INTRODUCTION
Private mortgage money offers unique advantages for the professional real estate investor. Private mortgage lenders are able to close most loans in 2 weeks or less whereas institutional lenders require 6 weeks or more to close and fund a commercial mortgage loan. Further, private mortgage loans are asset based; the real property itself is the basis of the lending decision. Hence, if a property is producing or can produce sufficient income to pay the interest on the note and the value of the property will fully secure the note and provide sufficient equity, then the borrower’s credit is not an issue. Instead of concentrating on minute detail of the borrower’s credit history as institutional lenders do, private mortgage lenders concentrate their due diligence efforts on the real estate securing the loan. They provide the professional real estate investor with the ability to borrow on underwriting criteria not available through institutional lenders. No credit check or detailed application forms are required and private mortgage lenders can usually render a decision in 24 hours.
Private or hard money lenders loan up to 65% of appraised value. These loans are typically interest only, paid monthly and due in one year and may be renewable for a second year. Both 1st and 2nd lien financing may be available, with 1st lien interest rates at 8 – 12% and 2nd lien rates at 12-18%. Sometimes there is no application fee or other costs up front; fees of 2 – 5 points at closing are common.
Hard Money Loans
Hard Money Lenders specialize in hard to place short-term real estate secured loans including commercial, construction, bridge, land acquisition, development, residential (in selected areas), raw land and other real estate related loans. These Hard Money Lenders are often used when: time is essential, the project or property does not meet the criteria of conventional lenders, bad credit, bankruptcies, judgments, foreclosures or IRS problems muddy the waters. In order to interest a Hard Money Lender in financing a project the borrower(s) must be willing to adhere to the basics of Hard Money Lending. The term ìHard Money actually derived from the idea that the Project is hard to finance, not that the Lenders are Hard to work with. Hard Money Lenders often will take higher risks and loan money quicker to Qualified Projects than the Conventional Lenders, at a higher rate, but the project must make financial sense. The most important factor to a Hard Money Lender is risk of their investment and the collateral of the project.
WHY REAL ESTATE INVESTORS ARE WILLING TO PAY HIGH RATES TO BORROW PRIVATE MONEY
When interest rates of 8 to 12% are added to 2 to 4 points, the real estate investor/borrower is paying 12% plus annually for the money borrowed. Its obvious why this is a great deal for the private mortgage investor/lender and the broker, but why should real estate investors be willing to pay these high rates when conventional mortgage money costs 4 to 6%? There are many reasons, but all fall into four categories.
Speed of Closing the Transaction.
Mortgage money obtained from banking or institutional sources, called conventional mortgage money, usually takes between 45 and 90 days to fund. Institutional lenders need not only obtain appraisal of the value of the property, but also require detailed examination of the borrower’s credit history and current financial status, as well as financial statements and tax returns not only for the property securing the loan but for all real property and business interests owned by the borrowing entity and the borrower himself. Private mortgage lenders on the other hand can usually complete a transaction within 7 to 10 days. Since the property value itself is the main criteria to be used in determining loan eligibility, much less information on the borrower and the borrower’s other properties are required, resulting in a much quicker approval process. The private mortgage lender is protected by lending at a much lower loan to value ratio, 65% is typical for the private mortgage lender vs. 80% – 90% for the institutional lender. Further, the private mortgage lender can make a decision within 24 hours of receiving information; institutional mortgage money must be approved by a loan committee that may only meet twice a month, and that may send the loan request back to the loan officer for more information, necessitating a further two week delay until the committee meets again.
Real estate investors will often need cash immediately to take advantage of a purchase opportunity below market price. In many cases a seller being foreclosed upon is in denial until the last possible moment. In these cases it may be possible for a real estate investor with cash available to purchase the property at 50-60% of market value – if he can produce funds before foreclosure. Conventional or institutional financing takes way too long. The real estate investor wanting to take advantage of this opportunity either needs to have the cash liquid or utilize the services of a private mortgage lender. With so much profit potential in these situations, paying the private mortgage lender’s premium interest rates and fees is a small price to pay for being able to complete the transaction. If the real estate investor decides to keep the property, he can refinance with conventional money at his leisure. Further, if the investor in the above example seasons his property, that is owns the property for more than a minimum amount of time (6 months- 12 months is usual), then it may become possible for him to refinance based on the appraised value of the property rather than the lower of appraised value or cost. In such a case the real estate investor may be able to pull out some or all of his profit in the form of a new loan in excess of his property purchase price.
