I get asked by real estate debt investors regularly, “Why do fix-and-flippers pay such high interest rates?” and “Why don’t they just go to a bank?”
It’s no secret that hard money loans are expensive, so it can be confusing why a savvy investor would pay that much for the privilege of the loan when there seem to be better options.
It is important to understand that most banks will not fund fix-and-flip projects. The loans have too short of a term and are too administratively heavy on bank resources, making the juice not worth the squeeze.
The national average fix-and-flip takes 5.5 months, according to ATTOM. A good chunk of that time is spent rehabbing the house, so there are inspections, construction draws, and constant accounting. There is a lot of hands-on servicing, which is a lot of effort, to only have the loan for 5.5 months.
Add the fact that many fix-and-flip investors are buying the worst of the worst. Many of these houses are not habitable and, in most cases, not marketable. These are not assets a bank would ever want to own in the event of foreclosure—it does not meet their risk profile.
If the flipper is lucky enough to find a bank that will do a fix-and-flip loan, hard money may still be a better option. Here are three reasons why smart real estate investors choose hard money over borrowing from banks.
1. Speed
Banks are slow. I have seen banks taking two or more months to get a deal done.
I am experiencing this right now on an industrial building my partners and I are buying. A Minnesota bank offered a term sheet to our team two months ago, and we still have not closed. Luckily for us, the seller is understanding and has allowed us to push back the closing date, giving our bank the time they need. That is OK if the seller understands, but not all sellers are willing to wait.
Impatient sellers are common with residential purchases, and this is especially true if there are other buyers lurking, ready to close with cash on hand.
Speed is a competitive advantage for fix-and-flip investors. Speed allows them to separate their offer from others that a seller may be considering. Offering a closing in 10 days or less is an attractive option for a motivated seller and may be more important than getting top dollar for their home. This is especially true if there is a looming deadline like a foreclosure auction.
Hard money lenders understand the fix-and-flip business and can close fast!
2. Flexibility
Banks are highly regulated, with strict guidelines that must be met before they are able to originate a loan. Criteria like high credit scores, easy-to-document income, and liquidity are essential to getting a deal done. Many banks also want to see cash flow from a property, which vacant homes under construction will not produce.
Hard money lenders have what I like to call common-sense underwriting standards. Sure, they need to do some due diligence to ensure they keep their money safe, but they understand that a successful project is what is needed to get paid back not W-2 income.
For example, being a self-employed borrower with an irregular income stream could easily prevent a bank from loaning money to you. But if you have a strong deal, a co-signer, or something else that makes the hard money lender comfortable, they will still loan you the money.
It is about telling your story on what you plan to do and how you plan to pay the loan back. Because there is so much flexibility with hard money lenders, each one will have different standards or guidelines, and each will have different areas where they are willing to make exceptions. A good credit score may be required for one, while another may not pull your credit at all.
Having a strong value proposition and brokering relationships are truly keys to having the money available when you are ready to purchase.
3. Higher Leverage
This is probably what separates hard money lenders from banks the most. As stated, each hard money lender will have different guidelines, which include down payment requirements. Most hard money lenders will require a smaller down payment, while banks require large ones.
For example, it is highly common for a bank to require 25% to 30% down on loans to real estate investors. It is also common for hard money lenders to only require 10% down. Sometimes, they will not require a down payment at all.
Increasing leverage on a deal accomplishes several things. Money is finite, so everyone has a limited supply. Hard money is more expensive and will likely create less profit on each deal, but limiting the amount of down payments creates options.
The real estate investor may be able to get a deal done that they would not have been able to if forced to put down 30%, or maybe they can do two or three deals instead of just one. Giving up some profit on one deal to enable a second or a third can easily create higher income.
Hard money lenders allow investors to scale and accomplish more. This is the real key to why fix-and-flippers love hard money loans.
Final Thoughts
All this said, there is an obvious downside to hard money loans. Higher leverage creates higher risk, and those high rates can turn a good deal into a bad one quickly. Investors should stay focused, stick to strict buying criteria, and move fast when utilizing this creative lending source.
Hard money loans are an important and powerful tool that can create opportunities that are not possible with banks, but they are higher risk and should be used conservatively.
