commit to a gross loan amount, fund the initial amount required and then slowly sell off the remainder of the fractionalized shares over the several months of the construction period. (do note that the Lenders fees are payable in full in the first advance to the borrower)  

To pursue unpopular loan types and development situations was a risky strategy. However, rapidly rising land values and the general availability of credit to refinance hard money debt to either alternative hard money debt or conventional debt covered up the foolhardy nature of this type of lending and the generally unsophisticated investors probably felt as comfortable in this type of loan as they did in making an investment in a loan secured by an income producing apartment complex or office building. Even though times were good, hard money lenders routinely engaged in illegal activity during this time. Fast and loose may be a fairer term (and less likely to get me sued) Appraised values were often boosted to make loan to value ratios comply, and there were certainly omissions and misrepresentations made in the offerings to investors to get loans done.   This type of activity was far easier to get away with for the un leveraged lenders as scrutiny by the investors was generally fairly lax and they were rarely in contact with other investors in that loan, for the most part not even knowing who they were.  The vast majority of hard money lenders elsewhere in the nation had adopted the new, leveraged model of lending and therefore had a bank behind them analyzing every loan that was made to make sure it conformed to agreed policies and procedures. Even so, fraud to varying degrees was still relatively commonplace, although perhaps less blatant.

The old style, un -leveraged lenders were making the vast majority of their income in fees at the closing of loans (approximately 90% of income) when  the market crashed. Overnight, new investor capital dried up and existing investor capital was tied up in loans with little chance of immediate repayment. A few loans were done but the glamor of real estate investing was at an end and uncertainty dogged the marketplace.

With so much of their income being generated by fees on new loans how were these lenders going to survive in a market where new loans were non existent?   Where was a source of income to pay rent, mortgages, school fees and car payments? 

There was only one place to find it. 

The loan servicing portfolios. Since the market crash the traditional role of the loan servicer has needed to be redefined and its new role understood. 

Historically, on each loan that was funded, the lender would hold back a small portion of the interest rate paid by the borrower as a “servicing fee” This amount was highlighted in the offering circulars on each new loan and was typically between 0.5% - 1.0%.

The purpose of this fee was to satisfy the costs incurred internally in managing the investment accounts of hundreds of fractionalized investors, calculating the proportionate amounts due to each investor, monitoring loans to ensure the timely payment of real estate taxes and insurance, collecting loan payments and cutting checks for distribution to investors.  The individual(s) assigned to handle this role for the firm were essentially just intelligent administrative personnel. Loans however were starting to fail pretty rapidly. Many loans stopped paying, becoming non-performing loans and in some cases foreclosure was necessary.  Firms now had three distinct groups of “loans” to handle. Performing loans, Non performing loans and Foreclosed assets known as REO (real estate owned). 

The traditional role of the loan servicer described above was accurate for performing loans but the majority of loans were no longer in this category. The loan “servicing” role became much broader and too technical for the administrative personnel assigned to handle it and was also too technical (and ill suited) for anyone else in the firm which was basically comprized of account executives – high pressure salespeople now confronted with the intricate and laborious task of solving technical problems they were not qualified to handle and with no clear idea on how this would be compensated. The widespread defaults caused another major issue. Income to the firm. Only “servicing fees” now remained to generate cash flow. This amount was relatively small and could only be earned if borrowers paid the mortgage, meaning they could only collect fees on performing loans. 

So how could the firms who fractionalized generate enough income to survive?

Legally, they could generate income in areas agreed to by the investors. These areas were covered in three specific documents. The Participation Agreement (PA), the General Offering Circular (GOC) and the Specific Offering Circular (SOC).  

The PA and the GOC were signed and agreed to by the investors when they first became an investor with the firm. The SOC varied on every loan and had to be agreed to by the investor on every loan in which he or she chose to invest. The SOC typically only covered the servicing fee applicable to that loan as well as the loan fees payable to the firm. 

The two crucial documents were the Participation Agreement (PA) and the General Offering Circular (GOC). The necessary legal language which floated between the two documents is relatively specific when it comes to servicing fees.

The lenders right to collect it is covered in the GOC (and the specific amount collectable (which varied ) mentioned in SOC. Any change in the % amount collected for loan servicing would have to be approved by a majority of the dollar ownership of each loan. Other fees which the lender may  charge to the investors are only dealt with vaguely and appear in the GOC. 