Another instance in which opportunity exists for the real estate investor to utilize private mortgage financing is when a property owner is in need of cash quickly – much sooner than possible when borrowing conventionally. I’ve lent in numerous such situations. One was when a lady who owned two rental houses free and clear needed $30,000.00 immediately to get her son out of jail in Mexico. In another situation a real estate investor had allowed relatives to live rent free in a duplex he owned asking that they pay the property taxes. He called me on a Thursday needing a loan; foreclosure for taxes due was to occur the following Tuesday. We were able to close by Monday and save a $130,000.00 property from being lost for $35,000.00 in back taxes, interests and penalties.
Borrowers May Not Want or be Able to Provide Personal Financial Information
The borrower may not have all financial information on all his real properties and businesses up to date or complete; he may have filed for an extension on his latest tax return; his accountant may be behind in preparing his financial statements. The institutional lender will want evidence and confirmation of even the smallest detail of the real estate investorís personal and financial life. This is all important to the institutional lender since he is making a loan based upon the credit of the borrower as much or more than on the value of the property. While not being able to provide complete and detailed personal financial information would negate or at least severely delay getting an institutional mortgage, it should have no effect on the borrower’s ability to obtain a private mortgage loan.
Many borrowers simply do not want the hassle of filling out pages of applications, providing financial documentation, producing profit and loss statements on bank forms, going through credit checks, explaining minor credit issues, or providing tax returns. Many of our borrowers buy 10 or more properties each year; unless they plan to hold a property for the long term they either use bank pre approved credit lines or private mortgage financing. This saves time and hassle and assures them and the seller that a transaction can be completed in a timely manner.
Sometimes life situations dictate the willingness of a real estate investor to provide details of his financial life for a public record where it can be accessed by just about anybody. More than once we’ve lent money to real estate investors with perfect credit who could have easily secured much lower cost conventional financing but were either getting ready to go through a divorce or involved in a messy lawsuit and did not want to provide signed financial statements.
The Borrower and/or the Property Does Not Qualify for a Conventional Mortgage Loan.
This can be anything from low borrower credit scores or too much borrower debt, to the borrowerís properties not producing a sufficient enough income. Further, the property itself may not support the type of loan the borrower wants. Many institutional lenders will not loan amounts under $500,000; many will not lend second lien money even if there is significant equity in the property. If major repairs or rehabilitation is necessary, institutional investors will not be interested unless the project is very large and the borrower has an extensive track record. In these cases private mortgage money may be the only resource for the real estate investor/borrower. If a property is producing or can produce sufficient income to pay the note and the value of the property will fully secure the note and provide sufficient equity, then the borrower’s credit is not an issue for the private mortgage lender.
Professional real estate investors, those entrepreneurial individuals who buy, lease, manage, restore, build and sell real estate full time, will often reach a point in their career where conventional financing is hard to come by. Somewhere between ownership of four small residential units where qualification is based on personal credit history, and ownership of large office buildings where loan qualification is based on the cash flow of the property, all real estate investors run into a financing problem. They have too many properties to qualify as small investors but their properties are too small to be considered for financing on the properties own strength. Further, the professional investor will not have a steady income from a job or business with verifiable history to strengthen credit scores. It is at this point that the investor must make a decision; take on partners or pay the high interest and fees for private (hard) mortgage money. Money borrowed is always less expensive than taking on an equity partner.
Every city has areas that are close to downtown and going through significant change. For most of the last half century this change has been downhill; the flight to the suburbs left these neighborhoods abandoned by all but the poor, the aged and the criminal. However the last five years have brought revitalization to many of these areas. Population growth of these inner city neighborhoods are increasing at a tremendous rate with young professionals willing to pay high rents and empty nest couples willing to pay high prices to purchase and restore these close in houses.
