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Hard money loans are debt investments which theoretically sit in the safest part of the capital stack. But many investors are gambling with their hard money loan investments and have no clue that they are. And if the real estate cycle comes to an end, many are prone to especially suffer unexpected losses.

In part one of this guide we talk about what a hard money loan is and the hidden costs that many investors don’t realize can kill their return and principal. For those interested, here are the other sections of this guide:

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• Part 1 - What is hard money loan investing?

• Part 2 - How to protect from loss

• Part 3 - The Due Diligence Check List 

• Part 4 - Top 19 hard money loan funds

• Part 5 - Postmortem: Money flushed down the drain (a loan that took years to resolve and lost 60%)
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What is a hard money loan?

 

In theory, you should never lose money on a hard money loan.

It works by you loaning money to another investor who uses it to purchase a property and improve it. Once they complete the project and sell it at a higher price (or refinance it with a bank) you get back your money plus a nice return.

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And if the borrower flops and can’t pay you back, you have a backup plan. Assuming you’re in the first position (meaning your debt is senior to all others) you foreclose on the property and become the owner. Then you can sell it and recoup your money anyway. You might have to wait several months (or longer if you were unfortunate enough to have loaned money in a state that only allows judicial foreclosures). But theoretically you should still win either way.

How to lose money on a sure bet.

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However, in practice, many people can and do lose money making hard money loans. Almost always it’s because the investor didn’t give themselves enough cushion for the many hidden costs that happen when the investment turns from passive (holding the note) to active (borrower defaults and you have to foreclose to recover your money). There are a slew of them and include:
 

1. Foreclosure and resale costs:
    

   • Legal (attorney costs) and administrative costs (process, court fees, title fees, etc.) to notify the borrower they’re in default, attempt a cure, foreclose on them and take title to the property.
      

   • Triage of the uncompleted rehab, and often bidding out, hiring, managing and paying contractors to perform the rehab.
      

   • Cost of selling the property including broker real estate sales commissions, closing costs and taxes.
      

   • Holding costs including property taxes, insurance and maintenance.
      

   • Time value of money costs: the loss of the use of your money for several months or longer until you recover it.
      

   • Management: either time or money for you or your representative to oversee the above process and make sure it’s done successfully and properly.
      

2. Recession costs
    

   • A severe recession can cause the price of all properties in the city to drop drastically. For example, in the Great Recession the average US city experienced an 11% 1 year drop from April 2008 (167) through March 2009 (147).

     
     Some cities like Miami experienced a 26% one year drop from June 2007 (264) to May 2008 (193).
     
     If you loan for more than a year, the drops were even more severe over the longer time period.

 

1. Unexpected things go wrong costs:
    

   • You overestimated the value of the property.
      

   • You underestimated the cost of making the improvements.
      

   • You overestimated the value of the improvements.  Note: Be especially cautious here on platforms that make high LTV loans look lower than they really are by over-inflating the value of the property by using overly-optimistic after-repair-value (ARV) projections.
      

   • The neighborhood takes an unexpected turn for the worse and prices drop.
      

   • Rehab uncovered hidden problems with the property.
      

   • Damage done to the property that is not fully or at all covered by insurance (fire, vandalism, etc.)
      

   • Etc., etc…

 

My bill is *how* much?!
 

During the last recession banks paid a hefty $50,000 per property (on average) to foreclose and they lost a shocking 30%-60% of principal on average!   

And that doesn’t even count the cost of having to pay people to manage and oversee the process. These losses were much larger than banks ever thought they would be, and that miscalculation was the root cause of the global financial near-collapse that caused the Great Recession.

So if you care about protecting your money, it’s important to structure your loan right to insulate yourself from downside risk. We’ll talk about that in part two of this article.

Beat the banks

 

One quick thing, before talking about that, though. I should explain that the banks do a few things that you probably don’t want to copy.
 

1. Many of the above loans were made in judicial states, where foreclosure requires a court process that can span for years and costs a lot more money. (Here's an example that took more than a year and investors lost 60%+) Many smart investors confine their loans to only states that allow nonjudicial foreclosures. This takes months instead of years and is much cheaper. Here's a great resource that tells you which states have a nonjudicial foreclosure process. And RealtyTrac documents how long the process takes in different states.
    

2. Some states have a right of redemption, where the borrower can redeem the property back from you, even after you have foreclosed on them! This really puts the status of the property in limbo and makes it difficult to resell. For example, in Alabama, they can do this for up to a year. Personally, I avoid states that have this issue. RealtyTrac documents the right of redemption for different states here.
    

3. Many investors confine their loans to properties that are not owner-occupied since laws allow people living in a house can drag out the foreclosure process for years. If you do choose to do owner-occupied loans, make sure you’re getting even more of an equity cushion (which we’ll talk about in part two) and enough higher yield to compensate for the increased time and aggravation. (And in defense of owner-occupied, they do tend to have a lower default rate and a higher loan recovery rate).
    

So how do I protect my money?

In part two of this guide, we’ll talk about general guidelines to protect your loans from loss and a review of options that can help you do this.

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