In real estate investing, there are plenty of value-add opportunities with sellers stipulating all-cash closings. The underpinning of an all-cash requirement is not the source of the funds but the time necessary to access it. Hard-money loans offered by private lenders are an interesting hybrid between borrowed funds and cash.

This article will not represent that a hard-money loan is the same as cash. It is not—borrowed funds are borrowed, and cash will always be cash. However, this article will explain how a hard-money loan is the next-best alternative to cash when the investor needs borrowed funds to close or prefers not to deplete their liquidity in one deal.

A seller’s all-cash requirement will be met if an investor follows the theories behind a hard-money loan.

Key Takeaways

• A hard-money loan is the next-best alternative to cash
• A seller’s motivation behind “all cash only” offers is time, not the source of funds
• Private loans have a shorter underwriting and qualification process
• Every investor must consider the pros and cons of private loans and cash transactions
• The cash-on-cash returns are generally lower when a larger amount of equity is invested through cash over a shorter period

Defined Terms

• After-Repair Value – the projected market value of a property after renovations are complete
• Cash-on-Cash Return – the return on the cash invested in the property against the distributable cash made to the investor
• Debt Service Coverage Ratio – measures a property’s ability to service a loan after all operating expenses are met
• Stabilized Property – occurs when a property generates enough cash to meet all operating expenses and loan payments without additional cash injected by an investor
• Traditional Lender – banks, credit unions, and other credit facilities insured by the FDIC and regulated by Fannie Mae and Freddie Mac

This article will guide a real estate investor on structuring an offer to a seller requiring an all-cash closing, along with the pros and cons of a hard-money loan and cash.

The Hard-Money Loan vs. Cash

Hard-money loans are structured to finance distressed properties in a market that will support the full value of the renovations and upgrades. Often, properties with these opportunities hold no value to a traditional lender and would not meet the collateral requirements necessary to secure a loan.

Private lenders seek these value-add opportunities and base their underwriting on the after-repair value rather than the cost, or the purchase price. The investor determines whether the spread between the purchase price and the after-repair value will meet the targeted cash-on-cash-return.

The combination of the highly-competitive market and the housing demand has set an all-cash buyer in a better position for a seller to accept an offer. Sellers and buyers of properties in any state of disrepair want to act quickly. The motivating factor on both sides of the transaction is time.

While a traditional lender may take from 4-5 weeks to underwrite and approve the borrower and the collateral, a private lender will underwrite the transaction on its measurement of the risk and the merits of the deal.

Private lenders are then able to fund within days, not weeks.

It is not commonplace for purchase contracts and a seller’s cash requirement to be written as:

“All cash or private lender loans only.”

Investment Strategies

Typically, the investment strategies of a real estate investor are:

• fix-and-flip, and
• buy-and-hold.

These strategies are discussed below, along with the considerations for a hard-money loan and an all-cash offer.

Fix-and-Flip Strategy

This strategy is for the short-term investor. The investor will seek a distressed property with the best potential to increase the after-repair value. Often, the property is marketed for sale simultaneously with the renovations. A private lender will underwrite the transaction on the after-repair value as though created and will often fund most of the renovation work.

Because of a private lender’s willingness to lend further into the capital stack, an investor can benefit most from positive leverage. The investor can seek other investment opportunities with the same amount of cash.

The higher a lender will go into the capital stack, the less required equity is needed of the borrower.

Although there is always risk when using borrowed funds, the investor will lose the value of additional opportunities if all of their liquidity is invested in one deal.

With all considered equal, the cash-on-cash returns are lower when a large amount of cash relative to the value is invested over a short period of time.

Buy-and-Hold Strategy

Real estate investors need to take a harder and deeper look into their personal finances and targeted returns over a long-term hold. The investor’s cash-on-cash returns will increase by the cash flow when less cash is invested.

An all-cash purchase will decrease the purchasing power and hinder the scaling of a portfolio. Because the investment property is held longer, the time of recapitalization and realizing the total profit is spread over the hold period.

Hard-money loans are often refinanced with traditional loans when the property stabilizes. Private lenders are now offering an alternative to conventional long-term permanent money loans. These are referred to as DSCR loans. These loans also provide higher leverage. The underwriting and qualification look to the debt coverage ratio at stabilization, and the borrower’s liquidity to cover any vacancy period. The access to capital is faster and the qualifications are less rigorous.

Leverage is also an important consideration with the buy-and-hold strategy. The use of leverage needs to be considered at the time of acquisition and when the property stabilizes.

The Pros and Cons of a Hard-Money Loan

All real estate investors must know and understand the fundamentals of a hard-money loan before agreeing to any leveraged position.

The pros of a hard-money loan are:

• shorter approval process
• underwriting based on the merits of a deal
• borrower’s credit and income are secondary
• flexible terms and options
• funding the renovation scope as part of the capital stack, and
• more tax benefits resulting in lower taxable income.

As with all things, there are cons to consider. These include:

• interest rates and fees will be higher
• shorter terms mean shorter periods to satisfy the loan, and
• if there are no negotiated extensions, the lender can institute foreclosure proceedings

The Pros and Cons of Cash

Cash is king, but not always for investors when returns and the value of lost opportunities are considered. The pros of an all-cash closing are:

• no loan process to maneuver through
• no interest payments
• equity will be set at 100%, and
• use of 100% of the cash flow

However, when an investor considers its cash-on-cash return and the reduced purchasing power of its cash, the cons are:

• lost opportunities due to capital constraints
• absence of positive leverage effect
• less liquidity
• fewer tax benefits resulting in higher taxable income, and
• lower cash-on-cash returns

Hard-money loans are not equivalent to cash but are the next-best alternative. When an investor is pre-qualified with a private lender, the access to capital will be shorter.

An investor should know to educate the Realtors involved in a transaction to write the following in an offer:

“All cash or private lender loans only.”

The reference to the private lender will signal to the seller and the Realtor that a very short financing contingency is needed to close.

An investor needs to weigh the pros and cons of a private loan against an all-cash offer before entering any leveraged position.