This has presented a tremendous opportunity to the real estate investor with access to non conventional financing. Most conventional lenders have been slow to catch on to this trend; while not specifically redlining these neighborhoods they have enacted barriers making borrowing on these properties for investors all but impossible. We have had great success lending to 5 or 6 investors/rehabbers who buy property in these areas, spend $50,000 plus for improvements and repairs, and then sell them to homeowners. The conventional lender’s refusal to acknowledge property value increases in these areas, unwillingness to lend on property needing repair, and insistence on income verification from the real estate investor/rehabber have allowed us a very profitable niche area for our private mortgage financing.
The Real Estate Investor May Be Able to Borrow More from a Private Lender than from an Institutional Lender
Institutional lenders are concerned with both the appraised value and the purchase price of the property. Private mortgage lenders are only concerned with the appraised value, as long as the appraised value represents a low to medium market price. The real estate borrower will often be able to invest less equity in a property by borrowing private money although private mortgage lenders loan to value will be lower than institutional lenders.
The real estate investor may be able to borrow more from the private or lender and therefore have less of his own capital invested in the property. Institutional mortgage lenders lend based on the lower of the cost of the property or appraised value of the property; private mortgage lenders lend based on the appraised value only. Hence the real estate investor utilizing a private or hard money loan is not penalized for purchasing the property at a significant discount to market value. Additionally, most private mortgage lenders do not have onerous seasoning requirements to make the loan.
INVESTMENT PARAMETERS USED BY THE PRIVATE MORTGAGE LENDER
The investment parameters for private mortgage loans differ considerably from those of institutional mortgage loans, as we partially discussed in the previous section. The most important parameter private mortgage lenders consider when evaluating a private mortgage loan request is the loan to value ratio or LTV. This is the ratio of the amount being loaned expressed as a percentage of the properties value. For example if an office building is worth $100,000 and an investor borrows $65,000 total secured by the office building, then the loan to value ratio, or LTV is 65%. Private mortgage investors will typically lend up to 40% on raw land or undeveloped property; 60% on commercial income producing property such as office buildings, shopping centers, warehouses, etc. and 65% on residential income property such as a duplex or apartment complex. The key words here are up to; the maximum amount will be loaned if all additional criteria are met and if the lender feels good about the loan; lower amounts can be loaned if the either the loan or the borrower is considered less than ideal. This is a gut decision made by the private mortgage lender with an in depth understanding of the criteria being used and the experience of looking at many lending proposals.
Type of Properties
The second parameter is the type of properties to lend on. This is often determined by the comfort the lender has in disposing of this type of property in case of default. All other things being equal, single use property which would take a year to sell is obviously less desirable than a multi tenant office building which would not only sell quickly at 80% – 90% of market value, but which would be producing income with tenants paying rents while the property is up for sale. Different categories of real estate are residential, multi-family residential, office building, office warehouse, warehouse, shopping center, industrial and single use facility. All these categories can be divided further. Residential can include singe family residences, duplexes, or four unit. Multi- family residential can include small (5-20 unit) apartment buildings, medium (20-100unit) apartment buildings, and large (100 + unit) apartment complexes. Each of these categories can be further classified as A, B, C, or D property, based on age, condition, amenities, location, rental rates and area. Office warehouse can be classified by size and condition as well. Shopping centers are usually classified as strip centers, neighborhood centers, area center, town center or regional mall. A single use facility is a facility that can only be used for one type of business, such as a drive thru restaurant, and typically would have only one tenant.
Cash Flow of Property
The third investment parameter private mortgage lenders are concerned with is the cash flow or income potential of the property being put up as security for the note. Although many private mortgage lenders are liberal in this area, the monthly interest payments to keep the note current must come from somewhere. If the property is rented out and is producing a cash flow
after all expenses of an amount at least equal to the note payment, the monthly payments can be covered by the property income alone without the borrower having to come out of pocket. This adds a great degree of safety to the note. Cash flow from other income properties or other sources can be substituted for cash flow from the property being placed as collateral; however, the income to pay the mortgage payments must be available from some source.
