Why Do People Borrow From Hard Money Lenders

A common question I hear is why would a borrower ever borrow from a hard money lender, especially since hard money loans typically come with higher interest rates and fees than traditional bank loans. While hard money loans come with higher interest rates and fees, there are several reasons why someone might choose this option over a traditional bank loan.

Speed & Certainly of Execution

One of the main reasons people turn to hard money lenders is speed. Banks have strict lending criteria and require a lot of documentation before they will approve a loan. This can be a time-consuming process, and borrowers may need to wait weeks or even months to receive the funds they need. In contrast, hard money lenders can often provide funding within a few days, making them a good option for borrowers who need cash quickly. This is particularly true in the real estate industry, where investors may need to move quickly to secure a property.

Flexibility

Another advantage of hard money lenders is flexibility. Banks have strict guidelines for loan approval, and borrowers with less-than-perfect credit or other issues may find it difficult to qualify for a loan. Hard money lenders, on the other hand, are more willing to work with borrowers who don’t meet traditional lending criteria. This makes it easier for borrowers to get the funding they need, even if they have a blemished credit history or other challenges.

Credit Problems or Issues

Hard money loans are typically secured by real estate, which means that the borrower’s property serves as collateral. This can be an advantage for borrowers because it means that the lender has a stake in the success of the project. If the borrower defaults on the loan, the lender can seize the property to recoup their investment. This makes hard money loans less risky for lenders, which in turn makes them more likely to approve the loan. Borrowers benefit from this arrangement because they are more likely to get approved for a loan, even if they have a less-than-ideal credit history.

Unique Properties & Projects

Another advantage of hard money lenders is that they are often willing to lend on unique properties that traditional banks would not consider. For example, banks may be hesitant to lend on fix-and-flip projects or rural homes. Hard money lenders, on the other hand, specialize in these types of loans and are more willing to take on the risk. This makes hard money loans a good option for borrowers who are looking to invest in unique properties.

The Interest Costs Are Secondary For Short-Term Loans

Most hard money loans are typically short-term loans, which means that they are designed to be paid back within a few months to a few years. This can be an advantage for borrowers who only need funding for a short-term project. For example, a real estate investor who is planning to buy and sell a property within a few months may not want to take out a long-term bank loan. A hard money loan can provide the funding needed to complete the project, without requiring the borrower to take on a long-term debt obligation.

Conclusion

The reasons listed above are some of the common reasons that someone would borrow from a hard money lender. However, investors should stay diligent and learn about the types of borrowers a lender works with before making any investment decisions.

Hard Money Lending & Recessions

One of the interesting aspects of hard money lending is that returns do not necessarily correlate to the economic or business cycle and that the best times to lend are often when there is (what the cool kids call) FUD or fear, uncertainty, and doubt. Consider the below scenarios.

• When times are good, risk tolerance is high and risk aversion is low. Investor capital is plentiful and competition drives rates down as investors compete for loans. In other words, good economic times can be challenging for returns.
• When times are bad, risk aversion is high and risk tolerance is low. Capital is scarce and there is very little competition, so investors are in the drivers seat and can set rates and terms. In other words, bad economic times present great investment opportunities (although risk may be higher).
• Of course, many economic environments are not extreme. There are many years of slow growth or slow decline with a mix of promising and troubling news. Risk tolerance and risk aversion swings up and down and capital ebbs and flows. In my experience, this is one of the best times to lend as nobody is ebullient and flooding the market with capital and the economy is not collapsing and causing massive risks either.

Credit Spreads

Credit spreads are a measure of how much yield (or return) investors are paid above a benchmark rate (typically US Treasury rates). As the above below chart of corporate bond credit spreads illustrates, relative returns are low when the economy and businesses are doing well and high when there is a lot of uncertainty in the market. This is a graphical representation of the bullet points above.

Below are several reasons why credit spreads may increase during times of stress.

