Top 7 Mistakes New Hard Money Lenders Make

These are some common real estate investment mistakes that I wish someone else had taught me as a new hard money lender. For the most part, these are common knowledge, but others are a little bit less common.

1.) Inadequate Due Diligence

The number one mistake that I see is inadequate due diligence. Most lenders, unless you’ve been in the real estate world for a long time, are excited to do their first deal. Very quickly, they say “Let’s wire the funds, do the docs and we’ll be good to go.”

It depends on your nature as an investor. Personally, I’m very comfortable with risk when I’m using my own capital. I’m a little bit more willing to jump in and decide to do something quickly.

However, when it comes to using other peoples’ capital, I’m the exact opposite. I want to go through everything with a fine-tooth comb and make sure that every ‘T’ gets crossed. When others are trusting me with their capital, I want to make sure that the deal is solid and we’re not missing anything.

There are some opportunities that you do want to jump in relatively quick. Hard money lending is not that way.

I heard a quote once that said “The deal of a lifetime comes around about twice a year.” People think that these opportunities are never going to come around again.

“The deal of a lifetime comes around about twice a year.”

That’s just not true. It’s definitely okay to pass on a deal, be a little more conservative, or just take a little bit longer with your due diligence. Make sure that we look at all of the numbers and all of the comps.

We make sure that our loan to value (LTV), our loan to ARV (LTARV) and our loan to cost (LTC) look good. All the basic checkmark metrics. When you’re putting your funds on the line, especially investor’s funds, you want to be extremely careful with the due diligence, especially all of your underwriting.

One of the great things about hard money is there is an element of speed. Typically we can underwrite a deal in a day, or even an hour. Then, we can fund the same day or the next day as long as all the title work is completed. Because that’s one of the pros of the business, sometimes people get a little bit too aggressive. They check it off and move onto the next. I think that’s where you get into trouble.

2.) Overvaluing The Collateral

Another thing that I commonly see is overvaluing the collateral. A lot of lenders will just take the borrower’s numbers at face value. More often than not, I see that borrowers are definitely inflating their numbers.

I don’t think most borrowers are trying to be intentionally malicious, but many are overly optimistic on the ARV and the market conditions. They think their project is going to be a great flip and sometimes, that is the case.

Two or three years ago, you could pretty much buy anything at any price. By the time you completed the project (after holding on to it for 3 or 4 months), it would sell for over asking price or way more than than you thought it would.

We’re just not there anymore.

Typically, I like to take anywhere from 5% to 7% off the top of what the borrower’s say the value is. I find that doing this gives you a more realistic number as to what the true value is. For example, I collect comps from the borrowers. I ask them “What makes you think that this is what your ARV is going to be? What makes the property worth this right now?” Again, I don’t think it’s malicious, but I think that borrowers are a little bit too optimistic.

The interesting thing about comps is they can be fudged in your favor. Say you want a property to sell for $400,000, you can typically find a comp and “force” it to work for you. Will it sell for $400,000? Not necessarily.

Always do your due diligence and make sure that you look at your own comps and not just the borrower’s comps. Listen to your gut. More often than not, it’s correct.

3.) Overly Optimistic

Many borrowers are overly optimistic on the current market conditions. Your job as a lender is to stay up-to-date on the current market conditions.

Someone once told me that a lender is a “steward of capital”. I like to envision a bodyguard or a knight in shining armor guarding something.

That’s how I look at it when an investor comes to me and is trusting me with their funds. It’s my job to guard that capital. I would feel worse if I lost an investor’s money over my own. Obviously, I don’t want to lose my own capital, but I will do everything in my power not to lose investor capital.

Being overly optimistic on market conditions is something that we see all too often. There’s a lot of these institutional investors that when COVID came around, they just stopped lending altogether. I think that if you’re an optimistic investor, you’re confused.

“Why they would do that? There’s still plenty of good deals to be found.”

Honestly, I think that was really smart by those institutions. When you see a change in the market, you can protect a lot of capital by just pumping the brakes. You can say “Let’s keep lending , but let’s only do 65% LTV instead of 75%, like we were doing previously.” If that means that you can’t lend to some of the traditional borrowers that you’ve lent to in the past, so be it. It is your job to guard that capital.

One great thing about being a lender is you get a pulse on the market just because you have outstanding loans. You can see that things are churning really quickly or that loans are taking a little bit longer to pay off.

If you have loans that are not paying off as quickly, you can notice that the market might be pulling back a little bit. You can then decide to pull back on your guidelines and your requirements to lend.

4.) Exit Strategies

Another investment mistake that I see is lenders will take the borrowers exit strategy at face value. On our loan application, we have a field that asks “What’s your exit strategy?” People fill it in and typically say either one of two things: “Sell” or “refinance”.

