Hard Money Lending

“A comprehensive look at the process and its merits”

Nikhil Raheja

Financial Analyst

Keystone State Capital Corporation

Financial Consultants
1800 JFK Blvd. Suite 300
Ph: 1-888-828-9916 Fax: 1-215-754-4994
Table of Contents Page

I. Introduction 3
II. Hard Money Loans 3
III. Process of Lending 4
IV. Bridge Loans 5
V. Interest Rates and Fees 6
VI. Safety Measures 7
a. Personal Guarantee 7
b. First Mortgage Position 8
c. Confession of Judgment 8
d. Deed in Lieu of Foreclosure 9
e. Third Party Escrow Account 10
VII. Demand for Hard Money Loans 10
VIII. History of Hard Money Loans 11
IX. Non-tradable Capital 12
X. Similarity with Mortgage REITS 12
XI. Industry Size and Statistics 13
XII. Legal Structure and other issues 13
XIII. Figures 15
a. Real Estate Loans at all Commercial Banks 15
b. Nominal Change in Commercial Mortgages Outstanding 15
XIV. About the Author 16

2
Introduction

Hard Money loans are short term asset based loans extended mostly to real estate developers.
These developers use the funds in the rehabilitation of real estate assets, in an attempt to sell the
finished properties at much higher prices. Over the last several years, the hard money lending industry
has grown exponentially, filling up a widening gap in the supply and demand for loans caused by a
reduction in conventional bank lending. Due to the high interest rates and the safety measures used in
the loans, the industry has become an extremely safe and profitable alternative for investors,
disillusioned with the charm of the regular market based investments.

Hard Money Loans

Hard money loans are short term loans made to businesses for their operational needs. These
loans are made primarily against property based collateral that is usually over 200% of the loan amount.
These loans are can be for any duration between 3 months to a few years. However, most loans in the
industry are made for a period of 6 months or less.

Hard money loans are originated against the collateral, primarily the real estate being
purchased, or renovated. The loan to value ratios(LTV) demanded in such transactions is usually
between the range of 30-65%, ensuring that the borrower has enough equity in the property, thus
creating a large safety net for the lender in the event of a decline in property values. In addition, some
lenders also lend based on the After Repair Value of the property (ARV), allowing the borrower to
borrow a higher amount against the property at hand. In these instances, the loan value against the
current price for the collateral might be higher; however the risk is minimized through several special
assurances such as the personal guarantee, which is explained later.

In addition, the Hard Money Lenders do not preoccupy themselves with the incomes,
employment, or the credit histories of the borrowing companies; instead, they direct their focus
towards ensuring that they have enough collateral to claim even if there is a default or a massive decline
in the property prices. Due to a decline in lending through the conventional channels, demand for such
private short term loans has been soaring over the last few years. As a result, Hard Money Lenders face
a shortage of funds against the increase in demand from the developers, who are seeking to profit from
a decline in property values. Also, these loans are quicker to get approved and close, as opposed to

3
loans from banks, which would take a bureaucratic route and take at least 4 weeks, as opposed to a
week with the Hard Money loans.

Despite the growth in the industry, the default rates remain much lower than that of the
banking industry. An average hard money lender suffered a default rate of less than 1% in 2008-09.
Most of these hard money lenders are registered privately, and thus are protected from the vagaries of
the sentiment based market. The investors in the hard money lending firms depend only on the
profits/interest generated by these firms, and not the capital gains/losses on the stocks of these firms.

Process of lending

Once the funds have been secured by the lender, a borrower with a viable business strategy is
located. There are 4 other key steps involved in the qualification of the borrower.

Underwriting is the gathering and assessing of information about the borrower and the property to
determine if the loan is viable.

Processing includes the work with the Title Company (to obtain title insurance), with the Escrow agent,
Realtors, Insurance agents, Appraisers, etc.

Document preparation is the preparation of all loan documents.

Lender inspection is that part of the due diligence where the lender makes a visit to the property in
question and determines the viability of the loan based upon the strategy, neighborhood, etc.

Once the above process is over, the loan terms are finalized with the borrower. These include
the duration of the loan, the interest rate to be charged, personal guarantees from the borrower, an
audit of the borrower`s personal assets. Other steps might include a deed in lieu of foreclosure, and a
confession of judgment, these two safety measures have been explained in a lower section. Also, some
cautious lenders might demand to know the exit strategy of the borrower, which the lender would use
to complete the project if the property is foreclosed upon due to a default.

