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Structuring Hard Money Loans: Four Escalating Strategies to Minimize Your Risk

Structuring Hard Money Loans: Four Escalating Strategies to Minimize Your Risk

As the economy has recovered from the downturn of 2008 and banks once again have money to lend, they remain bound by regulations and restrictions that keep them from making loans that carry even the slightest of risks. Private lenders are left to fill the substantial void in lending, where there are risks worth taking for the appropriate return.

The question for such lenders, be they companies, family offices or maybe even individuals with money to lend and an appetite for a little risk, is how to structure a loan against real estate to become comfortable with the added risk that a bank would not take?

Let’s start with the most basic concept of hard money lending—there is simply a greater risk that the hard money loan will default, so it’s critical to make as much money as possible while the loan is still current, and to take as much collateral as you can in order to mitigate your risk.

A starting point: Obtain detailed PFS’s and request a pledge of all assets listed

The borrower who has come to you for a loan could not qualify for the bank loan and is not in the best position to negotiate terms. While there is some competition for these borrowers, the hard money lender should always start by asking for everything, including the kitchen sink.

Obtain personal financial statements (PFS) for each of the borrower’s principals, and scour those for any assets listed. Do not let a principal give you a scaled down PFS—the documents should be detailed, clearly listing how each asset is titled. If there are unencumbered assets, you should take liens against them, and if assets exist that have senior liens, ask for junior liens. Membership interests in other limited liability companies can also be very valuable, even if they are minority interests.

Risk tactic #1: Get a guaranty with a confession of judgment clause

A guaranty from each principal is just as important as taking collateral. Each guaranty (and each promissory note) should contain a confession of judgment clause (or cognovit clause) if such clauses are legal in your state. A confession of judgment clause can save months of time in the collection effort after a default occurs.

Risk tactic #2: Take a 100 percent pledge for the LLC that holds the real estate

The underlying real estate should be owned by a special purpose entity, preferably a limited liability company (LLC)—which, put very simply, owns nothing else but the real estate—to act as security 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 defensive court action against the lender.

Risk tactic #3: Consider an option agreement.

The above is the most conservative structure a hard money lender should take. More aggressive hard money lenders are structuring into ownership.

For instance, certain hard money lenders form a new entity, use that entity to buy the membership interest in the limited liability company that owns the subject real estate and offer the “borrower” an option to buy back the membership interest. The “borrower” will sign an option agreement along with an agreement to manage the property, or even a master lease. The option agreement provides for monthly payments (equal to what principal and interest payments would have been under a typical note) to keep the option open, and a period of time during which the option may be exercised. In the event the “borrower” misses an option payment, the option is extinguished and the lender already owns the property, eliminating the need for foreclosure of any kind.

While this structure is not bullet proof and could trigger transfer taxes, it does serve to put the “borrower” behind the eight ball, fighting an uphill battle in a court of equity trying to prove this was actually some kind of equitable mortgage loan. With the appropriate protections in place, the hard money lender should win the necessary verdicts in short order.

Lenders who employ this “option agreement” structure often require that the borrower pay all transfer taxes, and, upon the exercise of the option, all costs, taxes and expenses of the re-transfer. The management agreement provides that the “borrower” is responsible for the operating expenses of the property in addition to all option payments, but may keep a portion of, or all of the rents.

Risk tactic #4: Use pre-signed agreed orders

Another aggressive structure is for the hard money lender to take “pre-signed agreed orders,” wherein the borrower agrees to a judgment of foreclosure (or consent foreclosure in states where this is permitted), along with an agreed order for the appointment of a receiver. The court captions, of course, will not be complete at signing, but the loan documents provide that the borrower authorizes the lender to fill in the blanks in the event of a default. Note that this structure works in some jurisdictions, but not all.

In all cases: Fully understand that hard money lending is risky

Hard money lending can be risky and collection can be tough, but with the right structure up front, hard money lenders can ensure a good return on their investment.

William Schwartz is a partner in Levenfeld Pearlstein’s Banking & Restructuring Group. He concentrates his practice on representing borrowers and lenders in financial services, litigation (including bankruptcy) and workouts.

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