Lack of funds is the highest barrier to becoming a real estate investor. It is a competitive field: fast and easy access to funds is the key to success. Traditional lenders provide few alternatives to competing with all-cash buyers. If you are working with a bank or a credit union, it might take 45 days of intense scrutiny to make the underwriting decision. More significantly, they do not finance residential or commercial properties that require renovations. Private loans offer a viable alternative to the niche neglected by conventional lenders by providing investors with quick access to funds they need to fix and flip a home.
How do private loans work?
Just like regular mortgages, private loans are liens against the title of your property. Once you repay your loan, the lien is removed. Private loans are issued by private lenders – firms or, in some cases, private folks that lend their very own funds. Private lenders are also known as hard money lenders. The major distinction between hard money financing and a traditional mortgage is that private lenders do not finance consumer debt. Private loans are considered business or “commercial” loans, regardless of whether you are buying is a single-family home or a multi-unit. Because private lenders work exclusively with investors, they are regulated differently from lenders who cater to consumers. In general, private lenders are free to take any risk they feel is acceptable and can develop their own unique underwriting criteria.
A word of caution: it is not uncommon for private loans to be confused with subprime loans. Both types of financing might have underwriting flexibility when it comes to working with borrowers with low credit scores or difficulty verifying their income. However, private money is very different from subprime lending. Subprime loans market to consumers in precarious financial situations, while private loans provide quick and easy access to funds to real estate investors.
There are three main reasons for private loans’ popularity among real estate investors:
Cold hard cash aside, it might be your only source of financing.
Private lenders fund properties traditional lenders won’t touch with a ten-foot pole. These types of homes often come with disclosures such as “Sold As-Is” or “Handyman Special”. Traditional mortgage providers are not set up to manage the risk of funding rehabs-in-process and prefer to avoid this type of business altogether. Without private lending, many real estate investors with limited savings would have no choice but to twiddle their thumbs on the sidelines.
Private financing offers access to unparalleled leverage.
Traditional mortgage loans are based on your home’s current value as defined by a real estate appraisal and are a percentage of this value. For instance, if you are buying a property that is selling for $300,000 and are working with Fannie Mae type of lender that lends up to 90%, the maximum mortgage amount you can qualify for is $270,000. The other $30,000 will come from your own pocket.
On the other hand, private lenders base their financings on the value your property will have once you complete your rehab. This value – commonly referred to as the after-repair value or ARV – is likely to be higher than the current distressed price. A licensed real estate appraiser will determine the ARV by comparing your home with recently sold properties in your area that have also been rehabbed. Let’s suppose your ARV is $435,000. Some private lenders might offer you a loan as large as $282,000, covering not only 100% of your acquisition price but also contributing to your rehab budget. The ability to purchase something by contributing only the minimum amount of your own funds is called leverage, and private lending excels in it.
With private loans, you can close as quickly as any cash buyer.
Investors prefer private loans not only because they can finance properties in need of renovation but also because they can close as swiftly as any all-cash competitor. The majority of private lenders use simple underwriting criteria and focus primarily on the investor’s potential to make money. “If we feel that a borrower has a good chance of making a profit, we will find a way to fund the transaction,” – says Kyle Sennott, the Managing Partner of New Funding Resources, a Washington, DC-based private lender. “At New Funding, we focus on your deal’s potential, not on your credit score or income.”
Is private money right for you? It depends on these three factors.
You have your own capital to invest.
Private loans fund the lion’s share of what you need to purchase and rehab a home, but it does not mean you can start investing in real estate without having some capital of your own. By lending on a residential or commercial property that is in disrepair, private lenders take quite a bit of risk. They want to make sure they are working with borrowers who have a demonstrated track record of success, as evidenced by the level of their savings and their willingness to tap into them. By contributing some of their hard-earned cash, real estate investors show they are committed to the transaction and are willing to share its risk with their lender.
You are ready for higher rates and fees.
Private loans are more expensive than traditional financing. Typically, their rates fluctuate between 9% and 14% annually and compensate the lenders for the risk they take. For example, if a borrower fails to rehab the property, a private lender could wind up with a loan that far exceeds its current value.
You have a solid exit strategy.
Private lending democratizes real estate investing and opens doors to those without substantial capital to buy a property outright. However, as soon as your rehab is complete, there are no reasons to rely on hard money and pay the interest rates that come with it. If you are working with private lenders, make sure you have a viable exit strategy. The majority of private lenders do not want to hold your loan for too long, either. Typically, they require you to repay it – either by selling the property or refinancing it with another lender – within a year or so.
Private lending offers opportunities for growth to different types of real estate investors. Those with substantial reserves might be able to pursue other business opportunities or invest in several properties at once. Those with only a modest nest egg to invest, can leverage private funds to effectively compete with the most well-heeled investors. Private money is not for everyone, and not all who apply would qualify for a private loan. However, it’s a financing mechanism that offers many benefits and, used wisely, can help build your wealth.