Many times, real estate developers hit a snag. They’ll get enough funding to start a construction project, but run into a cash crunch in the middle of it. Or they may simply have trouble getting a loan from a bank or other traditional lender. Many times, they’ll turn to a natural ally – the Self-Directed IRA investor – for a special type of financing called a ‘hard money’ loan.
Here’s how a hard money loan in a Self-Directed IRA works.
The borrower is often a real estate speculator or small to mid-sized real estate company. Many of these developers have a hard time getting traditional financing, as most mortgage and bank lenders prefer to concentrate on residential mortgages and more traditional loans. Meanwhile, they have a construction project that may take anywhere from 3 months to five years to complete, and they need money to finish construction and unlock the value of the property.
The property won’t be generating much income, or any income, until it’s completed and they can begin selling or renting units or houses. So there’s no money available to make regular payments. This means that most bank or traditional lenders won’t touch these kinds of loans – their portfolios are designed to rely on regular payments from their lenders to maintain liquidity for depositors – which the Self-Directed IRA investor doesn’t have to worry about – at least until he or she retires.
The borrower usually needs an interest-only loan or a loan with no payments, with a balloon payment due shortly after the borrower can sell off the property, or at least get enough tenants paying rent to refinance. The borrower also generally needs a quick decision and little or no underwriting based on income. With hard money lending, the security comes not from income underwriting, but from the real estate itself: The underlying property secures the loan as collateral. In this regard, hard money lending is said to be asset-based, rather than income-based.
In order to attract capital, then, the borrower will have to pay an above-market interest rate on any borrowed money – often – 2 percent to 5 percent above the market rate for traditional mortgages. This is very attractive for Self-Directed IRA investors, who are always looking for a way to get market beating returns at a minimal or controllable level of risk.
The lender does not generally receive regular payments on a hard money loan. As a hard money lender, you’ll generally wait until the loan is due as a single big balloon payment, or you’ll refinance the loan if the lender needs more time and the two of you can come to an agreement on terms.
Meanwhile, because it’s a retirement account, you may well have the patience you need to make this kind of lending work. It’s not for lenders who need current income to live on. But if you are not planning on accessing your Self-Directed IRA assets for several years anyway, the hard money lending concept can work very well.
Of course, there are risks to Self-Directed IRA hard money lending. The developer could default, in which case you could foreclose on the property securing the loan. Interest rates could increase, and you’d still be locked into the somewhat lower rate opportunity.
Note that you cannot provide hard money lending to yourself or any other prohibited individual, which includes your spouse, descendants, ascendants and those of your spouse, or any business entities they control.