Perceived Risk

One reason credit spreads widen during time of distress is simply due to perceived risk. If the economy and businesses are doing very well, I may lend at 5% (as an example). However, if the the economy is in a recession and businesses are challenged, then I am going to lend at a higher rate because I need to be compensated for the higher risk.

Behavioral

There may be a lot more lenders willing to lend when times are good. People may be competing to lend at 5%, so someone may start lending at 4.9%, and then 4.8% and so on. This is a concept Howard Mark’s refers to as a “race to the bottom” which he coined months before the 2007 Global Financial Crisis began. When times are tough, there may be less people willing to lend. They may not want to lend for anything less than 6%. But there are less people lending too and they may find that although they could lend at 6%, nobody is lending for less than 7%. So they lend at 7% or 6.9% or whatever rate, but it is higher than the aforementioned 5% (again, these are just illustrative examples with simplistic numbers).

Shortage of Capital

Some real estate lenders hold loans on their balance sheet. However, many lenders do not hold loans. After a loan is originated and funded, it is sold and securitized. In other words, it’s bundled with other loans and turned into a security (such as mortgage-backed security, a collateralized loan obligation, and other types of bonds) hence the term securitized.

Securitization Slows or Stops

When times are good, people take out mortgages, borrow to expand their business, and so on. Loans are being originated and securitized into a hungry market where investors snap them up quickly. When there is some volatility in the markets, the appetite for these investments dissipates and several things happen.

The securitization machine slows (or even stops) and lenders get stuck with a bunch of loans. The lenders thought that they would be able to sell the loans into the securitization market, but they’re not able to since the demand dried up. So the lenders have capital tied up in loans that they cannot sell. Until the markets start buying their loans again, the lenders do not have enough capital to make new loans. From a borrowers perspective, there are less lenders and capital available.

As an investor, my focus is to utilize balance sheet lenders (which many hard money lenders are) rather than to focus on business models that focus on originations alone. This is because the returns may dry up and capital can get trapped if/when securitizations slow.

Investors Blow Up

Many real estate lenders and investors use leverage. Some are heavily levered. When volatility hits, some of these levered players receive margin calls. In other words, their lenders tell them to repay the debt or post additional collateral. In many cases, the lenders’ lenders can take control of the assets and liquidate them (which may exacerbate the problem if liquidations drive prices down which causes additional margin calls based on mark-to-market dynamics). The net effect of all of this is that additional capital is removed from the lending ecosystem.

Again, as an investor, my focus is to utilize balance sheet lenders (with no or very little leverage) rather than levered vehicles full of securitized or syndicated assets.

Opportunity for Lenders and Investors

For hard money lenders and investors that manage risk well during the good times and have capital to deploy to when things get tough, there are many opportunities. A lack of capital means that lenders can set the following terms more easily:

• Higher rates and points
• Lower LTV
• Stronger covenants & DSCR (debt service coverage ratio)
• Longer duration (if desired)

Of course, the above opportunities are only available to those who enter periods of distress and recessions with the ability to lend. Even a balance sheet lender may be constrained due to their existing risk exposures or inability to expand their balance sheet (via either debt or equity).

One the biggest determinants of hard money after-tax returns is asset location. For those who are unfamiliar with asset location, it is framework for classifying the account types that investments are held in. One of the main reasons for considering asset location is to maximize after-tax returns (which can differ quite a bit from pre-tax returns).

Research indicates that higher-returning assets should be held in tax-advantaged accounts (such as an IRA, 401k, or Roth version of either) and lower-returning assets should be held in taxable accounts. If two assets have similar return profiles, then the more tax-efficient one should be held in a taxable account and the less tax-efficient one should be held in a tax-advantaged account. This all presumes that there is limited capital in a tax-advantaged account (otherwise investors would put all of their investments in a tax-advantaged account!). In short, tax-inefficient assets with high expected returns should should be prioritized for tax-advantaged allocations.

