By: Minsok Oh | LinkedIn
Securing capital is one of the key challenges when it comes to real estate investing in Connecticut. Not surprisingly, there is a lot of money in the tri-state area, and therefore lots of competition for real estate investors. Much of this competition are cash-buyers. Traditional financing options may not work if you don’t fit a bank’s credit criteria due to poor credit, not being able to prove your income, or having too much debt. Enter hard money loans – an excellent choice if you need real estate funding fast.
It’s important to understand, however, that hard money loans come with some risk when buying investment real estate in Connecticut.
Below, we will go through the key risks and best ways to avoid mitigate them.
- High Interest Rates
One of the main risks associated with hard money loans is higher interest rates. These rates are always greater than bank mortgages, often four or five percent higher. In Connecticut’s real estate market, where property values are already relatively high, increased interest payments can increase the holding costs substantially.
Mitigant: Hard money loans are only intended to be short term solutions. You are not paying interest on them for a long period of time, thereby greatly reducing the overall interest cost. For example, if bank loans are at 8%, and hard money loans are at 12%, you are only paying 4% more annually, or 0.33% additional per month. If you exit the loan in 9 months, you paid 3% more in total. On a $300,000 loan that equates to only $9,000. While not insignificant, presumably the value-add equity and “forced appreciation” that was created well exceeded that amount.
- Short-Term Nature
Hard money loans are typically short-term loans, with loan periods ranging from six months to a three years, although one year is the typical term. In Connecticut, where real estate transactions can be complex and time-consuming, the short-term nature of hard money loans can lead to significant pressure refinance of face loan default.
Mitigant: Plan your real estate investment strategy with the loan’s short-term nature in mind. Ensure you have a well-thought-out exit strategy, such as refinancing with a conventional mortgage or selling the property, to repay the hard money loan within the specified timeframe. As a back-up scenario, most hard money lenders will agree to a loan extension provided you have made your previous monthly payments on time.
- Loan-to-Value Ratio
Hard money lenders base their loan amounts on the property’s appraised value, known as the loan-to-value (LTV) ratio. Lenders will look to leave significant room on the table for a market downturn, so their loan amount is not at risk. As such, lenders rarely make loans that exceed 75-80% of the as-is value, or 65-70% of the after-repaired value (ARV).
Mitigant: Before securing a hard money loan, ensure you have a clear understanding of the property’s appraised value and the lender’s LTV requirements. Be prepared to make a larger down payment to meet the lender’s criteria. If you do not have this money on hand, partnering with another investor is a good solution. Also, keep in mind that most hard money lenders will fund the full rehab cost, so you will only be required to come up with the initial downpayment and costs to start the rehab (rehab funds are typically funded by the lender in stages, after a portion of the work is done).
- Prepayment Penalties
Some hard money lenders in Connecticut impose prepayment penalties, which can be costly if you intend to repay the loan early. These penalties are designed to ensure that lenders receive a certain amount of income – typical penalties are 3 or 6 months, but a few lenders require a full 12 months.
Mitigant: Carefully review the loan agreement and discuss the possibility of prepayment penalties with your lender – you may be able to get it waived in exchange for a slightly higher interest rate. Create a realistic timeline and recognize that something things move slower than expected. For example, if the loan exit strategy is to refinance with a bank, that process may take 3 months by itself, not counting the amount of time it takes to fix/stabilize the property. An SBA loan may take even longer. What we have found is that rarely does the pre-payment issue come up in practice.
- Default Risks
Defaulting on a hard money loan can lead to an accruing high default interest rate, and potentially even the loss of the property used as collateral.
Mitigant: Conduct a thorough risk assessment of your investment project before securing a hard money loan. Ensure you have enough set aside to cover interest payments. In addition, have a contingency plan in place to address unexpected challenges. For example, if the original plan was to flip the property, but the market slowed down, renting the property and securing a long term rental loan may be a better option.
- Lender Reputation
Not all hard money lenders in Connecticut are created equal. Some may have a history of predatory lending practices or poor customer service. Choosing the wrong lender can lead to a host of problems throughout the loan term. Comfort and trust are critical and key priorities when it comes to choosing your business partner, which is what your hard money lender ultimately is.
Mitigant: Research prospective lenders carefully. Seek recommendations from fellow investors or real estate professionals in Connecticut. Make sure you are comfortable with the representative from the lender. Do they seem knowledgeable and easy to work with? Are they interested in your success or just making the loan? How do they handle loans that hit their maturity date (do they automatically put them into default or do they offer extensions)? These are the questions you should be asking.
Hard money loans are an important alternative financing tool for real estate investors in Connecticut, providing fast capital when traditional financing options may not be feasible. However, like any financial product, hard money loans come with some inherent risks that must be carefully considered and mitigated to ensure a successful investment venture. By understanding these risks and implementing the mitigation strategies discussed, real estate investors can navigate the Connecticut real estate market confidently, knowing they can use hard money as a beneficial financing tool.