Ukrainian oligarch might be looking to buy some million-dollar homes in the Hollywood Hills. Or a veteran real estate developer might need to close on an office building before hitting a tax deadline. Or an NBA star might want to borrow against his contract to make payments on his houses while he’s short on cash.
They can all turn to hard-money lenders, companies that can finance transactions that banks can’t. The loans are made not on the banking world’s standard definitions of creditworthiness but against secured assets.
This type of lending is on the rise in Los Angeles as bankers, hamstrung by post-credit-crisis regulations that restrain risk-taking, can’t make loans as freely as they might like amid a boom in real estate and an influx of foreign buyers. Also, lenders have a lot of cash on hand because their investors are seeking higher returns.
The term hard money is related to what backs the loan, which is a hard asset. Most hard-money lenders don’t embrace that label; they prefer “bridge financing” or “alternative lending.” They typically get their money from investors seeking double-digit returns and provide senior loans at a loan-to-value ratio of about 50 percent to 60 percent, giving them plenty of wiggle room to sell the asset for a profit if the borrower defaults and they have to take ownership. Interest rates are typically from about 8 percent to 12 percent. For junior loans, interest rates will be higher. A similar bank loan – if one were possible – could run as low as 3 percent in the current climate.
Such appetizing returns come with a certain amount of risk – there are reasons hard-money borrowers can’t get cheaper bank loans, and the assets can lose value. But in this economic climate, hard-money lenders are more than willing to chance it.
While one theme in recent years has been banks’ reluctance to loan amid tougher regulations, the opposite has happened in the hard-money world. There, investors frustrated by anemic yields from most fixed-income investments are lining up to put their money to work.
“I think the supply outweighs the demand for good loans at the moment,” said David Rifkind, a managing director at George Smith Partners in Century City, which has been doing hard-money loans for more than 20 years. “There’s no problem engaging interest in a good loan request right now. It’s a wonderful time to be an intermediary, that’s for sure.”
It’s not loan-sharking, but that is the practice’s historical precedent. Today, a hard-money borrower is much more likely to be a sophisticated businessman in a suit rather than a gambler desperate for a big win.
“A few years ago, the term ‘hard money’ had a really bad stigma attached to it,” said Johanna Traynor, a loan officer at the Lone Oak Fund in Brentwood, a large hard-money lender, “especially because many lenders were predatory.”
Certain hard-money lenders were known to have extreme interest rates, which they used to drive properties into foreclosure in order to sell them for a profit. By basic economic logic, lenders will charge more if a borrower or asset in question is deemed riskier. However, some weren’t shy about putting a little extra squeeze on borrowers and using their loans as a backdoor to take ownership of a property.
The most notorious local case of hard-money lending came when the recession hit and wiped out real estate values. Ezri Namvar, a major hard-money lender to L.A.’s Persian Jewish community, was overleveraged and when his creditors came calling he couldn’t make good on what he owed.
He is now in federal prison after being convicted of stealing $20 million from four clients in a desperate scramble for cash. (See sidebar, Page 26).
However, most hard-money lenders in Los Angeles – and there are hundreds of them – take outside equity investments in the loans, unlike Namvar, who borrowed cheap and made expensive loans.
Lone Oak did $378 million in hard-money lending in 2013, making it the largest dedicated hard-money lender in the country last year, according to Scotsman Guide, a Bothell, Wash., industry publication that covers the mortgage lending business. That’s a 3 percent increase from the previous year. In volume, the firm closed 844 loans last year, 15 percent more than a year earlier.
All five of the largest hard-money lenders in the country closed more loans for a higher total dollar amount last year than they did in 2012. They combined to issue $550 million in hard-money loans last year, up 9 percent from the previous year.
They often do this with a small number of employees and without much of a visible presence. Lone Oak lent almost $400 million with fewer than 20 employees.
While there will always be people who need money and can’t get bank loans, it’s the available cash from lenders that’s the major driver of the business now.
Institutional investors are participating on the lending side through debt funds and investments in large hard-money lenders such as George Smith Partners. The firm can finance deals up to $350 million, such as the construction of a major mixed-use project the firm is doing in Santa Monica. On the lower end, there are plenty of wealthy people sitting on cash that’s bringing in almost no interest. Investing in hard-money loans, which are often backed by high-grade assets, can be compelling.
One Brentwood hard-money lender, whose investors are high-net-worth individuals, said that people are clamoring to invest with him because he can deliver returns of 10 percent or more.
“I’m constantly bombarded by investors that want to give me money and want these yields,” he told the Business Journal, requesting anonymity because of the confidential nature of his business.
Home for deals
Hard money is most often used in large real estate transactions with a level of complexity that keeps banks from financing such deals. That might be due to an international buyer who has a hard time getting a loan without a Social Security number, or a highly time-sensitive close. Today, it’s commonly a result of failed deals resulting from the 2008 financial crisis leaving a credit stain on otherwise successful and competent developers that prevents them from getting conventional bank loans.
