Hard money lending has an undeservedly negative reputation. Among the many criticisms the industry faces are higher interest rates and shorter terms. But there is a valid reason for both: the significantly higher level of risk hard money lenders face. Risk is everything in commercial lending, whether you run a bank or operate a hard money firm.
Actium Partners is a Salt Lake City, Utah firm that offers both hard money and bridge loans. They write loans primarily to real estate investors in Utah, Colorado, and Idaho. Here are the top three risks they say every hard money lender takes with every loan:
1. Payment Delinquency
A typical hard money or bridge loan is structured as an interest-only loan. This is to say that small monthly payments cover only the interest due. Borrowers do not pay off the principal until the loan’s maturity date. With all of that said, the biggest risk hard money lenders face is payment delinquency.
Hard money borrowers are expected to make their monthly payments as scheduled. They are not afforded special treatment just because their loans aren’t conventional. Likewise, a hard money lender faces just as much risk when payments are delinquent. They need those payments to keep their own businesses going.
The unfortunate truth is that hard money lenders cannot be as lenient as banks with delinquent payers. Their risks are so much higher that they need to be very firm in how they deal with delinquencies.
2. Failing Exit Strategies
Borrowers need to present exit strategies with their loan applications. What is an exit strategy? It is a reasonable plan for paying off a loan at maturity. Given that Actium Partners writes most of its loans to real estate investors, an exit strategy they see pretty frequently is the borrower obtaining conventional funding.
A good example would be a client asking for a hard money loan to purchase a commercial office building. The loan comes with a 6-month term, giving the borrower that amount of time to arrange conventional financing. What if he fails and does not have the money to make good on the hard money loan at maturity? It is a risk that both he and his lender take.
From the investor’s perspective, not being able to make good carries the very real risk of losing the property. The lender’s perspective is just the opposite. Hard money lenders do not want to be landlords. Yet they may be thrust into that position if a borrower cannot pay off his loan on time.
3. Falling Property Values
Hard money loans are secured by collateral. In almost every case, that collateral is property. Therefore, the third risk hard money lenders face is the risk of falling property values. Let’s say the economy unexpectedly tanks in the third or fourth month of a 12-month loan. a borrower could suddenly find himself underwater. He may feel like he has no incentive to repay what he owes.
Hard money lenders rely on property values remaining stable. The last thing they need is a situation in which the borrower is struggling to make monthly payments while the value of his collateral simultaneously drops. This puts a lender in a precarious position.
The risks faced by hard money lenders are very real. Those risks can be quite substantial, which is why lenders set their interest rates several percentage points higher than conventional lending rates. It is also one of the reasons hard money lenders prefer short terms. Their goal is to mitigate risk by maximizing interest and getting out of the loans they make as quickly as possible.