Once the terms of the loan have been settled, the loan is extended to the borrower through the
escrow agent. Some lenders may loan out the money in stages, thus keeping an eye on the progress of
the renovation. Each further loan segment is issued at the completion of a particular stage in the

4
development of the property. This is done to ensure that the lender can proactively take possession of
the collateral in case the borrower has misappropriated the funds or the construction is not progressing
as per the initial plans.

Most properties chosen by the borrowers are dilapidated and have huge potential for value
addition at low costs of improvement. Ideally, the lenders give loans for projects in the surrounding
areas, so they can be supervised. Some lenders even arrange the stock of building materials needed by
the borrower, so as to precipitate the process of closing the loan and the start of the development.
These lenders keep in constant touch with the borrowers to gain a better estimate of the date of the
completion of the project. Also, it helps them know in real time if the loan amount needs to be
increased due to previously unforeseen events. These lenders develop good relations with their
borrowers, causing these borrowers to become repeat clients.

Most of these loans are non-amortized balloon loans or Interest only loans, requiring the
borrower to pay the principal only at maturity. Once the principal and the interest are paid in full, a new
loan is issued to the next borrower within a few days, ensuring that the capital does not stay idle. A
successful hard money lender attempts to create at least 2 loans with the same money each year, with
each loan yielding high rates of return.

Some other borrowers also use Hard Money loans as Bridge financing to fund their ongoing,
long term construction projects. These Bridge loans are described below.

Bridge Loans

Several real estate borrowers take out short term intermediate loans from Private loan firms to
pay for real estate projects, until low interest bank financing is secured. As they receive financing from
the bank, they pay off the loan and the high interest rates charged on it. Bridge Loans are quite
common in the real estate industry, as they are sometimes used to start new projects until a current
property is sold and funds become available. These funds are then used to pay off the loan.

Hard Money Lenders initiate these bridge loans along with conventional short term
development loans. While the duration and interest rates charged on these loans remain the same, the

5
key difference lies in the purpose for which these loans are taken, with bridge loans being taken mostly
to “bridge” the gap between current needs and future availability of financing.

These bridge loans, like hard money loans, may be taken out for any operational projects
besides real estate development. Private equity firms along with several large Hard Money lenders issue
these bridge loans in large amounts. For instance, NBC Universal used $6.1 billion worth of Bridge
financing to pay off its current parent, General Electric Co. as compensation for the stake that GE would
sell back to NBC.

These Bridge loans are structurally similar to Payday loans, where an individual borrows a small
amount, to be paid back on the receipt of the salary at the end of the month. Here the borrower may
issue a post-dated check to the lender, cashable at the end of the loan term. Bridge Loan financing is a
multi trillion Dollar industry with growing prospects, concomitant with a decline in bank financing.

Interest Rates and Fees

Hard money lenders usually charge annual rates of more than 10%, sometimes going up as high
as 30%. Some lenders may charge a higher rate in the case of a default, a “Default Rate”. In addition,
some other lenders may also charge a “prepayment penalty”, compensating themselves for a lower
interest amount received due to payment of the loan before the end of the loan term.

A borrower is also required to pay loan fees that cover everything from the origination
expenses, escrow account fees, and title insurance. These fees are expressed in % points and can be as
high as 10%. A lot of Hard Money lenders return most of the profits generated through interest and fees
to the investor, keeping for themselves a small profit, and thus generating a need to increase the funds
under management.

Usury laws in most states limit the amount of interest rate that can be charged from a borrower.
However, these laws do not apply to loans extended to corporations. As a result, Hard Money loans are
exempt from usury laws. Not surprisingly, the high interest rates charged on the loans by these
borrowers give a false impression of usury; however the rates in question are annual, while most
borrowers borrow for 3-6 months, thus paying an interest in proportion to the duration of the loan. So a
Hard money firm that charges 19% annually from its borrowers would only charge 19/4, or 4.75%, from

6
a borrower who borrows for 3 months. So, in effect, this borrower would be liable for just that small
interest charge and the loan fee applicable.

Safety Measures

Personal Guarantee

Most loans in the country are recourse type, which implies that the lender has recourse in the
event of a default by the borrower. In other words, the lender can take the borrower to courts to
recover the money not paid back by the borrower, or not recovered from the collateral pledged. But,
there are many states where only non-recourse mortgages are created. A lender has no judicial right to
stake claim to a borrower`s personal assets in these states, and must be content with the collateral.