Hard money loans (and private debt, generally) fits the bill. Net expected returns are typically in the high single digits or low teens (which is on par with the long-term returns generated by stocks). Additionally, private debt is typically very tax-inefficient as it generally taxed at ordinary income tax rates. Even real estate lenders that elect REIT status are still taxed on 80% of their income. Yes, the 20% deduction helps, but not that much. So from a tax standpoint, there is a strong case that hard money lending should be held in a tax-advantaged account.

Every strategy and fund is unique, but I would say that the bar for investing in hard money lending and/or private debt in a taxable account is incredibly high. In many cases, I do not think it makes much (if any) sense to invest taxable dollars in these strategies because the tax drag is so incredibly high.

Risks Of Investing In Hard Money Lending In An IRA or 401k

The question I ask myself is: if I could generate equity-like returns with less risk and volatility, why wouldn’t I do that?

While my immediate answer is that its a rhetorical question, I can think of a few risks and reasons why investors may not want to invest in or concentrate hard money exposure in an IRA or 401k.

• It’s not necessarily less risk. Sure, lending appears less risky until the defaults start and then that 10% return morphs into 2% return or a -5% return. My perception of risk could be incorrect.
• Perhaps there are even better opportunities available. If the stock market is down 20-30%, maybe it’s better to invest in stocks. Or maybe it’s better to buy other assets from distressed sellers, such as private equity secondaries.
• I’ve seen some multimillion dollar 401k’s and IRAs, but many are below $1 million dollars. The minimum investment for many small private lending funds is 100k or 250k. So investors are often giving up diversification in order to invest with a private lender in a tax-advantaged account.

How I Invest My Own Money

Don’t tell me what you think, tell me what you have in your portfolio.

Nassim Nicholas Taleb

As of 2023, the majority of my tax-advantaged accounts are invested in private lending funds. This is not a recommendation, but I’m personally comfortable with the risks that I am taking in order to generate the returns that I expect.

Investing in hard money loans can be attractive, but many individual investors may have no idea where to start or what questions to ask. Asking questions and getting information before an investment is made is important for private investments because they cannot be sold as easily as stocks or bonds (which can be sold with a few clicks generally). Below are some basic due diligence items that I ask hard money lenders for before deciding whether to invest or not. My personal preference is to invest in hard money loan funds rather than individual loans, so the below is oriented towards funds although many of the topics may apply to individuals loans as well.

I work with a handful of hard money lending funds and they’re all different. Different risk profiles, geographies, portfolio compositions, and so on. There are no right/wrong answers necessarily. The purpose of the below questions is to either very information or better understand a hard money lender or fund.

Hard Money Fund Composition

Property Type & Loan Type

Different property types have different risk and return profiles. Typically, funds loan against multifamily, commercial, industrial, retail, and office, although land or other esoteric property types are out there.

It is equally important to understand what types of debt are being used. Bridge loans, fix-and-flip, value add, and lines of credit are common. Understanding why a fund’s borrowers use hard money is also a good data point.

LTV

One of the most basic data points that investors should evaluate is loan-to-value (LTV), which is a percentage calculated as the loan amount divided by the value of the property.

CLTV

In addition to LTV, investors should also inquire about the combined loan-to-value (CLTV), which is a percentage calculated as the balance of all loans divided by the value of the property.

First Liens vs Second Liens

Properties can be financed in a number of ways, so hard money lenders and investor need to understand a property’s capital structure (or cap stack). Common equity is typically most junior, meaning that common equity will absorb losses first. Debt in a first lien position is generally the most senior, which means that it will take losses last. Some properties have multiple mortgages and so some debt sits in the second line position. Second position generally sits above equity, but below first lien position. Some hard money investors hate second lien positions and won’t touch them. I’m comfortable with second liens if the CLTV is low enough (and even more so if there are appropriate intercreditor agreements in place).

Geography

Geography is important to understand from a concentration or diversification perspective. Diversification is often desirable, but not if it comes at the expense of a lender operating outside their region of expertise. I’m not too particular about diversification across states, although it is important to know whether loans are in judicial or non-judicial states.

