Mortgage Article

  • by Dan Harkey
    Educator & Private Money Finance Consultant

    Real property borrowers have access to alternative lending sources separate from banks and other institutional lenders—the subset of the lending business is designed for non-bankable and bank-decline loan transactions.

    The question arises as to how you locate borrowers who need these types of Loans.

    A) “Private money, hard money, and bridge loans” are used interchangeably:

    These terms, private money, hard money, and bridge loans refer to alternative lending methods separate and distinct from banks and institutional lending; investors/lenders fund the loans, usually as one or more private parties. Pools of investment capital accumulated by many private parties are also frequently used to finance private money loans. If there is a pooled entity, there will be a sponsor/manager.

    Private money lending has advantages when banks decline or the loan transaction is non-bankable until property-related problems are solved, like finishing a partially constructed building or renting income property with an excess vacancy that needs increased occupancy to the point of rent stabilization.

    B) Reasons to choose private money financing:

    Private money borrowers have unique problems to solve or quick closing requirements that render bank financing unavailable. Once the issues are solved, bank financing or selling the property on the open market becomes an option.

    Here are transactions where private money loans will benefit borrowers.

    (1) Fast loan approval with possible 2-to-4-day funding for bank declines and fallouts: Maybe the bank has already done significant underwriting, including opening escrow & title, obtaining an independent appraisal, and completing application and financials. Some private lenders can use the banks’ information to fund faster, particularly when they have a mortgage pool or immediate capital available to invest.

    (2) Debt consolidations for consumers, businesses, or a combination of both: In most cases, the is used for debt consolidation, lowering the borrower’s monthly payment obligations. The funded loan should give the borrower some breathing room to improve their credit to obtain a long-term bank loan. Also, if the loan is a second lien, the average interest rate between the first and second is calculated to show a ”net-effective rate.”

    (3) Marginal to poor creditworthiness where a borrower is not bankable, and approval of a loan request are primarily property equity driven.

    (4) Special purpose-unique properties- Churches, synagogues, restaurants, bars, automotive repair shops, body repair shops, gas stations, and other single-purpose or limited properties.

    (5) Limited document loans where the requirement is a loan application, credit report, and 3 to 6 months of bank statements. The objective is to prove the ability to pay the outstanding loan payments and other debt obligations.

    (6) Post-COVID fresh start loan. A borrower may need to catch up and give themselves breathing room for accrued and differed payments. One may refer to this as a “fresh start loan.

    (7) Payoff loans coming due or past due: Refinance and pay off existing first, second, and third lien position loans that may be due. Sometimes, refinancing the second and providing cash out is the appropriate answer to the loan request. Loans are available for both owner and non-owner-occupied residential and commercial properties.

    (8) Cash-out for any reason refinances based upon the protective equity of existing real estate. Proceeds may be for business and consumer purposes. The Federal Government and some states, such as California, require a special license to engage in consumer-purpose lending.

    (9) Junior lien or second-position loans on both owner and non-owner-occupied dwellings for business purposes

    (10) Construction completion, rebuilding, or upgrading properties in poor or marginal condition: The loan is usually necessary because the collateral property or the borrower needs to meet bank underwriting guidelines in its distressed or partially completed state. Loan approval by the lender will consider the as-is-value and the as-completed-value.

    (11) A borrower may own and operate a cash-based small business with limited financial strength. A lender will require 3 to 6 months of personal and business bank statements. The borrower is still required to prove that they or they can make the required payments.

    (12) Leveraged existing real estate equity developed over time to borrow additional funds, purchase other investment properties, or invest in a business enterprise.

    (13) Purchase a property with a cash down payment, sweat equity, and seller’s agreement to carry back a subordinated junior lien. The property seller would have the borrower sign a promissory note and a deed of trust with a set interest rate, payment schedule, and due date. The subordinated second is recorded concurrently with the first trust deed but with a recording number after the first.

    (14) Inherited property where family members and successor trustees who are beneficiaries need funds for distribution to the beneficiaries, pay the estate’s legal costs or fix up the property for a future rental. Another option is fixing it and selling it on the open market.

    (15) Loan on unimproved raw land. Loaning on raw land can be a complex process. Is the land parcel part of an existing subdivision, referred to as an infill lot, a commercially or industrially zoned parcel within a subdivision, or a larger parcel held for future development? The borrower may need to use the property as collateral to raise funds for future entitlements, including engineering, architecture, various reports, and fees to develop a fully entitled parcel ready to be built. The borrower would pay the loan off as part of the construction loan.

    (16) Retail strip and community centers, industrial or other properties that require upgrades or repositioning: Many centers are distressed due to the COVID shutdown vacancies, where tenants could not pay rent.

