Hard money lenders are stuck between a rock and a hard place.
On one hand, they see a New York regulator's efforts to clean up the business with an investigation into whether some lenders are making "hard money" loans with the intent to foreclose as an opportunity to weed out illegal operators. On the other hand, they fear the negative attention will unfairly label the entire industry as predatory.
Hard money loans are designed to help investors or business owners that traditional banks can't serve repair or buy distressed commercial or rental real estate in a way that decreases community blight. Particularly in the run-up to the housing crisis, some hard money lenders has been criticized for making loans designed to fail and forcing owner-occupants into foreclosure.
"The hard money business has gone through a great effort to make sure it's cleaned up," said Gordon Albrecht, senior director at special servicer FCI Lender Services Inc.
Hard money loans, which consist primarily of high interest rate, lower-balance, short-term loans backed by real estate, are typically made by individuals or other small, non-institutional lenders often referred to as the private lending market. While Albrecht wants predatory lending stopped, hard money lenders fear an investigation could make people mistakenly think the business primarily involves making loans designed to fail to homeowners who occupy properties.
"We fear regulators don't understand the positive impact of hard money lenders. Let's not throw the baby out with the bathwater," said Larry Muck, a Kansas City, Mo., broker and current chair of the American Association of Private Lenders. (His term will end when the group holds its annual conference in Las Vegas this November.)
New York Department of Financial Services Superintendent Benjamin Lawsky acknowledges in a press release about the investigation that "many hard money lenders may be engaged in legitimate financial activities."
His concern is not with these, but "with certain unscrupulous companies appear to be taking advantage of borrowers in tough financial straits by making loans that are designed to fail," he said.
However, the investigation targets "short-term, high-interest loans" made by hard money lenders that "are secured by a home or other real estate," conjuring up images of a past era when lenders made loans to homeowner occupants without regard for ability to repay, forcing consumers into foreclosure. And this is what some market participants think is misleading.
Private and institutional lenders alike did in the past commonly make high-rate, single-family loans based primarily on the value of a property, most notoriously and on a widespread basis between 2005 and 2007. This included some short-term hard-money loans. But that has been changing since institutional lenders' subprime credit loans with high loan-to-value ratios ran up against depreciation in home values, leading to a bust that prompted regulatory reform.
Albrecht finds today, most private lenders he works with comply with regulations prohibiting loans made to owner-occupants without regard for the ability to repay. He estimates that currently, "at most" 10% to 15% of the loans in the private lending market are owner-occupied, and a portion of those loans are "soft money" mortgages (a second component of the private lending market). But Muck is more hesitant to name a percentage, and Albrecht acknowledges precise data on the business is difficult to come by.
Soft money loans have five- to 10-year terms, 8% to 10% interest rates with two points and fund within five to seven days. Hard money loans, in contrast, have six-month terms and 12% to 19% rates. Hard money loans are generally small, on average under $100,000 for single-family properties and from $250,000 to $5 million for commercial, Albrecht said. However, that's only an average and more higher-priced markets have larger loans, Muck said.
Institutional lenders generally have trouble making these types of loans due to Basel III capital constraints and other considerations, like the rising administrative costs that stem in part from increased regulation, said Muck. Private money has stepped in to fill that gap, he said.
Hard money loans are used most often by smaller investors to rehab properties, according to Albrecht. Flip-and-fix investors generally are able to repair and sell properties within three to six months at such a significant profit that they have no problem paying the loans, even though they have somewhat higher rates, he said.
Performance problems with hard money loans of this type are rare today at Albrecht's shop, he said, although he suspects there could be a small number of players, possibly left from the old days, evading current compliance requirements. Muck said it's clear from word in the market that there are still loan-to-own schemes out there that need to be eradicated, but added he had little insight into New York in particular.
There are some understandable risks in hard money loans, such as the uncertainty of repair or construction costs. And sometimes there are loan performance problems, even though "in general, private lenders are very successful today because asset prices are rising," said Muck.
If a loan does run into trouble, the borrower can usually sell the property to satisfy the debt and still have money left because it's a low LTV loan. "The whole idea of hard money lenders trying to take people's property was a subprime routine. In hard money, there is a very low percentage that would ever go to foreclosure," Albrecht said.
He said he tells private lenders upfront he won't jeopardize his license or ratings by servicing noncompliant loans, and hasn't seen many as a result. Albrecht noted he doesn't service loans that are handled in-house by broker-originators, nor does he work with any of the lenders being investigated in New York.
Hard money borrowers are generally smaller, newer investors that lack the credentials and resources of institutional investors. In addition to the borrowers' typically significant fix-and-flip profit, what justifies hard money loans' higher rate is the fact that they are made so quickly on properties, often before repairs or construction are done, Albrecht said.
These borrowers usually need a fast source of financing, and such players don't have time for a lengthy loan application process. Many do eventually start using institutional financing instead as they grow and gain experience, he said. They may get a lower-rate institutional take-out loan later.
Legitimate lenders in the space are very careful to make sure that despite the relatively higher rates "hard money" entails, they don't run afoul of state usury laws designed to determine when rates have gotten so high they are excessive, said Muck. The return on the financing for private mortgage lenders is comparable to that of venture capital, he said.
Making predatory hard money loans with the intent of foreclosure doesn't make business sense because private lenders profit most from making multiple loans to reliable borrowers who they can use for referrals, said Muck.
"If you're a loan-to-own guy, good luck building a relationship with entrepreneurs in this business," he said. "If you're engaged in predatory lending practices, you're putting the entire industry in a bad light, so cut it out. There are way too many good things going on."