Many respected developers had to default on loans, which prevents them from passing the muster of bank credit committees. These same developers now want to take advantage of what’s become a sizzling real estate market in Los Angeles, particularly at the high end. The smaller fix-and-flippers came when the real estate recovery began and now bigger players have hit the scene.
“There’s a lot of the 90077-massive-house-being-built-for-the-children-of-oligarchs,” Rifkind said, referring to foreign buyers moving money into the ZIP code for Bel Air.
Lone Oak recently provided a bridge loan on one such property. A developer was building a spec home in Bel Air and needed more money to finish the project. Lone Oak gave him an interest-only, 12-month loan for $8 million at a 7.9 percent interest rate. It will be used to pay off the existing construction loan of $6 million and provide $2 million to complete the build-out. When the house is sold – Traynor believes it will go for about $30 million – Lone Oak will get its money back.
The fund is able to charge such a high rate because it assumes a lot of risk in this deal. If the housing market takes a hit, it might be hard to sell the house. It’s not like there are millions of potential buyers for a $30 million estate. However, more and more developers are building homes on spec for that target market.
“We get multiple calls every week for houses that may want a $10 million construction loan, but they expect to sell for $20 million, $30 million,” said W. Scott Dobbins, president of Hankey Investment Co. on the Miracle Mile, the lending arm of auto finance billionaire Don Hankey, No. 26 on the Business Journal’s list of Wealthiest Angelenos. Hankey Investment only loans Don Hankey’s money, none from outside investors.
Most of the wealthy borrowers are real estate developers or private businessmen who need cash up front to take advantage of opportunities that might not be there by the time banks can deliver funding. Hard-money loans can come through in days; if banks could make the same loans, it would take weeks. But banks can’t make those loans.
“When you talk about an aggressive land acquisition with speculation in it, that’s really not for banks,” said Allen Staff, a president at Bank of America Corp. who oversees real estate lending in Southern California.
Unentitled land is deemed very risky, which is why people have often had to resort to hard money to develop it.
“The risk characteristics don’t qualify these projects for commercial banks,” Staff said.
A tax-delaying structure known as a 1031 exchange is another motivator of hard-money clients. Named for a section of the Internal Revenue Code, a 1031 exchange allows someone to defer paying capital gains tax when selling a property if he identifies one in the same general asset class within 45 days and closes on it within 180 days.
One of the hard-money lenders interviewed for this article was in the process of lending for the purchase of an office building near Century City. (He didn’t want to be linked with the transaction because it wasn’t finalized.)
The investor had another 1031 exchange property lined up but that fell through at the last minute and he needed to find something else quickly. He set up another deal and used hard-money financing to close before time ran out.
But it’s not just speed that motivates hard-money borrowers. They’re paying for a hedge against risk, even if they’ve got enough cash to avoid the high interest rate.
“It’s surprising how many people come to us that actually have net worth of $30 million, $40 million, $50 million, even $100 million that we transact deals with,” Dobbins said.
Even if they can afford to finance the entire deal with their own cash, they’d almost always prefer a loan – even an expensive one – to spread some of the risk.
“They have opportunities for an acquisition, they see a property that they need to close escrow very quickly and they don’t want to wait for a bank,” Traynor said.
The high interest rates aren’t too much of a deterrent when the money is being used to deliver even higher returns.
“If a guy’s making a deal that’s got to be done fast, and he’s making 30 or 40 percent on something, he doesn’t mind paying the high interest to get the deal done,” the Brentwood lender said.
He remembers being presented with an opportunity to loan cash to an all-star National Basketball Association player at an interest rate in the high teens. The player paid a high price for the cash, but it got him immediate money and the privacy of not having his request filtered through bank committees, which would have increased the chance of being leaked – to his embarrassment.
“I do loans for a lot of very famous people,” the Brentwood lender said. “They don’t want anybody to know that they’re borrowing money.”
The loan would have been secured by the player’s contract, which paid him north of $10 million annually with several years remaining. Pro basketball contracts might be safer collateral than even real estate. As an example, even if an NBA player is convicted of a felony and can’t play, the team still has to pay out his contract.
Major developers are another class of wealthy borrowers who have been seeking out hard-money loans, particularly those building projects starting with raw land. Since the financial crisis, land has been considered a “risk asset,” requiring banks to hold more capital in reserve when they make loans for land development. This impacts profitability, which has caused many banks to really scale back land development lending.
While George Smith usually participates in real estate deals on the debt side, the firm decided to take an equity stake in one of its latest projects, the Gibson, due to its highly desirable location in downtown Santa Monica. Rifkind was in charge of financing the project. The firm contributed bridge equity rather than a bridge loan, as the site is only blocks from the Third Street Promenade, making it a safe bet, Rifkind said.