Consequently, most Hard Money lenders have settled in states that allow recourse to a default.
However, despite offering loans in a recourse state, a hard money lender may still not be able to recover
the money if the borrower files for corporate bankruptcy (Chapter 11) or Personal bankruptcy (Chapter
13), or liquidation (Chapter 7). In this case, the lender must abide by the orders of the court and take its
share.

Some Lenders have come up with a brilliant way to escape the dread of bankruptcy by
demanding Personal Guarantee from the borrower. This Personal Guarantee ensures that no form of
bankruptcy overrules this guarantee and the borrower remains liable for every penny, including the
interest and fees owed to the lender, plus extra interest for a delay in the payment. So if a default
occurs, the lender could chase the individual`s personal assets to recover the money. This process has
ensured that these Hard Money lenders do not lose their money to defaults except in the most
unfortunate cases. In addition, the personal guarantee becomes a motivator for the borrower to be
diligent in the repayment of the loan. As a result, the lenders that take a personal guarantee almost
never see a default.

This feature is the USP of the Hard Money Lending industry. This assurance drives a huge wedge
of safety between the private lenders and the banking industry. So much so, that the banking industry
has recognized its folly and now it demands a personal guarantee on some loans. Historically, these
personal guarantees have been given by many famous enterprises, such as the personal guarantee

7
pledged by Donald Trump`s company to Deutsche Bank AG for $40 million on a $640 million
construction loan for the Trump International Hotel & Tower. Trump`s company defaulted on the debt
in November 2009, and is now being sued by the bank for the amount not yet recovered.

Find below the list of states with non-recourse debt requirement:

Alaska, Arizona, California, Connecticut, Florida, Idaho, Minnesota, North Carolina, North
Dakota, Texas, Utah, Washington

All remaining states, with the exception of a few with more complicated laws, allow recourse
debt.

First Mortgage Positions

Hard Money Lenders usually accept a first mortgage position on the loan, in other words, they
hold the first right to the property in the case of default, irrespective of the number of loans that may
have been taken on the collateral. This feature coupled with low LTV ratios ensures that the lender can
remain indifferent to the operational risks taken by the borrower. The lender simply depends on the
safety net created by a combination of low LTV ratio and a first lien on the property.

This strategy is timely since the banks that have held the second mortgage positions during the
current crisis have on an average recovered less than 10 cents on the Dollar.

Confession of Judgment

Some states like New Jersey and Pennsylvania allow a special arrangement between the creditor
and the debtor where the debtor trades away his right to protest a judgment against him if there is a
default. So with a confession of judgment, a lender may simply approach the courts with the signed
document and appeal for permission to foreclose upon the property. In this case, the borrower has no
rights to a trial, unless if he can draw focus upon any impropriety in the framing of the document.

8
 The confession of Judgment allows a lender to gain access to the collateral within 24 hours of a
default. This procedure is extremely rare in the country and is found in only a handful of states. Many
Hard money lenders have thus relocated to PA and NJ in pursuit of this feature.

Deed in lieu of Foreclosure

A Deed in lieu of foreclosure is a tool to allow the lender to acquire the collateral from a
delinquent borrower without the foreclosure proceedings. Several documents constitute the deed, such
as the Agreement in lieu of foreclosure, which explains the terms and conditions of the deed-in-lieu, and
the Warranty deed, which conveys legal ownership in the property to the lender. In addition, a
Quitclaim deed and a grant deed may be signed by both the parties.

Some Hard money lenders make use of this deed to ensure that the property in question is
transferred to them quickly, so as to avoid the time and costs of foreclosure. Another benefit to the
lender is that the property changes hands before the borrower can vandalize the property to get back at
the lender.

The advantages to the borrower are numerous. The borrower avoids the harassment of a
foreclosure. In addition, a deed-in-lieu eliminates all personal indebtedness and responsibility for the
borrower, as regards that loan. In addition, the credit score of the borrower remains unaffected since
the lender loses all rights to pursue the borrower for any amounts unrecovered.

The lender must provide a letter that assures that the debt is “paid in full”, and must waive the
right to a deficiency judgment, which prohibits the lender from seeking the borrower for any unpaid
debts after the sale of the collateral recovered.