That’s the default answer, but what happens if you can’t sell OR refinance? What other exit strategies are there? There’s a couple other things that we need to to look at.

We look at the borrower’s credit score. There’s a lot of people that assume just because we’re hard money lenders, we don’t look at credit score.

I think that’s the dumbest thing you can do. We absolutely look at the credit score. If a borrower can’t manage their household finances, what makes you think that they’re going to be able to manage a renovation project with you? The deal itself might make perfect sense, but the borrower can’t perform.

“If a borrower can’t manage their household finances, what makes you think that they’re going to be able to manage a renovation project with you?”

Another response we get from borrowers is if they can’t sell or refinance, they’ll “just rent it”. That doesn’t really work either. How are you going to pay the lender off? Most of the time, hard money lenders are in the business of short term loans, so we can turn that capital faster and faster. Renting is not going to be a good strategy because we’re not going to allow you to have this loan for longer than a year. On top of that, most of the time the monthly interest payments will grow and accrue faster than the rent will cover anyway.

All that to say, selling is a great strategy and most of the time, that’s the correct strategy. In this process, I typically like to look to see if the borrower has one, two, or maybe even three different exit strategies. If they can’t sell this property, do they have cash to be able to pay this off? Do they have a HELOC or maybe another private investor who they can JV with to get out of this loan? Dive into borrowers exit strategies. Ask yourself what would happen if this doesn’t pan out and how are we going to get our money back?

5.) Incorrect Use of Proceeds

A very common one I see all the time is when borrowers use the lender’s funds for a primary residence or a secondary home.

Under no circumstances can you lend to a borrower who is looking to use your money for a primary residence or a vacation/second home.

This conflicts with the TILA (Truth in Lending Act) and Dodd-Frank Acts. These are different acts that have certain protections around primary housing and you just don’t want to deal with it.

Let’s say you do offer a loan on a primary residence, the foreclosure and eviction rules get a little tricky.

Moral of the story, it’s just something that you don’t want to deal with. For that reason, we only lend on investment properties, and I highly recommend that you only do the same.

6.) Capital Reserves

Capital reserves are a big one because I can’t think of a single project that has ever been completed under budget and under the allotted time. They always go over and they always cost more.

I can’t think of too many cases where we didn’t go over. Maybe twice with over 70 flips that we had. It was rare. Typically it’s not like 5% to 10% more either. Most cases, I see 20% to 25% more than anticipated.

When we were flipping houses, we would add an additional $10,000 – $15,000 just for additional padding. Many people think that’s excessive. We wanted to make absolutely certain we had the cash as a buffer.

All that to say, when you’re looking at your borrower’s cash reserves, make sure that they’ve got significant cash set aside in a high yield savings account, a line of credit or whatever it may be. This is for when things go over budget because when it does, you’ll know they’ve got enough of a buffer to make sure they can finish the renovation, get the property on the market, sell it, and pay you back.

7.) Inadequate Legal Documents

The last thing that I see happen all the time is lenders with weak or inadequate legal documents. A lot of people will just find some some basic documents from RocketLawyer or wherever. ALWAYS have your documents checked by a real estate attorney.

And when I say “real estate attorney”, I mean who is specifically familiar with the lending laws and regulations where you live. This is the back-bone of your business and your security instrument. This is not the place to skimp.

If you don’t know of anybody or don’t have somebody close around you who is really good in the lending space, I highly recommend Geraci Law. We’ve worked with them in the past and they’ve been great. Their area of expertise is in the private and hard money lending space. If you need documents, they’re a great resource to make sure that everything you have is legal and binding in your state.

As far as our documents go, we’re pretty run of the mill. I lend in Idaho so we use a Deed of Trust. We also have a Personal Guarantee. This is to make sure that if a borrower can’t perform, we can go after their personal assets. In that case, they’re personally guaranteeing that property. We also have a High-Cost Loan Disclosure that says the property will be for a commercial purpose. This shows that the borrower has agreed that this is going to be a high cost loan, and are entering into it for that reason.

We also have a Balloon Payment disclosure. This states that the loan is a very short term loan, either 6 or 12 months, and the borrower is expected to pay it off in full within that time frame.

You can do a couple other things like Use of Proceeds affidavits or similar, but just make sure that your documents are always double checked by someone who knows what they are doing.

So many people use run of the mill documents and reuse them over and over again. They don’t have them updated, revised or checked either. Do this regularly. It is so worth it to make sure that everything is binding. In the event of a default, you want to ensure that you’re protected and you can take the property back.

Hopefully you learned a thing or two about some of the top mistakes that I wish I didn’t make when I started out. Some of these I didn’t necessarily make, but I wish somebody had taught me. Let me know if there’s anything that I missed that you wish someone had taught you when you were just starting out!