The developer purchased an old postproduction facility on four adjacent lots with the intent of building 106 apartments on top of 9,000 square feet of retail. As the land was not zoned or entitled for housing, it could take months, if not years, to get to that point – not a deal commercial banks would be able to underwrite.
Six months after securing financing and buying the land, the developer was able to get approval from the city to begin work on the project. Today, the building is nearing completion.
International buyers view high-end U.S. real estate in desirable cities such as Los Angeles as a great investment. But banks often can’t make traditional loans to foreign nationals, even rich ones, due to credit verification requirements.
“Foreign investors are trying to move their capital into West Los Angeles,” said Alexa Mizrahi, a loan officer at Lone Oak. “They see it as a safe haven for their investments and they’re acquiring a lot of high-end residential properties. We just did a loan to a Ukrainian who was trying to get his money out of Ukraine because of the crisis going on there, and was acquiring high-end homes in the Hollywood Hills.”
Buyers are not deterred by the high interest rates charged by hard-money lenders because an expensive loan is more helpful than no loan at all. The bridge loans are short term and the borrowers can afford the interest rates.
Hard-money lenders such as Lone Oak underwrite the asset, not the borrower, so they don’t have the same concerns or regulatory pressures as banks. They make loans based on the resale value of an asset, and a foreign national taking a significant equity stake in a piece of property is enough for them to lend the rest.
“If a foreign investor is coming in with 50 percent down on a property, we see that as more than ample skin in the game,” Mizrahi said.
As for these foreign investors, prices are high, but the cost of leaving their money in foreign banks might be higher. Cyprus had long been a favored shelter for Russian assets, but last year European authorities pressured the Cypriot government to confiscate money from large deposit accounts to pay for part of a bailout deal. Russians are now much less enthusiastic about stashing cash there, to say nothing about keeping it in their country’s fragile banks.
“Compared to American investors who are sometimes hesitant to do hard money because of the higher costs compared to banks, foreign investors really are trying to get their cash out of their home countries and into the United States,” Traynor said. “They may be paying higher than they would be at a bank, but to them, it’s much safer than keeping their money back in their home countries.”
Chinese buyers are also a particularly active in real estate across upscale L.A.’s neighborhoods. A Beverly Hills wealth manager, who spoke to the Business Journal on condition of confidentiality, estimated that there are at least 20 Chinese billionaires who have bought luxury homes in Los Angeles. In the small niche market of eight-figure homes, that’s made an impact.
Stuart Gabriel, director of the Ziman Center for Real Estate at UCLA, said the tap of Russian and Chinese money that has been coming into L.A. real estate and stimulating the hard-money market will keep flowing.
“The United States is the destination for flight to safety and flight to quality money,” he said. “That will continue, without question.”
The obvious risk in lending without underwriting a borrower is default. But by securing these loans against an asset at a conservative loan-to-value ratio, hard-money lenders can mitigate that risk.
Lone Oak has foreclosed on 20 properties out of 3,000 loans made over 11 years of being in business – and sold all 20 for a profit. But the firm isn’t built to earn its money that way, and its investors want their money delivered in a monthly check, not parked in a big house waiting to be sold.
If a borrower finds himself in a tough spot and can’t service or pay off the hard-money loan, these investors would almost always rather allow Lone Oak to extend the loan so they can keep getting that yield (which can rise as lenders charge a higher “default” interest rate) than move to foreclose on a piece of property.
“We are in the business of lending money,” Mizrahi said. “We are not set up for managing properties.”
The Brentwood lender believes that the real threat to hard-money lenders comes from government regulation, not borrower defaults. While he says he’s never had a loan go bad, he feels his conservative underwriting and sophisticated investors can withstand a bad business decision. They can’t do anything about regulators.
He pointed out a new state regulation limits the interest rate a lender can charge a borrower taking out a loan on one’s personal residence. He said that’s adversely impacted the business.
“You cannot lend to an individual on his personal home for personal reasons and charge more than 7.5 percent,” he said. “That has actually messed up a lot of opportunities for borrowers that would normally get hard-money loans and now they can’t.”
These borrowers are now protected against excessive interest rates, but some might prefer the option to borrow money at, say, 10 percent to not finding a lender who will loan them money at 7.5 percent.
When traditional lenders tighten up, hard-money lenders have more opportunities to move into business lines the banks have abandoned. And even when commercial financing is loose and the market is frothy, there will always be a certain subset of deals that banks can’t or won’t do – or that these borrowers can’t or won’t do with banks.
Rifkind sees hard-money lending as essentially a recession-proof line of work, but that’s not the only reason he’s made it his specialty.
“It’s the most fun part of the business,” he said. “Every deal is different.”
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