Exit Strategy
The fourth major investment parameter lenders must consider is exit strategy. Very simply, this is how the borrower plans to repay the loan. Since most private mortgage loans are short term the private mortgage lender has a keen interest in finding out the borrower’s exit strategy and in analyzing whether this exit strategy is viable, and the risk of this particular exit strategy. The exit strategy must have a reasonable chance of success. Typical exit strategies include property sale before the note is due, refinancing the property with a long term mortgage loan, packaging the property with other properties owned or to be acquired by the borrower and obtaining a blanket mortgage on all the properties, borrowing on equity in other property owned by the borrower and selling a partnership interest in the property to an equity investor. Each of these strategies has numerous variations. The lender must determine the viability of any particular exit strategy. For example, if the exit strategy is to refinance the property, the lender must determine if the credit score of the borrower is high enough to qualify for a long term mortgage; if the property cash flow is sufficient to cover the debt payments on a long term mortgage and if the property will meet the general criteria set up by the mortgage lenders most likely to refinance the property. This analysis becomes very quick and easy with experience and as knowledge of the mortgage and investment real estate market is increased over time.
Ability and experience of borrower
Finally, the private mortgage lender will evaluate the ability of the borrower to successfully operate the property and to successfully complete the property renovation or disposition plan. A professional real estate investor with a long and successful history of investment and renovation in the type of property and location being considered would be considered a prime candidate for maximum financing. A new investor trying to tackle a major renovation project with no construction experience would be prime candidate for a turn down. It is decisions in between these two extremes that will make or break an investment portfolio. To a great degree, adjusting the loan to value downward as the borrowing candidate’s experience and expertise decline can lead to a successful loan. Ultimately, a point is reached where the lender has so little faith in the borrower that the lending decision becomes a matter of whether the lender would want to own the property and whether the property if foreclosed on can be sold for a large profit. Ironically, it is just these situations where default may actually be least likely to occur. We have lend 20-40% loan to value many times where we had little confidence in the borrower but knew we could sell the property for substantial profit in short order should foreclosure become necessary. In each case the borrower had so much equity in the property that they did any and everything to keep payments current. We ended up with good loans at amazingly low risk.
DUE DILIGENCE -HOW PRIVATE MORTGAGE LENDERS VERIFY PROPERTY INFORMATION
Due diligence is concerned with the investigation of the property being used for collateral and the assessment and verification of the investment parameters being used to decide whether to make the loan.
APPRAISAL
The first item for the private lender to consider when performing due diligence is the appraisal report. We have the appraisal done by an appraiser we know and whose work we are comfortable with. The appraisal is a full appraisal, encompassing market, cost and income approaches to determine value. Although we are most concerned with the comparable sales approach, if the other approaches result in a lower figure we will use the lowest figure to determine the maximum loan amount. We insist that at least four comparable properties be used to determine market appraisal, as well as a different four (as rental comps) to determine value by the income approach.
The appraisal report will be fully read to obtain the appraiser’s opinion of the neighborhood and area that the subject property is located in. Appraisals will also have sections pertaining to the growth potential of the property area as well as verification of property demand for rental purposes. All this information must be assimilated by the mortgage lender to help determine his degree of interest in making the mortgage loan.
The appraiser himself and the appraise’s work should be familiar to the lender. The appraiser should be MAI certified, and should have significant experience in appraising and valuing the type of property being considered. Pay particular attention to the comparables being used as a basis for valuing the subject property. These ìcompî sales should be recent (one year or less) with few adjustment differentials with the subject property. Especially with residential property appraisals, the comps should be in the same neighborhood as the subject property. Being able to validate the appraisals accuracy is an art as much as a science. Specific knowledge of real estate industry procedures and standards are necessary, as well as local knowledge of a particular area. Real estate remains a very localized business. If the lender does not have the knowledge to render a reasonable judgment as to real property valuations in a particular location, than outside expertise must be brought in to access the situation.
METHODOLOGY AND PROCEDURES USED IN THE APPRAISAL
An appraisal is defined as “the act or process of developing an opinion of value.” (Appraisal of Real Estate, Twelfth Edition, Appraisal Institute). Real estate appraisal involves selective research into appropriate market areas; the assemblage of pertinent data; the use of appropriate analytical techniques; and the application of knowledge, experience, and professional judgment to develop an appropriate solution to an appraisal problem. The appraiser provides the client with an opinion of real property value that reflects all pertinent market evidence.