Fixed or Floating

Loans come in all shapes and size, some fixed rate, some floating rate, some fixed rate for a period followed by floating rate after a certain date. Understanding a lender’s loan terms and the portfolio composition of fixed- and floating-rate may help hard money investors model what returns might look like in various rate and spread scenarios. Read my recent post on hard money investing in different rate environments.

Loan Size

What is the average loan size? How does that compare to the overall portfolio? Is that number growing, staying steady, or something else? The thing I’d watch for here are big swings in loan size depending on fund growth. In my view, its better to have a consistent loan size rather that doing too many different types of deals or being forced to do larger deals because the fund is growing.

Hard Money Lending Process

Sourcing & Conflicts/Costs

How are loans sourced? Internally, through a broker network, a combination of both? Who is compensated for making loans and how much? Do any of the compensation arrangements represent a conflict of interest with the fund investors?

Legal Review of Loan Documents

Not all funds have this, but it is nice to see when a lender/fund has counsel review each and every loan document.

Defaults, Foreclosures, and REOs

One of the most important aspects to understand about a fund are the delinquency, default, and foreclosure rates. Ask how delinquency is and has been handled in the past; ask the same for defaults and foreclosures. Sometimes lenders do foreclose on properties and have “real estate owned” (REO) on their balance sheet. How many loans gone through the foreclosure process and become REOs and how have those REOs performed?

Investment Committee

Who sits on the investment committee and makes decisions about whether or not to fund loans? What are their incentives and compensation structured? Is anyone from the origination side of the business on the investment committee (this would generally be a negative)?

Hard Money Fund Terms

Liquidity Features & Lockup

Many funds have lock-ups, ranging from 30-90 days on the short-end to a couple of years on the long-end. A one year lockup seems to be an industry standard in my experience. The lockup could be a hard lock, meaning no redemptions are allowed before the lockup expires, or a soft lock where early redemptions are allowed subject to a penalty.

Fees & Compensation

Beyond interest, many lending funds charge origination fees and/or points to borrowers. It is important to understand whether 100% of the economics are going to the fund or whether non-interest income is being shared with the lender/manager and in what proportions.

Investor Qualification

Many funds accept accept “accredited investors,” but some may require investors to be qualified clients or qualified purchasers. Read our primer on investor qualifications to learn more.

Hard Money Tax Considerations

K-1 Reporting & Sub-REIT

Different funds report income differently for tax purposes. Some funds report income in Box 1 of the Form K-1 (which is not necessarily subject to the 3.8% net investment income tax [NIIT]). In my experience though, most funds report income in Box 6a of the Form K-1. Furthermore, most of these funds have elected to be taxed as a REIT (or established a “sub-REIT” which is subsidiary entity that holds the loans and elects to taxed as a REIT). The benefit of electing REIT status is that investors can claim a 20% 199a QBI (qualified business income) deduction; in other words, investors are only taxed on 80% of the income. There are non-tax considerations and risks of claiming REIT status too.

UBTI

It is important to know whether a fund is expected to generate Unrelated Business Taxable Income (UBTI). If UBTI is not expected, then investing through a tax-advantaged account (such as an IRA or 401k) is fine. However, I would avoid investing in hard money loans via a tax-advantaged account if UBTI is expected, since the income would be subject to Unrelated Business Income Tax (UBIT, a similar sounding acronym) which uses onerous trust tax rate schedule. Personally, I don’t want to ever file a tax return on behalf of my IRA or 401k (nor pay tax out of them).

Other Hard Money Due Diligence Items

AUM & Capacity

It is always helpful to know how much assets under management (AUM) a fund has. As a hard money investor, I like to see sufficient scale and know that my allocation will not be a disproportionately large part of the fund. It is also important to understand how much capacity the fund has. The lender and fund manager needs to balance the supply of capital coming in with the demand for loans. I usually just ask, “How much capital can you accept this month?” The answer may vary over time, but it is helpful to understand the supply/demand dynamics of the fund. Too little capital and the fund cannot make loans, too much capital and cash drag will decrease hard money investor returns.

