Though “debt” often has a negative connotation, the reality is that most real estate transactions depend on external financing. Despite its notoriety, however, leverage can prove to be valuable if managed appropriately. Not only can it reduce the initial down payment on a property, but it can also be used to finance renovations, which may enhance long-term returns. With this in mind, the important question becomes: where do you get the capital?
Regardless of your prior experience, you can choose from either a traditional bank or a private lender. As a prudent borrower, it’s important to make sure you choose the capital partner that best suits your needs.
The traditional way to get financing for a real estate project has always been to go to your local bank. The bank assesses your credit with a litany of documentation. To complicate matters, it’s likely that banks will immediately deny your loan application if your credit history doesn’t meet abstract standards, without getting to know you or the reasons behind it. Banks typically underwrite the borrower, not the project or the sponsor. Private lenders work with you and want to understand your business.
Once you complete the necessary paperwork, the bank will determine your eligibility for the loan and, if applicable, the appropriate loan amount. This process can take at least a month on simple projects, and much longer on anything remotely complicated. Despite the layers of bureaucracy, time and effort, large banks are typically able to offer low interest rate loans because of economies of scale. Now, if you have all your documentation in order and don’t mind spending a couple of months going through the red tape, the low interest rates might make the effort worth it.
Even then, since the Global Financial Crisis of 2007 – 2009, banks have had to drastically revise their lending policies. The enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act means that commercial banks are now subject to capital charges relative to the amount of risk associated with the loans on their balance sheet. In other words, the act made it more expensive for commercial banks to lend to borrowers perceived as “riskier” – whether because of their credit history, lack of prior experience, or even size – and effectively forced many banks to withdraw entirely from the lending business in certain areas . . . and increasingly difficult for creditworthy consumers to obtain loans.
Consequently, in recent years more and more borrowers have been turning to private lenders to fulfill capital needs that would have otherwise been filled by banks. Before you turn to a private lender, though, there are a few things you should understand:
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Shorter-term loans: Loans with private lenders typically mature within one or two years, but some may last a few months. Therefore, if you’re looking for a longer-term loan and choose to go to with a private lender, you may have to refinance several times before your project is complete. Refinancings may be subject to additional fees, so make sure you know what those are before you commit to a lender. Alternatively, if you know your project will be done sooner, you are not committed to a long-term loan.
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Higher interest rates: Since private lenders are willing to take on more risk than a traditional bank, they are able to justify higher interest rates. Of course, these rates vary from lender to lender, but most will charge around 8% - 15% per annum.
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Quicker turn-around: Unlike a bank which may take months to review your loan, private lenders tend to move much quicker. Depending on the project, some lenders are able to get you financing in less than a week. Speed is vital to a project’s success, but more on that later.
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Less documentation: Documentation requirements will vary from lender to lender, but almost always, private lenders will accept documentation for your loan application that banks would automatically reject. This is in large part because banks are paperwork-oriented, and private lenders are willing to understand sponsors in more depth and try to understand the substance behind the paperwork. Not only does this insistence on perfect paperwork cause a massive headache, but also it takes a while to complete and verify. Private lenders don’t have to make their borrowers jump over the same bureaucratic hurdles that banks do because they have leaner, more efficient operations than banks and decision-makers are often many layers closer to the borrower. No matter how small you are, you matter to a private lender who may also be a small business and understands the struggles and issues entrepreneurs go through.
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A long-term partnership: When you work with a private lender, you usually work directly with the decision makers. These industry experts can prove to be a great source for advice along this real estate investing journey – especially if you’re just entering the space. Even if you’re an experienced developer, working with a long-term partner makes each subsequent project easier: the lender will have the majority of your information on file, and you may be able to cross-collateralize some projects. Banks, on the other hand, typically spend most of their efforts and attention on their largest clients.
The key differences between banks and private lenders are summarized in the table below:
| Typical Loan Terms & Requirements
(approximate ranges provided) |
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|---|---|---|
| Banks | Private Lenders | |
| Interest Rates | 4.5% – 8.0% | 8.0% – 15.0% |
| Closing Costs |
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| Term Length | 5 years – 30 years | 6 months – 3 years |
| Documentation Requirements | Include, but are not limited to:
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While initial requirements will vary from lender to lender and may be closer to banks, all private lenders are generally more willing to understand the inability to deliver a perfect file and work with the needs of smaller enterprises. |
| Speed | 1 – 3 months | 2 weeks or less |
| Flexibility | Generally set terms | Can usually negotiate terms, rates, length of the loan, repayment schedule, and sometimes even certain fees |
| Personal Guarantee | Required | Required |
| LTV | At least 70% | Between 50 – 80%, depending on the deal |
| People | Loan officers must meet rigid requirements, so it’s hard to develop a relationship if your profile falls outside their parameters. They are generally more experienced with the financing side of the business, as opposed to actual development projects. Further, banks typically have higher turnover due to their larger size, so it is difficult to build a long-term relationship. | You usually speak directly to the ultimate decision maker because of the small size of these firms, and build a relationship with the team. They are typically industry experts who can provide genuine guidance with your real estate project. |
Since loans for fix and flips are typically short-term, the small interest rate premium may be well-worth the cost. You may be willing to pay for the convenience: not only is the underwriting, or approval, process quicker, but closing period is very quick. Speed is critical in the flipping business as you need to secure the property you searched so hard for, and complete renovations as quickly as possible as you are responsible for covering property taxes, utilities, and homeowners’ insurance until the day you sell the property. Also, whether you are a novice or experienced flipper, you’ll be able to expand your business more quickly with a private lender than with a bank – providing you access to even more new deals and opportunities that you wouldn’t have otherwise been able to pursue. In a future post, we will dive into the math behind the two options.
In short, if you’re looking to take out a loan to finance your real estate project, consider all your options. Sometimes it makes sense to go with your local bank, but other times a private lender may be the right choice. What’s important is that you find the best lender for you.
If you have any questions about this piece, we are happy to offer advice on evaluating your financing options. Send us a note at contact@rdadvisorsre.com and we’ll reach out to see if we can work together to move your project to the next step.