The Evolution of Hard Money
In the March issue of Think Realty, Direct Lending Partners was a featured contributor, discussing the history of hard money and why it has long been considered the lending industry’s black sheep. We’ll be delving into the history of hard money loans, how they developed such an unsavory reputation, and why they serve a functional purpose for both real estate investors and borrowers.
Ask most people how long they believe the credit system has been around and you’ll find that the majority think of it as a fairly modern invention. Believe it or not, the concept of hard money is actually considered to be one the earliest forms of credit financing, dating back to the 18th century.
Historians believe that Hammurabit, the ruler of Babylon during the 18th century B.C.E., actually invented one of the first lending systems. Throughout time, many other civilizations (Roman Empire, Tang Dynasty, Spanish Empire, etc) have followed suit and developed their own forms of hard money loans.
These days, hard money loans are most common in the United States and Canada where the term “hard money” is used almost exclusively.
The Hard Money Loan
By definition a hard money loan is a short-term loan from private lenders. Hard money has remained largely unregulated by state and federal law outside of being subject to a few interest rate restrictions. These are often considered loans of “last resort” or short-term bridge loans.
How it works:
- A hard money loan is primarily used for real estate transactions
- Funds for a hard money loan come from an individual or company, not a bank
- Typically taken out for a short period of time, a hard money loan is a great way to raise money quickly, but comes at a higher cost and lower LTV
- The funding time frame is reduced immensely because these loans are not traditionally executed
- Hard money loan terms can generally be negotiated between the lender and the borrower and typically use the property as collateral
The modern banking system offers a wide variety of credit options from mortgages to credit cards, but hard money loans have long been (and will continue to be) vital to the real estate sector.
Where did the term “Hard Money” originate from?
This origin of the term “hard money” dates back to the Great Depression in the United States. With the collapse of the banking industry destroying consumer confidence and causing widespread panic, individuals began pulling their money out of bank accounts and keeping it at home, which ultimately led to a mass reduction in the amount of money in circulation.
This resulted in people finding they were unable to get access to additional cash when they were in need of it during the Great Depression. Lenders sought out a solution to help resolve this by offering loans that utilized real estate as collateral. Due to the risky nature of this type of loan, higher interest rates were charged, but with no other way to get quick cash, many property owners had no alternatives than to take out hard money loans.
Since that time we’ve seen hard money lending hit some highs and lows over the years in terms of its reputation. In the 1950s, for example, private short-term debt was vital to the world of real estate development. It became somewhat of a “last resort” option for commercial property owners who were looking for capital against the equity of their holdings.
By the 1990s and early 1990s, a major turn in the commercial real estate market resulted in an unprecedented number of banks experiencing considerable failures and massive losses. Due to this, private lenders became a widely popular alternative when it came to real estate financing.
Most recently, during the early 2000s, due to a major lack of regulation and an increase in speculation a real estate bubble was created that would see it all come crashing down. With foreclosures spiking by upwards of 225 percent between 2006–2008, foreclosure filings hit a record-breaking 3.1 million in 2008 alone.
Hard money loans have unfairly developed an unsavory reputation for being predatory, largely due to being misunderstood and/or misused. However, if used properly, hard money loans serve a useful purpose for investors and borrowers, both in good times and in times of national financial crisis.
The Rise of Private Lending
According to research by Bank of America, private lending had more than doubled by the 2010s and private debt within the U.S. is in excess of a whopping $700 billion.
So, why did private lending suddenly develop a better reputation in such a short span of time? It was largely due to real estate investors becoming increasingly frustrated with the Dodd-Frank Act and the hoops they had to jump through. Investors began looking for alternative lending solutions and quickly realized that the oft-referred-to “back alley operators” known as private lenders were now a viable, respectable alternative. Private lenders developed a new reputation of being established, above-board providers of smart lending solutions with billions in AUM.
Investors have discovered that private lending offers a variety of perks that traditional banks cannot provide, such as better speed and execution of loans, unique loan terms that include rehab costs, and the ability to provide more leverage.
Why have interest rates decreased so much?
Over the past 10 years or so lending has experienced a lot of change. Hard money interest rates were averaging 18 percent between 2009-2012 at a time when very little capital was available in private lending due to the real estate market being at its lowest.
With institutional lending being stifled, real estate investors had no choice but to rely on private lenders for hard money loans. As a result, private lenders leveraged this opportunity to fill a void left behind by Wall Street. Ultimately, this helped private lenders prove that private lending can be scalable and has earned its place in the world of real estate investment lending.
With today’s real estate market improving it has resulted in interest rates on private loans dropping as low as seven percent in some cases.
In the 2010s the Federal Reserve made interest rate cuts that allowed private lenders to acquire lower-cost capital thus allowing them to pass that on to real estate investors by offering them better terms.
Homogenization has also driven the reduction of rates and fees with private lenders entering the arena of real estate lending at startling rates.
Following the housing crisis we’ve also watched house flipping go mainstream. With television shows like Property Brothers becoming incredibly popular among the masses, it should come as no surprise that it has inspired a whole new generation of fix and flip enthusiasts. This, of course, has resulted in a need for even more capital and financing options.
The Wall Street Shuffle
Gone are the days when Wall Street snubbed hard money lenders. Having witnessed the success of many investors, Wall Street has taken notice of what hard money lenders are doing right, and now want their own piece of the action.
With the likes of banks such as Morgan Stanley, Goldman Sachs, Wells Fargo and many more having entered the area of fix-and-flip loans by offering lines of credit to lenders, it has helped lower the cost of funding loans.
As Wall Street has become more involved in private lending, we’ve also seen it lead to securitization, which provides legitimacy to the industry and shows acceptance in the eyes of investment bankers.
Private lending has come a long way and has finally earned a reputation for being a trustworthy, legitimate provider of hard money real estate loans. The industry will continue its upward trajectory of growth if we can continue providing reasonable rates and terms.
Let’s not forget that while we’ve enjoyed a prosperous time in the housing market for almost a decade, the bull cycle has been very long. Things are still looking good for 2020 despite the Covid-19 pandemic, but it’s important to remember that to remain successful in hard money lending and in real estate investing, you need to be prepared for rainy days. Make sure you have a solid long-term game plan should those rainy days arrive.
We’re expecting to see an increase in diversification among hard money lenders with women and minorities currently being under-represented. But times they are a-changin’ and we’re excited to be advocates of these changes. With fresh faces and new names abound, we’re going to see hard money tap into a much larger, previously untapped market.
Following the last great housing crisis we witnessed the staying power of hard money and its ability to fill a gap that ultimately helped the housing market rebound. With that in mind, we feel confident that the future of hard money lending is bright.
We’re living in an exciting time where the hard money industry is finally earning the respect it has long-deserved. It’s found its place in the mainstream and will only continue to grow and maintain its newfound positive reputation.
On a personal note, I have to say that as someone who has been driving change in this industry for more than a decade now, I’m thrilled to see what comes next!