Service Providers

I attempt to speak with the funds service providers. Administration is sometimes done in-house, but third-party administrators are generally happy to talk about fund processes and so forth. Legal counsel is important to independently verify. The same goes for fund auditors, although I find them generally less willing to speak or disclose information (and sometimes they requires pages and pages of forms in order to share very little). For auditors, investors often have to settle for whatever they can get.

Background Research

Some basic internet research is foundational and I’m sometimes surprised by what I can find with some quick google searches. That being said, I typically order a a background check before investing with any hard money lending fund too. There are a lot of services that will pull court records and data for less than $50, while a report from a private investigator may cost $500 to $1,000 or more.

Verify loans and amounts

One of the nice things about real estate is that most transactions and loan documents are publicly recorded with the county. I typically ask for a list of all loans in a portfolio and then will research a cross-section of those loans. I will go to each county’s website (pay the nominal fees if needed) and pull the loan documents on file to verify the existence of the loan, the entities involved, and verify the amounts. It is not always clear (especially if the loan structure is more complex and involves multiple entities, properties, etc.), but the manager should be able to answer any questions that come up. And if not, then time to walk away.

100% Transparency

I have a rule that I will not allocate capital to any sponsor or manager does not provide information that I request. Of course, the requests for information have to be reasonable for the fund as well as the size of the investment and some funds will require an NDA before providing the requested information. Yet, as an investor, it it is important to have 100% transparency.

Hard money lending is a great asset class for investors who need to generate income and it provides a different risk/return profile than traditional stocks and bonds. Successfully investing in hard money loans can generate similar returns to those of stocks with less volatility than bonds (read about hard money investing in various interest rate environments).

What Is Hard Money Lending & Investing?

Hard money has a negative connotation for some people, so some call the asset class private money or other names that refer to lending from a small non-bank balance sheet. In other words, hard money loans are mortgages that are not securitized, sold to financial institutions, or held by banks.

I wouldn’t get to hung up on labels or classifications (as there are some tangential strategies that may or may not technically be “hard money” lending); just recognize that hard money loans are originated by non-bank lenders and typically owned by individuals, families, and small investment funds.

Side Note: The question often comes up, but I am not sure why it’s called “hard money.” There are a variety explanations, claims, and theories on the internet. I won’t cover here because it’s not important, but curious readers can search online.

Hard Money For Individual Investors

My observation has been that nearly all private money lenders are small, regional firms. Many hard money lenders simply syndicate individual notes to individual hard money investors, while others pool notes into investment funds that are typically below $500 million (and many are below $100 million). There are a few larger funds out there, but not many.

Few institutional investors (if any) are able to even consider investing in hard money loans due to the small size of the lenders and hard money investment funds. Thus, this is one asset class where being small gives individual investors an edge over institutional investors. Individual investors may have challenges sourcing and conducting due diligence on lenders and portfolios of loans, but this can be mitigated by working with an experienced advisor.

Depending on the borrowers, leverage, fees, and other factors, net returns to hard money investors typically ranges from 5-15% annually.

Why The Hard Money Investment Opportunity Exists

The opportunity for investors has developed over time, largely as a result of regulations and the failures of traditional lenders which I’ll cover below. The reasons people have used hard money loans has not changed a whole lot, although it has become more difficult in recent years to obtain traditional financing.

Hard Money History

Hard money lending has existed for a long time, but it has grown exponentially since the Global Financial Crisis (GFC) of 2007-2009. While hard money lenders have historically had a reputation of primarily lending to riskier borrowers with issues, the quality of borrowers in the hard money space has improved quite a bit as banks retreated from lending following the GFC.

Over the past 15+ years, banks have been unable to make a lot of (what I would consider) common sense loans and hard money has been able to step into these situations and maintain an attractive risk/return profile.

There was too much (bad) lending prior to the GFC. Bankers blew up financial markets and the global economy with their lending. A lot banking regulations were passed in the years following the GFC (and rightfully so, in my opinion). Dodd-Frank was passed in the US, Basel III was agreed upon internationally, and so on.