Hard money lenders may or may not use a deed dependent upon the proportion of the debt
that could be paid off from the sale of the collateral. If the debts largely exceed the collateral, then the
lender would hold off on the use of the deed and may proceed with the foreclosure, so as to maintain a
claim on the borrower`s personal assets.

9
Third Party Escrow Account

An independent third party, such as The Escrow Firm acts as the agent for the disbursal of funds
to the Lender, borrower, and investors. As the Lending firm receives the money, it deposits the money
in the Escrow account with a third party (mostly a bank). The Escrow agent then becomes responsible to
disburse the money to the borrower as per the terms of the loan.

The loan is paid back by the borrower into the Escrow account, which the lender has no access
to, save for the interest portion, which may be drawn upon for working capital uses or dividend
payments to the investors. If an amount must be redeemed to an investor, the amount is mailed/wired
by the Escrow account on the directions of the lender.

All Hard money firms are required by law to use the services of an Escrow account. The Escrow
agent brings transparency to the operations and limits the amount of embezzlement, if any, perpetrated
by a dishonest lender.

Demand for Hard Money Loans

Bank lending has fallen precipitously with the onset of the financial crisis, leaving the borrowers
scrambling for the little credit available in the market. According to Jack Guttentag, professor of finance
emeritus at the Wharton School of the University of Pennsylvania, “The financial crisis has been good for
the hard-money lenders because it has made loans with less than perfect credit very difficult to obtain
from institutional lenders.”

The loan applications at an average hard money lender are up 50% since 2007. As a result, hard
money lenders are turning down most applications and have been accepting only those with the most
collateral and best credit histories. In addition, the interest rates charged by the borrowers along with
the fees have also increased substantially. This is an anomaly since Hard Money lenders seldom change
their fees or rates, which have remained immune to the changes in the underlying interbank lending
rates over the years.

During the housing bubble, most mortgages, residential and commercial, were being packaged
into Mortgage backed securities (MBS) and sold off; but with the start of the bust, the MBS markets
have remained seized for over 2 years. According to the Wall Street Journal, the first multiple borrower

10
commercial MBS deal since 2008 would be completed in the 2nd quarter of 2010 by Deutsche Bank. A
multiple borrower deal is where a security is formed from mortgages issued to several borrowers.
Consequently, the banks have had to hold on to their mortgages instead of selling them off, leading to
lesser new creation of mortgages and other loans.

The current mortgage market is being supported by Federal funds, with Fannie Mae and Freddie
Mac buying most of the residential mortgages from the banks. In total, the above two Federal agencies
and FHA combined are backing 90% of the new residential mortgages created, as opposed to 30%
before 2007. However, there is absolutely no federal support for Commercial Mortgages, and thus the
Hard Money Lenders have gained the upper hand in dictating terms to the borrowers who approach
them.

The volume of commercial mortgages outstanding in the United States fell by $99.1 billion in
2009, the largest-ever annual dollar decline, to $3.4 trillion, according to analysis by the Mortgage
Bankers Association. Most of the decline was the result of a $44.3 billion drop in the volume of
mortgages held by CMBS and other securitization vehicles, to $690.5 billion. But commercial banks,
which hold the largest chunk of the mortgage universe, also saw a $37.4 billion drop, to $1.5 trillion,
according to the trade group.

In Figure 1.1, a decline in the total real estate lending is depicted. The Real estate loans held by
all commercial banks fell by 4% in the last 1 year.

In figure 1.2, a nominal change in Commercial Mortgages outstanding can be viewed.

History of Hard money Loans

The term “hard-money” lending can be traced to the Great Depression when private individuals
started lending money because of the banking crisis, according to Leonard Rosen, who owns the La Jolla-
based company, Pitbull Mortgage School.

Later, in the 1950s, Prospective borrowers’ credit applications began to be scored

quantitatively. As a result, people with lower credit scores could not obtain the credit that they needed.
Therefore, a new market for Hard Money loans was created. The higher risk with lending to less
creditworthy applicants allowed higher rates and fees to be imposed by the lenders. People with money

11
to invest saw this market as a potentially very lucrative one, and the service began in earnest in the late
1950s.

The industry was hurt considerably with the real estate crashes of the 1980s and early 1990s
due to lenders overvaluing and funding properties at more than their market prices. When real estate
values fell, lenders lost substantial amounts of their investments. This, in large part, explains the lower
loan-to value ratios required by the Hard Money lenders today.