The underlying principles in the appraisal process are supply/demand, anticipation, change, competition, substitution, opportunity cost, balance, contribution, surplus productivity, conformity, and externalities.
In arriving at a final value conclusion for real property, an arduous and systematic process is undertaken. This process, as detailed in The Appraisal of Real Estate, Twelfth Edition is set forth below.
The valuation process begins when an appraiser identifies the appraisal problem and ends when the conclusions of the appraisal are reported to the client.
Each real property is unique, and opinions of many different types of value can be developed for a single property. The most common appraisal assignment is performed to render an opinion of market value; the valuation process contains all the steps appropriate to this type of assignment. The model also provides the framework for developing an opinion of other defined values.
The valuation process is accomplished through specific steps; the number of steps followed depends on the nature of the appraisal assignment and the available data. The model provides a pattern that can be used in any appraisal assignment to perform market research and data analysis, to apply appraisal techniques, and to integrate the results of these activities into an opinion of defined value.
Research begins after the appraisal problem has been defined and the scope of work required to solve the problem has been identified. The analysis of data relevant to the problem starts with an investigation of trends observed at the market level – international, national, regional, or neighborhood. This examination helps the appraiser understand the interactive relationships among the principles, forces, and factors that affect real property value in the specific market area. Research also provides raw data from which the appraiser can extract quantitative information and other evidence of market trends. Such trends may include positive or negative percentage changes in property value over a number of years, the population movement into an area, and the number of employment opportunities available and their effect on the purchasing power of potential property users.
In assignments to develop an opinion of market value, the ultimate goal of the valuation process is a well-supported value conclusion that reflects all of the pertinent factors that influence the market value of the property being appraised. To achieve this goal, an appraiser studies a property from three different viewpoints, which are referred to as the approaches to value. The three approaches are described below.
In the Cost Approach, the value is indicated as the current cost of reproducing or replacing the improvements (including an appropriate entrepreneurial incentive or profit) minus the loss in value from depreciation plus land or site value.
In the Sales Comparison Approach, value is indicated by recent sales of comparable properties in the market.
In the Income Capitalization Approach, value is indicated by a property’s earning power, based on the capitalization of income.
One or more approaches to value may be used depending on their applicability to the particular appraisal assignment, the nature of the property, the needs of the client, or the available data. The three approaches are interrelated; each requires the gathering and analysis of data that pertain to the property being appraised. From the approaches applied, the appraiser derives separate indications of value for the property being appraised.
To complete the valuation process, the appraiser integrates the information drawn from market research, data analysis, and the application of the approaches to form a value conclusion. This conclusion may be presented as a single point conclusion of value or as a range within which the value may fall. An effective integration of all the elements in the process depends on an appraiserës skills, experience, and judgment.
PROPERTY INSPECTION
A physical inspection of the property and neighborhood will be done by the private mortgage lender to verify the appraiserís conclusions and to determine property condition. If property condition is a concern, or if renovations will be required to bring the property up to standard, then the services of a licensed property inspector should be obtained and a thorough property inspection by the inspector should be undertaken. The property inspector will issue an inspection report, which of course should be read to determine any physical defects in the property. If the services of a property inspector are not used, the mortgage lender himself should plan on spending a sufficient amount of time inspecting the property to be satisfied that the property has no major physical defects.
FINANCIAL DOCUMENTATION
On any commercial properties or multifamily properties being considered for mortgage investment, the lender will, as part of the due diligence, examine all financial documentation relating to the property. While we as private mortgage lenders are not interested in the borrowers personal finances, we are most interested in the property’s finances, as this will determine the propertyís ability to service the loan. At a minimum the private mortgage lender must see rent rolls, examine leases, be provided with current and past financial statements and pro forma income and expense projections. Verification of the information provided will be done by a combination of checking with the parties concerned and through the lenders ability to determine if the numbers make sense based on his knowledge and experience dealing in these properties.
Due diligence is an on going process of evaluating and investigating each investment opportunity. An experienced mortgage broker will be able to assume a large part of the due diligence burden performed on each loan request.