It is common knowledge in hard money lending that property value is a key component in loan approval. So is a borrower’s exit strategy. Lenders are hard to convince when borrowers don’t have a reasonable and workable strategy that minimizes the lender’s risk. But did you know that property value and exit strategy are linked?
The two components can be, and often are, viewed separately. But it turns out that a borrower’s exit strategy can have both direct and indirect impacts on property value – at least as the lender sees things. It matters because lenders ultimately make approval decisions. Market analysts do not.
Property Value and Risk
The primary mechanism for approving a hard money or bridge loan is the value of the property being acquired. As Salt Lake City’s Actium Lending explains, the property an investor is acquiring acts as collateral on his loan. The lender wants to see enough value in said property to minimize its risk.
Risk is not a good thing in any lending scenario. It is especially detrimental in hard money because real estate investments are, by their nature, risky. Therefore, lenders place a ton of emphasis on property value in hopes of managing their risk.
A property with a high value compared to the amount of money being borrowed represents a lower risk. Meanwhile, a lower-value property represents more risk. This is all pretty straightforward. But why does the exit strategy matter?
Direct and Indirect Impacts
An exit strategy is the borrower’s plan for paying off his loan on schedule. One of the most common strategies is obtaining traditional funding. An investor will use hard money to obtain a new property, then turn around and refinance with traditional funding. Other exit strategies include:
- Selling a separate property
- Selling business assets
- Generating rental income
- Cashing in equity
- Flipping the acquired property
Let’s look at three of these strategies and how they impact property value. We’ll start with traditional financing.
1. Traditional Financing
Traditional financing is a scenario designed to accommodate loans with the shortest terms. Imagine a hard money loan with a 6-month term. No sooner does the loan close, the borrower starts working on traditional financing. He can get things wrapped up well within the agreed term. It’s not likely that the property’s real market value we’ll fluctuate all that much during the term. Today’s market value is likely to be very close to the property’s value three months down the road. This exit strategy has little to no impact on property value.
2. Flipping the Acquired Property
Property flipping, be it commercial or residential, is based on the goal of buying low and selling high. You purchase a distressed property or one in need of significant renovation, then fix it up and sell it for more money than you put into it. By default, this exit strategy increases property value. The property should be worth more when you put it back on the market because you have made drastic improvements. Thus, this strategy has a direct impact.
3. Generating Rental Income
Relying on rental income to repay a hard money loan is not uncommon in the commercial sector. Commercial rents tend to be more than adequate. The ability to build long term wealth through lies-and-hold properties dictates a higher property value down the road. But it’s more of a long-term thing. As such, this particular strategy has an indirect impact on property value from the lender’s perspective.
Exit strategy and property value are linked. Whether that link is direct or indirect, it will influence a hard money lenders’ decisions.