These fees arguably allow the lender to collect brokerage fees in the sale of a loan or foreclosed asset and property management fees in the event of a foreclosed asset. 

Other fees were more carefully hidden. The promissory note often included an obligation for the borrower to pay a 5% fee to the lender in the event of a loan defaulting. Any loan which did not pay off in time was guilty of a maturity default and that meant because of the crash EVERY loan had triggered that fee. Even borrowers who were still paying the mortgage wer in default as they hadn't paid off in time.  In theory, based upon loose and subjective interpretations of the PA and GOC, the investors and borrowers could be all kinds of fees. In practice, the firms were finding it very difficult to collect, as many of the investors couldno longer afford to pay costs and fees as all their money was tied up in loans which were not liquidating and the borrowers too were starving for cash. 

Nonetheless, there was no money anywhere else but in these loans.

Confronted with the reality of the depressed real estate market and legally tied to the PA and GOC in terms of what they could charge investors, the Principals of firms who fractionalized were faced with numerous practical and ethical dilemmas. Practical dilemmas in that it was hard to collect even that which was legally owed to them. Ethical dilemmas in that even if they could collect, it was far to small an amount to maintain a functioning company and continue to live in the manner to which they had become accustomed. It was theoretically possible to make new agreements with investors, charging more fees, in more areas and justifying it by pointing to the dramatic market changes and the nature of the work now needed to resolve the problems and return peoples investment. But this was an impossible task.  There was so many investors in each loan it was a major logistical challenge with no guarantee of success plus the investors were already distressed and cash poor. Asking them to bring more money to the table was unlikely to be successful. 

So these lenders often began illegally manipulating the loans, using various old tricks and some new ones to generate income for themselves, juggling loans and investor accounts and praying they could ride out the bad times.

Conclusion

What we have learned is that:

Organization of the investors is almost impossible in the event of widespread problems. Many loans have 200-300 people vested in them. Each of those individual investors is responsible for their share of costs. But some can't pay their share. Others can pay but don't want to. It is true that the GOC addresses this matter, whereby those investors who can pay have to put up the non payers share and they receive this money back in a priority position at a rate of interest. But contacting all the other investors and getting firm answers and commitments is impossible.

      To exacerbate matters, in the case of many firms, they have refused to release meaningful contact information to concerned investors (occasionally names but not phone numbers or email addresses) Accordingly, the only people who even have the ability to organize the investors are the firm itself.

When times were good the goal of the firm was aligned with that of the investors. We make our fees, you make your return. When times are bad, history has shown us that those goals diverge. The investors want their money back, prudently but swiftly. If this is what they want, the firm has a fiduciary obligation to follow their wishes. Of course, this is not in the firms best interest as selling assets or loans means no more ongoing servicing or other fees that might be made from that asset or loan. Without maintaining a virtual status quo in the portfolio they have zero sources of income so asset liquidation, which the investors are generally looking for, threatens the very survival of the firm financially. 

As no one party controls a majority of the loan in a fractionalized loan, no one party can take any legal action on that loan. The logistical issue of having so many small investors prohibits obtaining the majority vote necessary to take action and the remedial formula laid out in the GOC for the investors to take control of their own destiny is totally impractical  in the real world. 

Whilst the loan portfolios may be the only source of income to the firm in the current market the lifeblood will always be the investor base. Regardless of the flagrant breaches in their handling of the investor capital, their actions have always been driven by the hope that they could ride the market storm and return to a healthy lending environment where new loans and upfront fees generated the income they need to survive. Had the crash been a short lived market correction, rather than a deep seated lengthy recession it would be business as usual today. In this event, the goals of the lenders would have realigned with those of the investors and they would have liquidated the portfolio rapidly to give their investors the cash to reinvest.

As we all struggle through the current recession it will be interesting to see if an upswing in the economy brings back the old fashioned fractionalized lending model or if a new, less flawed model will develop to accommodate individual investors who want commercial real estate as part of their broader investment portfolio.

About the author

Nick Orford is a structured mortgage credit professional based in Florida who has been involved in the hard money lending industry for 20 years.

He is the main shareholder of Indie Capital Management, a private lender based in Clearwater, Florida. He is also the owner of Asset Management Services Group, LLC which currently manages $80m of various types of mortgage assets and instruments; and the senior underwriting advisor to First Commercial in California who specialize in private, un-fractionalized hard money loans