by Guest Contributor, Attorney Kim Lisa Taylor
NOTE: This information is of a general, educational nature and should not be construed as legal advice pertaining to your specific offering, exemption or situation. Such advice must be sought from your own attorney pursuant to an attorney/client relationship, after consideration of your specific facts or questions.
Hard money lender definition (usually an LLC or other legal entity) is the business of lending money (theirs or other investors’ funds) and actively seeking borrowers (rehabbers or other short-term borrowers) with which to place their funds.
Hard money lenders typically offer short-term loans or “bridge loans” backed by the value of the property instead of the creditworthiness of the borrower. Hard money loans may have lower loan-to-value (LTV) ratios than traditional loans and typically require that a borrower pay between two and five “points” (a point is a fee equal to 1 percent of the loan amount) and interest in excess of traditional subprime loans (ranging from 10 percent to 18 percent per annum).
Hard money loans may seem like easy money to some, but there is hard work involved in hard money lending, as in any successful business, and many decisions to be made. This article will outline some of the considerations for structuring and operating a hard money lending agreement.
QUESTIONS REGARDING RAISING THE MONEY
The first question is: Are you using your own or investor funds?
If you are using funds from private investors to fund a hard money lending program, you will need to make some fundamental structuring decisions about what you will give investors in exchange for their investment. Here are some common hard money loan structures:
- The hard money lender provides a matching service (matching private lenders with borrowers).
- Investors would be given a promissory note as evidence of the loan, signed by the borrower.
- These types of hard money loans are typically secured (recorded) by a specific collateral property, and investors are given a fixed return for their investment. Or less commonly, they are given a share of equity generated by the borrower.
- The hard money lender earns fees for its matching service.
- The hard money lender borrows money from private investors, pools it with its manager’s funds or the funds of other investors, and then loans the collective funds to others in the hard money lender’s name.
- Investors would be given a promissory note as evidence of the loan, with the hard money lender as the borrower.
- These types of loans are typically unsecured (not collateralized against a specific property).
- The borrowers would also sign a promissory note with the hard money lender, but with different terms (higher interest and points) than what the hard money lender pays to its investors.
- The hard money lender expert would earn all or part of the points generated from loan origination plus the difference between the interest rates (spread) earned from borrowers and paid to investors).
- The hard money lender in this scenario is “in the business” of issuing promissory notes to private investors. Because promissory notes are securities, the hard money lender would need to raise funds from private investors under a securities offering such as a private placement (e.g., Regulation D, Rule 506(b) or Rule 506(c)) or a registered public offering (such as Regulation A+, Tier I or Tier II), or an intrastate securities offering where all investors, loans and the hard money lender are in one state. Investors would be given a private placement memorandum explaining the risks of the offering, and sign a subscription agreement and the operating agreement to invest in the Fund. Securities legal counsel should be sought for this option.
- The hard money lender pools money from private individuals by selling interests in a manager-managed legal entity such as a limited liability company, usually called a “Fund,” where the Fund makes the loans to borrowers.
- Investors could be given points plus a fixed return for their investment, or a share of equity that the Fund earns on its loans.
- The Fund would make loans to borrowers, and it would record its interest against the property serving as collateral for the loan. The Fund is the hard money lender in this case.
- The “Fund Manager” would earn fees and a share of profits that the Fund generates from loaning its capital to others. This scenario would require the Fund Manager to raise funds under a securities offering.
- The Fund Manager is issuing “investment contracts” to private investors. Because investment contracts are securities, the Fund Manager would need to raise funds from private investors under a securities offering such as a private placement (e.g., Regulation D, Rule 506(b) or Rule 506(c)) a registered public offering (such as Regulation A+, Tier I or Tier II), or an intrastate securities offering if investors, loans, the Fund Manager and the Fund entity are all in one state. Investors would be given a private placement memorandum explaining the risks of the offering, and sign a subscription agreement and the operating agreement to invest in the Fund. Securities legal counsel should be sought for this option.
- Additional questions regarding the Fund structure include:
- What terms will you offer to investors? What fees will the Fund Manager earn, and how will you split profits with investors? Will you offer them a preferred return (where investors get paid a fixed return before the Fund Manager earns something), or will you simply split profits?
- Will you have more than one class of investors? For instance, you could offer a higher preferred return or a higher interest rate to investors who invest over a certain dollar amount.
- How long will you keep the Fund open to new investors? Will you establish a maximum dollar amount you will raise, or perhaps a minimum that you must raise before you use investors’ funds? If you establish a maximum, once you have raised the maximum dollar amount, you will close the Fund to new investors, and as loans are repaid, you will begin to repay your investors their initial investment.