These laws and regulations restricted banks’ ability to originate and hold loans on their books and/or regulated the cost to hold various types of loans. As banks pulled back lending, there was a shortage of capital in the market. Non-bank lenders, including hard money lenders stepped in to fill the void.

Where Traditional Lenders Fall Short

Non-QM Loans

Dodd-Frank designated that mortgages with certain attributes were “Qualifying Mortgages” (QM). It was very easy for banks to continue to issue QM loans, however non-QM loans became much more difficult to make (due to the inability to securitize them or hold on one’s balance sheet).

To qualify as a QM loan, a borrowers debt-to-income (DTI) have to stay below a mandated level, payments have to be fully amortizing, fees have to below a certain level, and so on. These are generally good guidelines to protect consumers from predatory lending and the economy from reckless financiers.

That being said, there was and remains a need for non-QM loans. Not every borrower fits in the QM box, especially borrowers with more complex situations. In this post Dodd-Frank world, it sometimes seems as if banks are more concerned about checking the right boxes than evaluating risk.

Bridge Loans

Consider a homeowner who is looking to sell their home and buy a new one. The borrower says to their bank, “Hey, give me a mortgage for this new house. I’ll sell the existing house and payoff the mortgage with the proceeds, so I’ll only have one mortgage like you want me to.” Many lenders would have gone along with this arrangement prior to the GFC.

However, after the GFC, lenders stopped going along with this. Instead lenders now respond with, “Not so fast. Sell the existing house and payoff that mortgage. Then, once you have no existing mortgages, we’ll give you a new one.” Essentially, banks no longer trusted the borrower to sell the old house after buying the new one (and perhaps for good reason).

This new approach works to an extent in a buyer’s market that moves slowly, but is very problematic in a hot real estate market. Someone looking for a new house might not want to sell their existing house before buying the new house (because it may be difficult to find a new house in a competitive market). But lenders generally won’t provide financing for the new house until the existing one is sold (and mortgage paid off).

Many hard money lenders offer a bridge loan product. In this case, a borrower can obtain a mortgage for a new house if they “cross collateralize” the loan with their existing house. In other words, the lender secures the loan with both the new house and the existing house. These types of loans can be a prudent investment, assuming there is sufficient equity between the two houses. However, banks will rarely make these loans today.

Certainty of Execution

As banks pulled back lending operations and focused on plain vanilla QM loans, there was less focus on serving borrowers with more complex situations. Borrowers with W-2 income are easy for a bank to understand, but someone with self-employment or K-1 income will be more difficult for a bank to evaluate these days. The same goes for borrowers with many properties, complex businesses, multiple entities, and so on. The amount of document requests, questions, and so on is expansive (some would say excessive and I’ve heard more than one business owner refer to the mortgage process as a “financial colonoscopy”).

The process to get a loan from a bank often takes time and there is no guarantee of success. This doesn’t work well in real estate where there are deadlines with non-refundable deposits on the line. For many borrowers, “certainty of execution” is much more important than a loan’s cost.

Conclusion: Hard Money Investing

One of the most attractive attributes about hard money lending as an asset class today is that the opportunity set has largely been created by regulation, rather than risk. The government has hampered banks ability to compete for certain types of loans, while it just unprofitable to make relatively small loans to complex borrowers (and difficult to scale as well). Asset classes with limited competition often have attractive risk/reward profiles. This may change in the future, depending on regulations, risk appetite, and so on, but the past 15 years have been a great time to be a non-bank lender/investor.

Hard money loans are an attractive asset class in many different environments. That being said, the characteristics of hard money loans make hard money investing especially attractive in low rate and/or rising rate environments. Below are some factors to consider before investing in hard money loans in different rate environments.

Readers unfamiliar with hard money loans as as asset class can read our post about investing in hard money loans.