    (17) Fix and flip loans for high-frequency purchasers to purchase a distressed property, rehabilitate with the expectation to resale, and turn a quick profit. Borrowers need both experience and some of their capital at risk.

    (18) Litigation settlements: A loan to buy out a business partner, pay off a pesky family member, an ex-spouse, a judgment lien, or a partition suit.

    (19) Pay off civil judgments and liens, including arrearage in property taxes, association dues, and federal and state tax liens.

    (20) Sale of existing promissory notes and deeds of trust to 3rd party investors: The sale is usually at a discount, whether the promissory note is performing or non-preforming. A deal will free up cash.

    (21) Hypothecation or pledge of a promissory note and deed of trust: A promissory note and deed owned by a borrower will assign the note and deed to a third-party investor as collateral for a new loan.

    (22) Cross-collateralization of more than one property: multiple properties are required to meet the equity requirements of the lender. The borrower would sign one promissory note but have recorded liens that encumber two or more properties.

    (23) Small mobile homes or trailer parks: properties that don’t meet the underwriting standards of intuitional lenders.

    (24) Vacation, Short-term, and rental income properties; Financials and history are necessary to prove the ability to make payments.

    (25) New ground-up construction or construction completion for a partially completed project: Most requests result from borrowers needing to fund additional dollars to complete the project when they deplete their capital or existing construction loan proceeds.

    (26) Collateral combines real and personal property such as a motel, restaurant, carwash, or gas station with mini markets. A recorded trust deed encumbers the real property, and a UUC-1 financing statement will be filed with the Secretary of State to encumber the personal property. Valuation and decision to make the loan must be on the real property only.

    (27) A long-term lease on commercial property has or is expected to expire soon. The lease expiration could cause a vacancy and a disruption in rental income. If the master tenant vacates the property, this will disrupt other smaller in-line tenants because the master tenant is responsible for the primary draw of foot traffic to the center. Banks will usually not make this loan. This loan is generally a bridge loan until the owner obtains a long-term lease with a credit-worthy tenant and manages the center back into stabilization.

    (28) Credit approval is subject to highly sophisticated lease analyses, with multiple tenants having different terms of leases, including length, lease rate, and lease provisions. Some tenants are on long-term leases, and some are on a month-to-month tenancy. Lease documents may include go-dark requirements for the anchor tenant or provide for lease cancellation in the event of excess vacancy or loss of an anchor tenant.

    (29) Some properties require mutual property access easements for ingress/egress or complex usage rights, such as reciprocal parking agreements. Many properties, such as churches and retail shopping centers, sign contracts with multiple property owners to use the entry/exit of the property or the parking in specific ways or at certain times.

    (30) Foreign nationals with and without social security. The borrower must have a US bank account(s). The borrower must have a process agent service arranged during loan processing.

    (32) “Notice of a substandard condition” or “notice of property noncompliance” is recorded on public records by a building department notifying the public that the property is out of conformance or in disrepair for building and zoning codes. The bridge loan funded by private lenders will provide funds to make substantial improvements and modifications to bring the property up to acceptable building, safety, and zoning standards. Institutional lenders will not make these loans.

    (33) Non-conforming property not complying with current zoning and building standards. As a result, there are strict limitations on repairing or replacing the structures in destructive acts such as fire, flood, windstorm, vandalism, or earthquake. The property may not be able to be rebuilt to an acceptable level after the destructive event occurs.

    (34) Earthquake seismic retrofit. Many older properties require upgrades with engineered reinforced steel frames bolted into the existing structure and walls shored up with steel support fasteners to withstand earthquakes.

    (35) Tenant improvements. Owners of commercial buildings need to provide funds to install interior or exterior improvements to satisfy the owner’s and the prospective tenants’ leasehold improvements.

    (36) Cannabis-related properties, manufacturing, and retail facilities: Some states have legalized lending in cannabis-related operations, and others have not.

    When borrowers are unsuccessful at closing their loans or a bank declines, they will discover alternative funding sources that provide much greater flexibility in the underwriting, approval, and speed of funding. Interested parties should consult a highly qualified lending specialist to help.

    Private money credit decisions:

    The creditworthiness of potential borrowers is guided by the five “C’s” as core components of whether to make real estate loans: character, capacity, capital, collateral, and conditions.

    The five C’s credit risk analysis identifies each borrower’s and collateral property’s strengths and weaknesses. The two industries, institutional and private money, weigh each factor differently in making a final decision.

    The five Cs of the credit risk analysis system are like a sliding scale, meaning one or more of the core components take on greater or lesser importance in the overall credit decision. Private money credit decisions focus on collateral, capital, conditions, and character, capacity to a lesser degree. Banks and institutional lenders concentrate on character, capacity, collateral, and, to a lesser degree, capital and conditions.