- When will investors get their money back? You must decide how long you plan to operate the company; will it have an end date? If so, you will typically have a reinvestment period where the proceeds of loans that are repaid within a specified period (e.g., three years) can be used to originate new loans, followed by a liquidation period where investors are paid back their investment as loans are repaid. The answers to the following questions will determine the Fund Manager’s likelihood of success in raising money for the Fund:
- Do you have a track record originating and servicing similar loans?
- Have you ever raised money in a securities offering before?
- Do you have a network of existing investors who might invest in your Fund?
- The answers to the following questions will determine which securities laws or exemption the Fund Manager can use to raise money for the Fund:
- Do you need to advertise for investors? If so, all must be verified as accredited investors under SEC’s Regulation D, Rule 506(c) or you must file for preapproval of a Regulation A+ Offering.
- What kind of investors will you allow? Can they be accredited, sophisticated or unaccredited?
- Will your investors all come from one state or multiple states?
- Will the collateral properties and/or borrowers all be in one state or multiple states?
- How soon do you want to start raising money?
Any of the above options may require the hard money lender or Fund Manager to have a mortgage loan originator’s (MLO) license to lend the money. Although there are some exceptions from licensure for lending to non-owner-occupants who do not use the funds for personal, family or household use, some states (e.g., Florida) have taken the position that loans originated on residential property (even to non-owner-occupants) may not qualify for this exemption. Further, in some states (e.g., California), a real estate broker must make or arrange the transaction or all loans will be subject to the Usury limit of 10 percent. A hard money lender expert should check with a real estate attorney or the real estate regulatory agencies in the states where the money will be loaned to determine what licensing, if any, may be required.
In conclusion, all of the options will require a sophisticated accounting system to keep track of loans on behalf of investors and borrowers. There are third-party fund managers and loan administrators who can help with this. Private lending associations like the American Association of Private Lenders (aaplonline.com) can refer resources for private lenders.
|Hard Money Lender Borrows From Investors/Makes Loans to Others||Pooled Fund Sells Interests to Investors/Fund Makes Loans to Others|
|Securities Offering Required?||No||Yes; seek securities counsel||Yes, seek securities counsel|
|Mortgage Loan Originator’s License Required?||Maybe||Possibly||Possibly|
|Payment Choices for Investors||Interest/points||Interest/Points||Preferred return/share of equity|
|What Hard Money Lender Earns||Fees/commissions||Points/spread between interest paid to investors and interest earned from borrowers||Fund Manager earns Fund administration fees and share of profits (distributions)|
|Secured by Collateral?||Usually||No||Fund records its interest; investors own part of the Fund|
|Investor Has Right to Foreclose?||Yes||No; hard money lender can foreclose||No; Fund can foreclose|
QUESTIONS REGARDING LENDING THE MONEY
In addition to the choices described above, you will need to decide on the loan terms you will offer to borrowers:
- Will you require that borrowers pay straight interest, shared appreciation or a combination? A shared appreciation loan is where the borrower splits profits with the lender that it generates from the collateral property.
- Will you require that points be paid on origination or periodic payments prior to maturation of the loan? Or will you allow the borrower to pay the entire loan balance plus points and interest on repayment of the final principal repayment?
- Will you charge points plus interest? If so, how much? Is it the same for every borrower, or is it determined case by case?
- How will you underwrite the properties? Will you use a broker’s price opinion? An appraisal? Who pays for it?
- Will all loans you originate be first-position, or will you offer second-position loans?
- What is your underwriting process to determine the sufficiency of the borrower’s collateral property, and what methods will you use to determine it?
- What is the loan-to-value ratio for loans you will originate?
- Will you underwrite the borrowers themselves? What kind of qualifications must they have?
- Will you allow borrowing by individuals (which may trigger the Dodd-Frank Act or SAFE Act) or will you require that they borrow via a legal entity?
- Will you require a loan application, and will you run the borrower’s credit?
- Is there a minimum FICO score requirement?
- Will you verify income?
- Will you require borrowers to give personal guarantees?
- Will you use MLOs or loan brokers to qualify borrowers?
- What duration are your loans? Will you offer extensions? If so, on what terms?
- Will you sell your loans to secondary note buyers or hold them for repayment?
- Who services the loans? (The manager or an affiliate of the manager, or a third-party loan servicing company?) Who pays the cost of loan servicing? The hard money lender or the borrower?
- Will you obtain a lender’s title insurance policy on every loan?
- Do you (or any members of your management team) have any real-estate- or securities-related licenses, and if so, in what states?
- Mortgage Broker
- Real Estate Broker
As you can see, hard money lending is a complicated business and should not be undertaken without proper training and planning, and in some cases, experienced securities counsel will be required to help guide you through the process.
by Kim Lisa Taylor