Heed these lessons before you commit to a loan from a private or hard money lender.
With the economy uncertain—and some economists predicting a recession—it’s wise to consider your borrowing options to ensure you make an informed decision. Each person’s situation is unique. If hard money or private money is an option you’re considering, here are some questions to ask yourself:
- Is borrowing necessary? Is seller-financing a possibility? Should you sell assets or seek other sources of financing? Looking for alternatives should be first on your list.
- Can you really afford the loan? Evaluate your ability to repay the loan, consider your income and existing debts, and anticipate your future financial circumstances. Remember to always consider the worst-case scenarios, especially a further economic downturn or possibly a job loss.
- What are the terms and conditions of the loan? Understand the interest rates, fees, and terms associated with the loan. Calculate the total cost of borrowing and how it aligns with your financial goals and return on investment.
- Do you really understand the risks? Assess the risks that accompany borrowing (e.g., declining property values, increased loan defaults, potential challenges in selling or refinancing the property). Always consider the worst-case scenario and how it can affect you and your exit strategy.
- Can you afford the risk? Can you sleep at night? Private money and hard money loans often come with higher interest rates and more stringent terms compared to traditional loans. Assess your risk to determine whether you can handle the additional burden. What is the worst-case scenario? Bad things happen to good people all the time.
- How reputable and reliable is the lender? Look for reviews, testimonials, and references to check their track record. Personal referrals are always the best. Ask the lender to tell you about their worst deal. Get them talking so you can learn about them.
- What is your exit strategy? Even if your plan is to sell the property, you need to understand how you can get refinanced out of it just in case it doesn’t sell. You need multiple exit strategies.
- Have you considered economic conditions? The economy changes. Check with multiple sources—not just the one who will tell you what you want to hear—to give you an update on current conditions and a prediction for the future. The update should focus on the real estate market and the business environment and use government economic indicators.
- Have you sought advice from other real estate investors you know, like, and trust and are successful and experienced? Nix gurus and people trying to sell you education. Talk to people you see doing honest business in your area.
Recession-Smart Asset Classes
During a recession, certain real estate asset classes may have better resilience and potential for returns. Here are some asset classes that are often considered to be a great investment during a recession:
- Multifamily properties. Investing in multifamily (i.e., apartment complexes and townhomes) can be a great option during a recession. The demand for rental housing often increases as individuals or families downsize or postpone ownership due to economic uncertainty. Well-managed and properly located, these properties can provide consistent rental income and long-term appreciation.
- Residential rental properties. Rental properties, particularly in high demand areas, can provide a consistent income stream during a recession. Affordable housing options such as 1-4 family units and desirable rental markets tend to be more resilient.
- Commercial properties. Commercial properties with long-term leases, such as retail and office space, tend to offer stability during a recession. However, be careful in this post-COVID, work-from-home environment. And, although online shopping is the new the norm, you still can’t get your nails done or hair cut online.
- Industrial properties and warehouses. Warehouses, logistics, and self-storage facilities tend to have consistent demand during recessions. With the growth of online retail and the need for efficient supply chains, the demand for the space is growing.
- Distressed real estate. Recessions often create opportunities to acquire distressed properties at discounted prices. Buying these properties, rehabbing them, and then selling them is known as fix and flip. Distressed properties include foreclosures, short sales, and properties with motivated sellers. Careful due diligence and a solid understanding of what you are doing is required for success. When working with these types of properties, remember above all that the sellers are experiencing what may be the most difficult times of their lives. Make sure the deal is a blessing to all involved.
The performance of real estate asset classes can vary, depending on specific market conditions and the severity of the recession. Markets are cyclical and always changing. Stay on top of the local market trends and assess the demand dynamics. Diversification within a real estate portfolio can help mitigate your risk. Investing in a mix of asset classes, locations, and property types can provide a more balanced portfolio.
Investors use many calculations to help them assess the probability of a project’s success. Here are three you need to think about:
- After Repair Value (ARV). This is an estimate of what the property will be worth once it’s been completely renovated. To calculate it, you need to know comparable sales in the area—and you’re not going to find that on Zillow. Ask a real estate agent to run comps for you. You need to consider the size, the age, and the style of the properties. Further, its location must be within a mile.