Investing in Hard Money When Rates Are Low

I first became acquainted with hard money investing in the wake of the 2008 Global Financial Crisis (GFC) when yields dropped precipitously. The public markets did not offer the yields that they once did, so I was forced to find ways to generate income without being exposed to excessive interest rate risk. Below are several reasons that hard money loans are an especially attractive asset class when rates are low.

Above Market Returns

The primary reason that hard money loans are attractive is because the expected returns are often higher than what can be found in publicly-traded assets. This is the case nearly all of the time, but the spread between hard money and traditional bonds is often widest when in low rate environments.

Points

Hard money lenders typically charge points on the front-end and/or backend of loans. So borrowers may pay 1% of the loan value upfront and another 1% at final payoff. Again, this is true throughout time, but points represents even more relative returns when rates are low (and some bonds may only pay 1-2% per year)!

Rates

Hard money rates are typically in the 5-20% range depending on a variety of factors. Even at the low end of this range, 5% is much higher than what many public fixed-income investments yielded from 2008 to 2022.

The after-tax spread is narrower for taxable investors, although the Tax Cuts and Jobs Act (TCJA) of 2017 TCJA helped hard money investors a little bit. In the wake of the TCJA, many hard money debt funds elected to be treated as REITS or created sub-REITS (where the fund would own a single REIT which would own the underlying loans). In either case, investors are able to avoid paying tax on 20% of their REIT-related income.

Of course, those who invest in hard money through tax-deferred accounts (such as IRAs, 401k’s, etc) or tax-exempt accounts (such as Roth IRAs and so forth) don’t have to worry about the tax inefficiency of hard money investment returns.

Penalties

Hard money loans typically have penalties and charge a penalty interest rate in the case of default. Furthermore, lenders are often able to actually collect these fees in the case of default because hard money loans are typically secured loans and include recourse. I’m no fan of a “loan to own” approach, but defaults often result in higher returns for hard money investors.

Contrast this to corporate bonds, which are often unsecured. Defaults nearly always result in lower returns for investors rather than higher returns. The possibility of defaults (by hard money borrowers or corporate borrowers) may be higher during periods of low rates as low rates can be a sign of economic weakness (either episodic or prolonged).

Low Duration

Hard money loans are short-duration assets, which is important when rates are low. The term low rates implies that rates could be higher and anyone investing in a low rate environment should be aware of the possibility and risks of rising rates. Fortunately, I believe hard money is also attractive in a rising rate environment.

Investing In Hard Money Money When Rates Are Rising

Hard money loans are an attractive asset class in many types of environments, including periods of rising interest rates. This is largely due to their short duration and illiquidity, although extension costs and floating rates can also benefit investors.

How Do Hard Money Loans Perform When Rates Rise?

People often ask me what happens to hard money rates when Treasury rates increase (or decrease). My answer is always: it depends. It depends on the level of risk aversion in the marketplace. Below are two real examples from the past few years:

Consider the Federal Reserve’s hiking cycle of 2018. The Fed increased rates quite a bit and yet hard money rates declined. This is because risk appetite was high (and risk aversion was low) leading to more competition to lend and lower rates.

Contrast this with the Fed’s hiking cycle of 2022. Not only did the risk free rate increase quite a bit due to the Fed, but risk aversion increased across the board and lenders pulled back (or exited the market altogether). Thus, competition for loans declined and rates increased quite a bit.

Risk Free Rate vs Spread

The above examples illustrate the fact that rates in the marketplace consist of two components: the “risk free rate” which refers to Treasury rates and a spread above that (to compensate for the risk of lending to a non-government borrower).

To illustrate this, consider when Treasury rates fell dramatically in February and March of 2020. Rates for non-government borrowers did not fall dramatically. Rather, rates skyrocketed because there was so much fear, uncertainty, and risk that the increase in spreads more than offset the decline in the risk free rate. In other words, the rates that non-government borrowers pay is more correlated to spreads than the risk free government rate.

Short Duration

Many hard money loans are have maturities from six months to three years. So the loans are turning over relatively quickly. In a period of rising rates, short duration assets tend to perform better because income can be reinvested into higher rates more quickly. Thus, in general, hard money loans tend to perform well when rates are increasing because the interest and payoffs are reinvested at higher rates more quickly.

