Investing in Hard Money Lending

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.

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