- Purchase price. This is the amount you pay to acquire the property. You make your money when you buy the house. Consider the current property condition and potential repairs before you make an offer.
- Rehab costs. These costs include all expenses associated with renovating and repairing the property. Don’t forget about the crawlspace and attic. Hidden problems will cost you the most. Your rehab costs should include materials, labor, permits, and any additional fees. Always complete a detailed scope of work. Doing your own work does not save you money!
Using these formulas, you can calculate the maximum allowable. As an investor, you want to have at least a 30% cushion if your intention is to turn around and sell the house.
So, the calculation would be:
- ARV multiplied by 70% equals the all-in price
- All-in price minus Repairs equals what you should pay for the house
Don’t forget to consider the holding cost on the house as well. Get it done quickly so you can get out of the deal and on to the next one.
Rent Income Considerations
Should current or future rent income be considered when buying an investment property?
Yes, rent income is a crucial consideration when you buy investment property. The income plays a significant role in determining the potential probability and your return on investment (ROI).
- Cash flow. You need to understand what your cash flow looks like as it pertains to mortgage payments, property taxes, insurance, maintenance, and vacancy costs.
- Loan qualification. For long-term financing options, rent income is the basis on which your loan is made.
- Property evaluation. For 1-4 family and commercial properties, rent determines the value of the property. True investment properties are based off the return on investment. If you are buying for the appreciation only, you are buying for the cherry on top. For some people, future wealth is their only goal, but be prepared to make up the deficit monthly.
- Risk mitigation. Rental income acts as a buffer during periods of vacancy or economic downturns. Reliable and consistent rental income helps mitigate the risk of any investment property. Saving any overage/profit to cover future vacancies and repairs is wise.
Determining the rental income is just a phone call away. Call any property manager and ask them if they were to list this house for rent, how much would they rent it for?
Hard Money vs. Private Money
Here are the key differences between the hard money and private money.
Hard money refers to loans provided by private lenders or companies that are typically secured by real estate. These lenders tend to focus on the collateral value of the property rather than on the borrower’s credit worthiness.
The key characteristics of hard money are:
- Collateral based. Many hard money loans are asset-based, meaning the loan is based on the value or potential value of the property itself and not as much on the borrower and their credit score.
- Faster and more flexible. Turnaround times are typically shorter; these loans are known for their quick approval and funding process. They may be more flexible in their lending criteria compared to traditional lenders.
- Loan terms. Typically, the term is between 6 to 12 months, and some lenders may offer longer terms. Rates range (as of this writing) between 9% and 18%—and even higher in some cases.
- Funding source. Hard money loans are often funded by private lending companies or individuals who specialize in private real estate lending. These lenders usually have specific criteria and guidelines for approving loans.
Private money often refers to loans funded by private individuals or small groups of investors. They can be friends, family members, acquaintances, and other individuals in the borrower’s network that have self-directed funds or cash.
Private money characteristics are as follows:
- Relationship based. Private loans are often based on personal relationships between the borrower and the lender. They either know them personally or through a referral.
- Flexible terms. Interest rates, repayment schedules, and other loan terms can usually be negotiated based on the mutual agreement between the borrower and the lender. They are usually more willing to work with a borrower in troubled times.
- Varied interest rates. Rates for private money can vary widely depending on the lenders’ preferences and the borrower’s financial situation. Equity pieces in your deal can also be an option because private lenders can be more creative.
- Relationship building. Private money loans provide an opportunity to build relationships with individual investors, who may very well become long-term partners, mentors, and sources of future financing. No matter the lender (i.e., family, friends, acquaintance), always make sure your note is in writing. No handshakes—preserve the relationship.
Hard money loans are typically obtained from specialized lenders, while private money loans are sourced from individuals who are willing to invest their own funds in real estate ventures. Some lenders, like us, are a combination of both. All types of financing can be beneficial. Terms and conditions of hard and private money can vary significantly from one lender to another. Be sure to create relationships with both types of lenders, because every investment is different.