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Closing Day, Show Me The Money!

October 26, 2021

Recently, I reviewed some old collateral we pulled together years ago for prospective investors seeking us out for private money placement. What stuck out to me while reviewing these pieces was the number of times I used private money and hard money interchangeably. As a novice in the field, back in 2014, I didn’t really understand or care about the difference in definition. In all honesty, I felt it was more semantics than anything else and who really cared what you called it so long as we provided a financial solutions people needed.

However, I began to understand the true difference between private money and hard money after COVID hit in March 2020. Not by definition, but more about how it impacts the borrower. Anyone actively involved in real estate investing when COVID shut down the real estate market (and the world!) was affected in some way. Some active investors have horror stories to share about trying to fund or refinance their projects during these “unprecedented times”; an overused phrase that just wouldn’t go away.

In a matter of weeks, many mainstream lenders stopped funding altogether or froze untapped rehab and construction funds being held back by the lender. Of those lenders who remained open, many changed guidelines to lowered loan to values (LTVs), raising underwriting standards with higher cash reserve requirements, requiring higher prepaid interest, or more conservative valuations of the property. This left real estate investors at risk of losing earnest money deposits and the acquisition itself. The notification about new loan conditions or funding cancellations sometimes came only a day or two before their scheduled closing! Borrowers couldn’t pay invoices past due, couldn’t initiate any new work, and some were still paying interest on funds not released. Overnight, the real estate investing arena changed. Someone moved their cheese and in the middle of the game changed the rules.

Yet, some lenders, including us at Flynn Family Lending, were still active and funding deals throughout last year. In fact, the lenders that kept capital moving had their best year ever because of these other sources drying up! So the question becomes, how could they be in business but others not? The answer lies in their source of capital!

There are a variety of ways a private lender or hard money lender can gain liquidity to lend capital. That method, which involves a variety of sources, also dictates how and when they can lend their capital. If someone is calling their business a private lending business, is it truly private? Is it a lender that has backing from an institutional investor such a warehouse line of credit? Is a lender dependent on secondary markets to sell the loans they have originated in order to regain liquidity to lend again? These questions may seem arbitrary, money is money at the end of the day, but those sources all have different strings attached to the capital. The lender you are talking to may not have the authority to make the funding decisions all the time.

Most borrowers may not really know where their lender gets their capital and, quite frankly, they likely do not care as long as their deal gets funded. But when something like COVID happens or even a recession, and real estate investments are precariously in the hands of “flakey” lenders, active investors need to start paying more attention. Most markets in the country had only seen a fast growing bull market for real estate, there were no bumps in the road before COVID. Investors with less than ten years of experience had likely never seen an economic downturn or anything negatively affect real estate. In an era of record low interest rates, everyone is buying, people were selling to upgrade to large homes, it was a decade of prosperity! Now these same investors were hitting wall after wall looking for funding.

So how do I see the difference between private money and hard money? To me, private money is using your own funds or, to some extent, other people’s money to fund a real estate backed loan. As a private lender, someone has direct control over the capital. When an active investor is talking to a private lender, they are likely talking to the decision maker. Private lenders generally do their own in house processing and underwriting. They meet the borrowers, walk the properties, know many of the key individuals involved in the closing process such as appraisers, title companies, and real estate attorneys. Private lenders are working with their own capital, so they have the flexibility to price that capital, come up with creative solutions to get the deal closed, and can have some wiggle room on terms for the loan as well.

Contrast that with hard money lenders which typically utilize a pooled mortgage fund and other capital deployment strategies (warehouse line of credit, venture capital, or to selling out funded loans on the secondary market) to free up capital for further redeployment. Hard money lenders are often more liquid than most private lenders, so they do have a place in the market for financing needs. Yet, being aware that they have sold those sources of capital on a particular business model can help an active investor choose the best option for financing. Hard money lenders must work within the parameters agreed upon by their source of capital. These often involve metrics such as borrower credit score, amount of experience a borrower must have, upper limits for debt to income, and also a strict adherence to when points, fees, and interest are paid. There is often no negotiation when it comes to the terms of the loan such as in interest rate, origination points, personal guarantees, escrow holdbacks, and other fees. Hard money lenders simply do not have the ability to change those terms because their capital came with the stipulation that only loans that check all these boxes will be funded or bought on the secondary market.

You may say this is inconsequential, and before 2020, it was to a certain extent. However, whether a lender has control over their own capital or not, really makes a difference. Just ask some of your fellow real estate investor friends. If a lender taps out their pooled fund and no one is buying loans on the secondary market, the lender is benched from funding new deals until they can free up more capital. If a lender relied on capital partners to table fund loans, and these partnerships suddenly stop as they did last year, the lender is also sidelined, leaving borrowers in the lurch.

In contract, most true private lenders did not have these market constraints in capital deployment. Our business grew nearly 25% YOY in 2020, largely due to our own control of capital (and a lack of active competition). My investors still needed a safe place to invest their savings and we could call the shots as a local lender, making their deals even more secure given the uncertain market conditions at the time. Those lenders with dependency on capital markets did not have this luxury. In fact, lenders and capital partners across the nation shuttered their doors for nearly the entire year and many just now returned to pre-COVID capacity in second quarter of 2021.

While this doesn’t necessarily make my private lending business any better than the hard money lenders in my market, COVID-related impacts on lending now mean borrowers have to be more aware of these capital considerations. They have learned ignoring them creates financing complications down the road, even if the lending guidelines have nearly returned to pre-COVID accessibility. If the “bubble” is upon us, borrowers and lenders alike could find themselves scrambling as we did last year amidst the pandemic. While no one could have predicted a global pandemic would have happened, much less how that would have affected their business, it is a good exercise in where vulnerabilities lie within your business model. It spurred a new conversation between active investors and capital partners, and made many investors keenly aware of how tenuous their funding situation really could be. The two terms, private money and hard money, are still thrown around interchangeably, and hopefully this makes you realize that they can be quite different. While the differences upstream can seem small, their implications downstream can be enormous for an active investor. Know the source of your funds and what risks may be involved in that source. That doesn’t mean private lenders have no risk of not being able to fund a loan, but knowing that the source of capital is something they directly have control over might be an important question to ask your lender on future projects.

In theory I think the distinction means little but when it comes to real world application it could mean the difference between closing on your next project or not.