Alternative Loan Options for Residential Real Estate Investments

Conventional loans are often the most difficult for real estate investors to obtain. Some lenders do not allow income from investment properties to be counted toward total income, which can make balloon underwriting a problem for certain investors, especially those who already have several existing conventional real estate loans reporting on their credit. In these cases, the investor must seek his investments outside of conventional financing. Two of the most popular options for alternative financing are portfolio loans and hard money loans.

Loan Portfolio

These loans are loans made by banks that do not sell the mortgage to other investors or mortgage companies. Portfolio loans are made with the intention of keeping them on the books until the loan is paid off or comes to term. Banks that make these types of loans are called portfolio lenders and are typically smaller, more community-focused operations.

Advantages of Portfolio Loans

Because these banks don’t trade in volume or answer to large boards like commercial banks, portfolio lenders can make loans that commercial banks wouldn’t touch, such as:

• smaller multi-family properties
• properties in disrepair
• properties with an unrealized value after completion
• pre-stabilized commercial buildings
• single tenant operations
• special-use buildings such as churches, self-storage, or manufacturing spaces
• construction and rehabilitation projects

Another advantage of portfolio lenders is that they get involved with their community. Portfolio lenders like to lend on properties that they can go out and visit. They rarely lend outside of their region. This also gives the portfolio lender the ability to push guidelines when the numbers on a deal may not be stellar, but the lender can visit the property and clearly see the value of the transaction. Rarely, if ever, will a commercial banker visit his property, or see more than he can glean from the appraisal report.

Disadvantages of portfolio loans

There are only three downsides to portfolio lending, and in my opinion, it’s worth the trade-in to receive the services mentioned above:

• shorter loan terms
• higher interest rates
• conventional subscription

A portfolio loan generally has a shorter loan term than conventional conforming loans. The loan will have a standard amortization of 30 years, but will have a balloon payment in 10 years or less, at which time you must pay the loan in cash or refinance it.

Portfolio loans also typically carry a slightly higher-than-market interest rate, usually about a half-percentage point to a percentage point higher than what you’d see from your big-name mortgage banker or retail business chain.

While portfolio lenders sometimes stray from the guidelines for a large property, you may have to qualify using conventional guidelines. That means decent income rates, global underwriting, high debt service coverage ratios, better-than-average credit, and good personal financial health. If you don’t meet any of those criteria, your loan will be out of consideration with most conventional lenders. Two or more are likely to eliminate you from applying for a portfolio loan.

If you find yourself in a situation where your qualifying criteria are affected and you cannot be approved for a conventional loan or a portfolio loan, you may need to visit a local hard money lender.

Hard money loans and private money

Hard money loans are asset-based loans, which means they are written primarily considering the value of the asset that is pledged as collateral for the loan.

Advantages of hard money loans

Hard money lenders rarely consider credit score as a factor in underwriting. If these lenders review your credit report, they will most likely make sure that the borrower is not currently bankrupt and has no open judgments or foreclosures. Most of the time, those things may not even get you out of underwriting a hard money loan, but they may force the lender to take a closer look at the documents.

If you’re buying a property at a deep discount, you may be able to finance 100% of its cost with hard money. For example, if you’re buying a $100,000 bank-owned property for just $45,000, you could get that full amount from a hard-money lender who lends at a 50% loan-to-value (LTV) ratio. That’s something conventional and portfolio lenders can’t do.

While private lenders check the income-generating capacity of the property, they are more concerned with the current property value, defined as the value of the subject property as it exists at the time of loan origination. Vacant properties with no rental income are rarely approved by conventional lenders, but are favorite targets for private lenders.

The speed at which a hard money loan transaction can be completed is perhaps its most attractive quality. Loan speed is a huge advantage for many real estate investors, especially those buying properties at auction, or as short sales or bank foreclosures that have short contract fuses. Hard money loans can close in as little as 24 hours. Most take between two weeks and 30 days, and even the longest hard money timelines are still less than most conventional subscription periods.

Disadvantages of hard money and private money loans

Typically, a private lender will make a loan for between 50 and 70 percent of current value. Some private lenders use a more conservative as-is value called a “quick sale” value or a “30-day” value, which may be significantly less than a standard appraised value. Using a quick sale value is a way for the private lender to make a more conservative loan or to protect their investment with a lower effective LTV ratio. For example, you might have a contract on a property comparable to other single-family homes that recently sold for $150,000 with an average time to market of three to four months. Some hard money lenders will lend you 50% of that purchase price, quote it as value, and give you $75,000 toward the purchase. Other private lenders can do a BPO and ask for a quick sale value with a marketing lead time of only 30 days. That value can be as low as $80,000 to facilitate a quick sale to an all-cash buyer. Those lenders would therefore make a loan of just $40,000 (50% of the quick sale value of $80,000) for an effective LTV of just 26%. This is most often a point of contention in underwriting deals with big money lenders. Since a hard money loan is made at a much lower percentage of value, there is little room for error in estimating the true value of your property.

The other obvious disadvantage of a hard money loan is the cost. Hard money loans will almost always have a much higher than market interest rate, origination fees, principal fees, exit fees, and sometimes even higher attorney, insurance, and title fees. While some hard money lenders allow you to finance these fees and include them in the total cost of the loan, it still means you get less when you close on the loan.

Weighing the good and the bad

As with any loan, you need to weigh the good and the bad, including loan terms, interest rate, points, fees, and access to customer support. There is always a tradeoff present in alternative loans. If you have bad credit and no money for a down payment, you can be sure that the lender will charge you higher interest rates and reduce terms to offset the additional risk.

When dealing with private lenders, be sure to ask about their valuation method.

Also, with hard money lenders, you have to be careful in your research and background checks. While hard money loans are one of the most popular alternative financing options, they are often targeted by unscrupulous third parties. Before signing any loan paperwork, be sure to have all paperwork executed by a qualified real estate attorney and/or tax professional. If you suspect fraud or predatory lending, contact your state attorney general’s office.