It is important that hard money loan lenders can reduce risk any way they can. Given the inherently risky nature of hard money loans, it should come as no surprise that due diligence exists for lenders in the hard money world as due diligence exists for hard money loan borrowers. Although the basic rules are the same, lenders need to work a little differently on their side of the field.
There are several ways that hard money loan lenders can reduce their risk. Although it may sometimes involve taking on more control and collateral than usual, a lender can significantly reduce their risk on their transactions. Even as hard money loans move to a more digital underwriting and origination process, the basic rules will still apply.
Hard money loans have easier underwriting standards, considering the value and equity of a property rather than the creditworthiness of the borrower, and can be funded faster than a traditional loan, usually within five to 10 days.
Utilizing a guaranty from each principal is just the same as taking collateral, which makes it very important. A guaranty (and a promissory note) should contain a specific consideration known as a confession of judgment clause or a “cognovit clause”, if state law allows for such. A confession of judgment clause almost acts as a default judgement without the hassle of having to go to court, almost tantamount to a “pink slip” in street racing; lose the loan (or the race), lose your property (or your car).
An associated strategy that acts in a similar manner, albeit differently, are known as “pre-signed agreed orders.” This refers to a situation wherein the borrower agrees to a judgment of foreclosure (or consent foreclosure in states where this is permitted) within the conditions of the loan. This clause also comes along with an agreed order for the appointment of an independent receiver. Although the captions required by the court will not be filled in at signing, the loan documents do have the available provisions that authorizes the lender to fill in the blanks and immediately take possession in the event of a default. Much like a confession of judgement, a pre-signed agreed order structure works may be enforceable in some jurisdictions, but not all of them.
Pledges of collateral and provisions for a full equity takeover of the LLC that contains the collateralized property are more conservative and generally accepted methods for lenders to reduce their risk. These provisions are generally the more traditional ways that hard money loans have addressed risk in the past and is the general methodology currently employed by hard money lenders to reduce risk.
The underlying real estate should be owned by an entity, usually through the issuance of shares in a limited liability company (LLC) that ultimately owns the collateral for the loan. To protect their position, any hard money lender should take a first or second position against the real estate. The lender should also, if the situation necessitates, insist on a pledge of 100 percent of the membership interests, including all voting rights, in the entity that owns the real estate. This is especially true on a high loan-to-value (LTV) property or a borrower with less than stellar credit.
If the loan goes into default, the hard money lender can decide to either foreclose and take possession of the property or sell the assets. To ensure the smooth assignment of these shares, hard money lenders should require borrowers to amend any operating agreements to ensure that the lender or a specified administrator to act as a “special member” of the board. If this is to be done, make sure that the vote of this member is required for any material decision made by the borrower. This also includes the ability to file bankruptcy or to file any other kind of court action that could potentially be utilized against the lender.
The underlying real estate should be owned by a special purpose entity, preferably a limited liability company (LLC) that owns nothing else but the real estate pledged as collateral for the loan. The hard money lender should take a mortgage against the real estate, along with a pledge of 100 percent of the membership interests, including all voting rights, in the entity that owns the real estate.
If the loan goes into default, the hard money lender can decide to either sell the membership interest at a UCC sale or foreclose on the mortgage. Hard money lenders should also require the borrower to amend their operating agreements to insert the lender or its nominee in as a “special member” of the borrower. If you do so, make sure the special member’s vote is required for the borrower to file bankruptcy or any other kind of legal action against the lender.
Forming special entities not only allows the lender to seek further recourse but to more effectively reduce their risk. These entities allow the lender to segregate this asset from other assets in their portfolio and as a result, the lender can loan options that are more generous and less costly.
Hard money loan lenders have their own sets of risk, and must take appropriate steps on their own to mitigate any potential risk as much as possible. But taking these steps, among others, can help reduce the already significant risks that exist in the hard money loan world. Given that hard money lending is one of the riskiest segments in the lending world, any step taken is a crucial one.