Extensions

Many hard money loans contain the option to extend a loan. That is, a borrower can extend a loan beyond its original maturity date for a predetermined about of time, perhaps 3, 6, or more months. However, exercising an extension option often comes along with an increase in the interest rate.

In some rising rate environments, borrowers may find it more difficult to payoff a hard money loan either because it is more difficult to sell real estate or more difficult to refinance real estate. In these situations, extensions may be exercised more often.

Floating Rates

Some hard money loans are variable rate. Rather than paying a fixed interest rate, borrowers pay a floating rate that consists of a reference rate and a spread. For instance, instead of specifying a flat 9%, the loan may specify that the rate is SOFR plus 4%. If SOFR is 4.5%, then the rate is 8.5%. If SOFR goes up to 5%, then the loan rate increases to 9%. Previously many loans were tied to LIBOR, but SOFR has largely replaced LIBOR in the US. The reference rate could also be the Fed Funds rate, “Prime,” various Treasury rates, or swap rates.

Some floating rates may have an interest rate floor well below current rates. Using the above example of SOFR plus 4%, the loan might have a floor of 6%. So even if SOFR goes below 2%, the lowest possible interest rate would still be 6%. Other lenders will set the floor at the current rate levels, so the floor would be 8.5% if SOFR is 4.5% and there is a 4% spread.

Illiquidity

Most hard money loans are held on private balance sheets rather than securitized into the bond market. Many fixed-income investments decline in value when rates rise. However, hard money loans are typically held at par rather than marked to market, so investor redemptions are typically paid out at par. Therefore, hard money loans often offer more principal protection against rising rates than publicly-traded fixed-income.

Credit Quality

Rising rates can create problems for borrowers, so credit quality is especially important in rising rate environments. For instance, if real estate values decline, hard money lenders better make sure that their loan-to-value (LTV) ratios are conservative enough. Similarly, rising rates may mean that borrowing costs increase as a percentage of revenue and that borrowers may have more difficult refinancing a hard money loan with permanent financing (since the future debt service coverage [DSCR] ratio may not be sufficient). In other words, lenders must take extra care to ensure credit quality standards; otherwise losses would offset all of the benefits listed above.

Allocating to Hard Money During Rising Rates

In a rising rate environment, investors are generally better off allocating to floating rate loans. In an environment with declining rates, allocating to fixed rates may make more sense. Of course, it depends on what the current yield of the portfolio is, the proportion of fixed-rate and floating-rate loans, what the reference rate refers to, as well as where the various rate floors are at. First and foremost though, investors should always focus on credit quality as return of capital is always more important than return on capital.

Investing in Hard Money When Rates are High

It can still make sense to invest in hard money when rates are high, but it is perhaps not as attractive as when rates are low. The spread between hard money and traditional fixed-income is compressed, so there is much less opportunity cost than investing bonds. Additionally, investors may prefer to have more duration in order to benefit from appreciation if rates decline (since bond prices generally move inversely to rates).

In high rate environments, investors should continually ask themselves how much additional yield (or after-tax yield) do they need to compensate for the risk and illiquidity of hard money loans. At some point, it is more attractive to invest in public fixed-income rather than hard money loans. Again, that may be a higher bar for tax-advantaged accounts/investors who do not have to worry about the after-tax yields of such a tax-inefficient asset class.

Investing in Hard Money When Rates are Falling

There are pros and cons to being invested in hard money when rates are falling. One the one hand, hard money investors should continue to receive higher interest rates for a few months or years, as the existing loan book doesn’t refinance or payoff overnight. On the other hand, as an illiquid investment held on small private balance sheets, hard money loans do not generally benefit from declining rates in the same ways that publicly-traded bonds do through rising values.

Also, investors should evaluate why rates are falling. If rates are declining due to economic weakness, then credit quality is of utmost importance as borrowers and real estate may face difficulties.