Hard-money lending has been around for decades but had been marginalized for residential
borrowers in recent years. That is because of the rise of credit scores, and the ability of banks to bundle
low-grade loans and sell them on Wall Street. This provided the traditional lenders with a way to offer
mortgages to riskier consumers at interest rates lower than hard-money lenders charged. The subprime
crisis has changed all that.

Non-tradable capital

Since most Money lending firms are registered privately, and are not traded publicly, they are
not subject to the whims and fancies of investors. As a result, the investors’ success in these companies
is only a factor of the profitability of these firms, and not that of the stock trading sentiment in the
markets. Consequently, the returns of the investors from these companies were stable and predictable
during the financial crisis.

Similarity with Mortgage REITS

Mortgage Real estate investment trusts (Mortgage REITS) are almost the same as Hard money
lending firms. These Mortgage REITS follow the same business model of lending money to short term
developers, or of making bridge loans. However, Mortgage REITS are required by law to distribute 90%
of their profits amongst the investors each quarter. This rule helps them qualify for pass through
taxation. Conversely, most Hard Money Lending firms qualify for pass through taxation owing to their
registration as Limited Liability Corporations. The REITS, on the other hand, are registered as public
corporations, which generally do not qualify for pass through taxation. So a REIT abides by the Dividend

12
rule simply to provide the benefit of pass through taxation to its investors. Most REITS are publicly
traded, but it is not uncommon to come across a private REIT.

The benefit of registering as a private company was discussed under the previous heading,
“Non-Traded Capital”. The same logic applies to the Mortgage REITS. It has been profitable to hold a
Private REIT as opposed to a publicly traded REIT due to the immunity from undue fluctuations in the
stock prices.

Industry size and statistics

There are no hard facts available on the size of the industry, but combined with the Bridge loans
and Payday loans, the industry creates at least a Trillion Dollars worth of loans each year. There are
hundreds of Hard Money lenders in each state, but mostly concentrated in a few states with favorable
terms, like PA and NJ. The Hard money lenders market their loan services largely through word of
mouth, and through some small media. Hence it is often difficult to locate a hard money firm for a new
entrant in the development industry.

However, due to the decline in bank lending, the scope for the use of hard money loans has
expanded considerably.

Legal structure and other Issues

Like most small firms, Hard Money lending companies register as Limited Liability Corporations
(LLC). The chief benefit of registering as an LLC instead of as a corporation is the tax benefit. The
incomes of an LLC firm are subject to pass through taxation, where the incomes are only taxable to the
individual investors, but not taxable at the company level. This escapes the most common problem
faced by all public corporations, which are taxed at both the corporate level and at the individual level,
famously known as Double taxation. Even the mutual funds are maligned by the same issue since the
public companies they buy are taxed at the corporate level and the dividends are then taxable to the
mutual fund investor.

13
 Another advantage of an LLC structure is that of limited liability. As opposed to a partnership,
the owners of an LLC are not personally liable for any debts, or other damage. In addition, no annual
meetings of shareholders are required. Also, the investors could be foreign citizens.

The Hard money lending industry is lightly regulated, though depending on how a mortgage is
structured, lenders can be subject to state and federal caps on interest rates. The industry is monitored
by the Federal Trade Commission. The Federal Trade Commission's Web site (www.ftc.gov ) has links to
consumer publications that explain high-rate, high-fee loans, a category into which hard-money
mortgages fall. The agency says it hasn't received many consumer complaints about hard-money
lenders.

14
 Figure 1

Figure 2

Nominal Change in Total Commercial

Mortgages outstanding(Billions)
300
250
200
150
100 Nominal Change in Total
Commercial Mortgages
50 outstanding(Billions)
0
-50 2005 2006 2007 2008 2009

-100
-150

15
About the Author

Nikhil Raheja is a Financial Analyst at Keystone State Capital Corporation. His key interests are
the Global equity and bond markets. Nikhil has been with Keystone State Capital for over two years, and
had successfully predicted and cautioned the firm against the 2008-2009 financial crisis.

He is a regular guest on the weekly radio show, “It’s your money”, with host Greg Sistek, every
Saturday on 1510 KFNN, the most popular financial radio station in America. Nikhil also authors a
regular article on www.Seekingalpha.com, the best online financial information forum amongst traders
and investors.

Nikhil has an MBA from a premier University, and holds the Series 65 license, a requirement for
Registered Investment advisors.

16