Often, the initial reaction of residential real estate investors is to shy away from hard-money loans due to the higher rates and fees. As a hard-money lender in Los Angeles, I want residential investors to know and understand the strategic use and placement of a hard-money loan in a fix-and-flip or a long-term hold scenario.
The key takeaways from this blog are:
- hard-money loans are a short-term solution from acquisition through rehab
- hard-money loans can close within weeks of the application
- hard-money loans can be utilized for short- or long-term holds
Why a Hard-Money Loan?
Private equity, or hard-money loans, are the best alternative financing mechanism when a conventional loan cannot be accessed. A hard-money lender will underwrite an investment opportunity from a value-add perspective; as a traditional lender will not, and cannot, do so.
The underwriting criteria for this financing alternative measures the risk of the creation of value at the back end. The investor’s experience in the residential sector is an important factoras opposed to credit scores and the stability of the property.
How Does a Hard-Money Loan Work?
The best application of a hard-money loan is acquiring an under-priced property needing repair and rehab. The objective is a quick, simultaneous close, perform the rehab project on time and on budget, place a tenant, and either sell the property or refinance with a conventional loan when the property stabilizes.
Below is an example and an explanation of how a hard-money loan would work in a fix-and-flip scenario.
- An opportunistic deal is identified. The seller is motivated and will sell the property for $300,000.
- The investor has $125,000 to invest in the deal.
- From the investor’s experience and connections in the market, it is realized that, for an investment of $100,000 for the rehab scope, the value-add will raise the property’s market value to $550,000.
- A conventional lender will not lend on this deal regardless of the investor’s experience or liquidity.
- A hard-money lender will invest in this deal at 12% (or 1% per month), at an 82% LTV, with interest-only payments through stabilization.
- The loan amount calculates to $328,000 (82% of $400,000) with a 2% origination fee and a 1% exit fee.
- The purchase contract required 10% down, or $30,000, and closing costs are estimated at 3%.
- With the contract deposit, the lender-required equity, and the estimated costs, the investor now has $43,160 of capital outside the deal. The acquisition and rehab costs are covered.
- The above assumes the closing costs are not financed.
- The investor has the liquidity (the remaining cash) to cover the debt service during rehab.
- At the end of the rehab, the property appraises at $550,000; closing costs are estimated at 1%.
- At the sale, the hard-money lender is owed $331,280 (principal plus the exit fee).
- The net sale proceeds of $544,500 (price less costs) leave the investor with a profit of $213,200.
- The amount of the investor’s cash in the deal was $81,840.
- The investor’s return is 38.3%.
The above scenario is a simplistic way of looking at a transaction without the time value of money applied to the return calculation.
However, the description of the deal does illustrate the placement and the use of a hard-money loan in the fix-and-flip objective.
If an investor has a long-term hold for cash flow as the objective, the remaining cash of $213,200 would meet the conventional lender’s requirement of 35% equity.
The Benefits of a Hard-Money Loan
The transaction described above would never close without access to the hard-money finance alternative. A conventional lender will not lend on an investment property until the value is created with stable cash flow.
The strategy is timing the acquisition, completing the rehab, and satisfying the hard-money loan.
An investor needs to approach the hard-money alternative as a short-term step in the process. Theymust also be aware that all personal funds invested must remain in the deal as equity.
If you are a residential real estate investor with either a short- or long-term objective,it is in your best interest to work with an experienced and respected hard-money lender in Los Angeles. PB Financial Group is a premier, direct hard-money and bridge lender that has provided quick funding since 2007 and has closed over 2,700 loans. Our objective is to efficiently satisfy your financing needs on important real estate projects throughout California.
PB Financial NMLS #357614/DRE #01522495