By Douglas Katz – 10/13/2022
So you have an investment real estate acquisition or project that you want to undertake and you cannot or do not want to pay cash. This, of course, means that you need financing, but what is the right financing. Counterintuitively, there are actually more options for investors than there are for borrowers financing a primary or second home for their personal use and these options vary greatly from the conventional space and often times from each other. There are reasons for this that I will clarify at a later point, but this also means that it is exceptionally important that investors know what the benefits are of each and how they can benefit by their use.
Full disclosure, this article gets in the weeds and provides a little more granular approach than you might expect, but that is the point. If you are unacquainted with these concepts and/or this article seems at a level above your comprehension, stop and get educated. Without knowledge of the tools available for you and the best way to decide, you risk losing money, time and other resources valuable to your real estate investment business. So, that said, how are conventional and hard money loans different and what are their strengths and weaknesses.
Conventional is the the first option that most people think of when financing a property. Generally, you can think of these as loan originated for sale to Fannie Mae or Freddie Mac or, at least, conforming to their guidelines and, therefore, a safer bet for the lender. For the borrower, there are some good definite benefits but also some drawbacks when using this financing for an investment deal.
Conventional Loan Benefits
- Price – Conventional loans are the most prevalent loans in the industry, so the pricing is generally better than the non-agency, hard money programs. Lenders can easily sell these loans in the secondary market and the pricing matches the flexibility that these loans provide. I put qualifiers to that statement because there are times, like now, when the Fannie and Freddie add surcharges and price hits to their pricing which narrows the pricing gap, but most of the time there is at least some price benefit.
- Terms – The conventional world also offers familiar terms to borrowers without some of the encumbrances in the hard money world. Things like prepayment penalties are not allowed for loans of this type, which appeal to some borrowers even with trade-offs that I will address further down.
- Familiarity – If you are investing, you have hopefully purchased at least one property for personal prior to your investment transaction. The process is one which you are familiar with and this can provide comfort and a better ability for you to manage your deal. Since your experience is more likely to match your expectations, this definitely works better for new investors. This benefit will wane over time, however, as you become more acquainted with the hard money process.
- Occupancy – Many if not most hard money loans do not allow for an owner to occupy the property for their own use. If you have the intent to use the property for personal use, conventional may be your only option. I get asked all of the time what if I just do the loan, hard money in that case, and just move in. The answer is that by doing so you have misrepresented on a legal document and are committing occupancy fraud. Hard money and private lenders will not risk running afoul of regulation because they specifically operate outside of the agency world for a reason. You can find yourself quickly having the loan called and requiring immediate payoff requirements. This is not a problem in the agency world where occupancy can be more fluid and change without changing the financing.
Conventional Loan Drawbacks
- Process – Because these are conventional loans, they are bound by the same regulatory requirements that apply to other conventional loans. The process involves much more documentation and there is little to no room for exceptions or subjective analysis of your deal. Many investors feel the return of aggravation for these deals can reach a point where the price benefit is not worth it.
- Flexibility – There is very little ability to customize financing with conventional programs. Issues related to regulation like the Fair Lending Act and very specific guidelines from Fannie Mae and Freddie Mac mean deviation is impossible. An exception that is not OK with Fannie and Freddie means an unsellable loan and lenders will not risk that. The private world, however does not have the same regulatory hurdles, so there is much more innovation for programs that are tailored for investors.
- Title and Vesting – For these types of loans, you will have to be guarantor, borrower and owner. Title can be individually or in a trust, but the option for vesting in a business is not an option. While some investors will close in their name and quit claim to a business, this is technically in breach of most mortgages. Rarely is it an issue but if the lender does discover the change they can at best make you re-title back in your name. At worst, they could call the loan and require payoff within a certain amount of time.
HARD MONEY/PRIVATE LOANS
Private loans are a completely animal. While still subject to basic regulation, they are free of the post-2008 regulation tsunami. They have a slew of benefits for real estate investors because they were literally designed for that market.
Hard Money Loan Benefits
- Process – Where conventional loans are underwriting you with the collateral as a consideration, hard money loans are different. While the lender does underwrite you as part of the deal, more focus is placed on the collateral. Although mileage may vary, you can generally expect to deal with less documentation and a less cumbersome process. The return on aggravation is for many borrowers worth the price premium.
- Guidelines and Underwriting – I sometimes hear comparisons to the wild west lending environment of the early 2000’s for describing the hard money world of today. Nothing could actually be further from the truth. Investors will not find easy money, but they will find programs designed for investors and underwriters familiar with real estate investors. Many rental programs do not require any client income information and only evaluate the property’s debt service coverage ratio. Others like fix and flip renovation loans have no income requirement at all.
- Terms – Because these loans are specifically designed for investors, they offer much more aggressive terms than the conventional lenders. Higher loan-to-value options for fix-and-flip deals and no mortgage insurance on investment deals over 80% are just a few examples that you will not find in the conventional space.
- Title and Vesting – Unlike conventional loans, hard money does not constrain your options. You can both borrow and vest in your own name or the name of a business entity. You should expect to be the guarantor, but there are even non-recourse options.
- Flexibility – When the situation warrants, borrowers should expect consideration for better terms or exceptions to fit their needs. This is not and should not be commonplace but when the risk is sufficiently mitigated by a strong file, hard money and private lenders can grant limited exceptions.
Hard Money Loan Drawbacks
- Pricing – Since conventional loans meet stringent requirements, lenders can provide better pricing for their programs. The ability to sell easily on the secondary market means loans originated under conventional guidelines offer less risk. The opposite is true of hard money and private lending. The non-uniform nature of the lending landscape means lenders have fewer outlets to sell loans and could more easily need to keep the loans on their books. This added risk costs money and the pricing reflects the premium to the lender for accepting that risk. In short, you are trading convenience, flexibility and increased capability to build their business.
- Regulation – This is one of those pesky strengths that is also a weakness. The lack of regulation does mean better options than the conventional space, but it also means that there is little to no regulation, consumer protection and recourse for borrowers. Lenders are not required to be licensed so there is little to no barrier to entry for lenders. Without some critical evaluation you have no guaranty as to the experience, integrity, credibility or background. This introduces a level of peril that you will not see in the conventional market.
- Terms – Just as with pricing, terms for these loans also include things to further protect the lender and their profitability. You should expect terms like pre-payment penalties for rental loans and interest reserves for fix-and-flip renovation loans.
Confused? I am not surprised. The answer is that there is no one best option all real estate investing scenarios. Both of these funding sources offer great benefits that when leveraged properly which is why I have remained active in both. The key for the investor is determining which is best at the time. With a little research and a good lender who can provide but more importantly advise on both types of lending, you should be able to fire from both barrels as necessary and grow your business to its full potential.