    1) Character-Is the borrower likely to uphold their obligation to meet timely payments per the loan agreement, irrespective of unforeseen future events? A credit report and background search will reflect the borrower’s payment history.

    2) Capacity- measures the borrower’s financial ability to repay the loan. Sometimes, a debt-to-income (DTI) ratio applies, which, in many cases, may improve by distributing the net proceeds of a loan to pay off debts.

    3) Capital- refers to the amount of available money invested in the property to protect the loan in the event of default—the more protective equity in real estate loan transactions, the safer the loans.

    4) Collateral- refers to the security property to be encumbered. If a borrower defaults on the loan, the lender will look to the protective equity in the collateral from the foreclosed property to recapture the principal and costs upon resale of the asset: the more protective equity, the safer the loan.

    5) Conditions- refer to the general conditions relating to the loan, such as length of employment, terms, and interest rate, and how the borrower may use the loan proceeds to improve their financial circumstances.

    Conditions also include considerations outside the borrower’s control, such as government intervention in real estate ownership, recently passed and pending legislative changes, the state of the economy, and industry trends.

    As to the fifth C- “Conditions,” assume a borrower’s request does reflect all positives for four “Cs.” Consider that the property is a small commercial building in a neighborhood with 60% vacancy. The declining nature of the area and other neighborhood conditions may prevent making any loans.

    Multiple types of lenders are helpful in the dynamic real estate market. There are tradeoffs.

    D) Institutional lenders:

    An institutional lender is a commercial or savings bank, savings and loan, trust company, credit union, industrial loan company, insurance company, large pension fund, or large business trust, and any other lender regularly engaged in financing the purpose, construction, or improvement of real estate, or any loans made by such a lender, or any combination of any of the foregoing entities.

    Institutional investors invest their funds under management in corporate equities, debt securities, government securities, residential mortgages, commercial real estate, and mortgage-backed securities.

    Institutional lenders are known as financial intermediaries because they create depository pools of funds and depositors’ money to lend out and use depositors’ money to lend out to borrowers. Institutional lenders follow strict, standardized guidelines. Lending underwriting standards are designed to limit risk.

    E) What to expect from bank and institutional lenders:

    Banks and institutional lenders may have the lowest rates and better terms of real estate lending. Borrowers may choose these loans if the transaction and the collateral property qualify.

    Bank employees operate under strict guidelines, with little flexibility or latitude to make exceptions. But banks, institutional lenders, and government-sponsored entity lenders (GSEs) with the lowest interest rates and best terms also have a much more rigid underwriting and approval process with limitations and time delays that kill many loan approvals. Institutional lenders also have strict state and federal regulations to comply with.

    Borrowers who expect tremendously low rates with banks must be ready for the maze of paperwork and a drawn-out processing and underwriting period that could take 60 to 90 days. In many cases, the frustration will be overwhelming and extend beyond the contract due date allowed to close the transaction.

    Usually, borrowers operate under stressful situations and must complete the transaction quickly. Many borrowers find alternative lending better because their financial upside is far more significant than private money cost and interest rates.

    F) Loan agents and brokers:

    A loan broker acts as an agent of the borrower to make or arrange the loan with the expectation of compensation. The broker must represent their client’s (the borrower’s) best interests.

    A separate and distinct mortgage broker represents private-party investors to arrange privately funded loans. The mortgage broker is the “middle person” between the borrower and the investor/lenders, private parties. In some cases, the broker will close the loan with their funds. But usually, the broker will complete the loan transaction with the investment capital of third-party private lenders.

    The broker is a fiduciary of the private investor parties and is tasked with protecting the client’s best interest. Sometimes, the broker will act as a dual agent for both parties. Of course, this assumes that all mortgage broker parties are professional and understand the “laws of agency.”

    G) Trust deed and mortgage investors:

    Investors/lenders or private parties who purchase an interest in notes and deeds of trust are called “beneficiaries.” Private-party investors are the lenders whose names appear as beneficiaries on the borrower’s promissory note, deed of trust, and title insurance policy.

    The executed promissory note is the borrower’s promise to pay, and the security instrument is the executed deed of trust or, in some states, a mortgage. Both legal documents are contracts between the borrower and private-party lenders referred to as principals, not the broker. After the loan closing, the investors, or the loan servicing agents of the investors, will retain the executed documents for safe storage and as evidence of the investment.

    Their agent has a fiduciary responsibility to protect their interests relating to the full disclosure of all material facts and risks known to the broker.

    In summation, private money loans are collateral-driven, even though the lender must review financials to prove that the borrower can pay the debts.
    Craig Daniger - Loan Officer
    Phone: 818-326-1915