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In this, part two of this guide, we’ll talk about general guidelines to protect your loans from loss, and review the options that can help you do this. Here are the other sections of this guide:

 

• Part 1 - What is hard money loan investing?

• Part 2 - How to protect from loss

• Part 3 - The Due Diligence Check List 

• Part 4 - Top 19 hard money loan funds

• Part 5 - Postmortem: Money flushed down the drain (a loan that took years to resolve and lost 60%)
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“May I have the comfy pillow?”

To protect yourself from all the many hidden costs of foreclosure, you never loan 100% of the value of the property. Instead, you loan less so you can sell the property for more than you’ve invested and cover all the extra costs too.  This is called an equity cushion, and the bigger the cushion the safer you are.

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If you loan out only $65,000 on $100,000 home, you’ve made what’s called a 65% loan-to-value (LTV) loan. The extra 35% is your equity cushion which you can use to protect yourself if you have to foreclose. To look at it another way: the lower your LTV, the larger your cushion and the safer your investment is. And the higher the LTV, the smaller the cushion and the riskier the investment. 
 

The wrinkle is that the higher the LTV and more risk you take, the more you can charge for interest. So there’s a trade-off between safety and return.

A general rule of thumb in the professional hard money world says 65% to 70% LTV is the sweet spot to maximize your return while not risking loss of principal. And that anything higher is speculation and puts increasing amounts of principal at risk.

The actual ideal LTV on any particular loan will depend on the specifics of the loan, including the asset class, size of the loan (smaller loans are more susceptible to overruns from fixed costs like legal fees, than larger loans) and the market and property itself. In general, things often play out something like this:
 

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Heading the Wrong Way?
 

Not everyone cares about protecting principal. If you don't, then it may be worth it to you to spin the wheel to get a higher return. 

On the other hand if you do care about protecting principal, the trend on many crowdfunding platforms in 2017 is bothersome and troubling.  In 2015, there were many 65 to 70% LTV loans to choose from. Today, most are 75%+. (2024 Update: very few 65% LTV loans exist today as well).
 

Since I care most about protecting principal, high LTV loans make little sense to me (especially as a long-term strategy or a large portfolio). I can gamble 7 times on 80% LTV loans and succeed. But if and when the 8th goes bad, it’ll wipe out all the small extra gains of the last 7 plus I’ll end up in the hole. I would’ve been better off sticking with a moderate LTV.

And if I have a large portfolio and we get a downturn (especially one severe enough to cause substantial price drops), it could turn into a bloodbath.
 

The Bigger Picture
 

For now (in 2017), investors are mostly dodging the bullet, because in an expansion, a rising tide tends to raise all boats. But expansions don’t last forever.

Update 2024: Unfortunately, many aggressive investors got burned in the shift from ultra-low interest rates to higher and the current real-estate slow-down.
 

Options for conservative strategies?
 

There are still a handful of moderate LTV loans available on the real estate crowdfunding platforms. If you only need to deploy a smaller amount of money, this might work for you.

However, if you need to deploy a large amount, there just isn’t enough volume to create a diversified portfolio.
 

So what I‘m doing instead is investing in hard-money loan funds that can cherry pick lower LTV loans because they originate them. And you can find plenty of moderate 65% to 70% max LTV funds.

These funds also have a few added advantages over buying individual notes. First, you have a professional manager who is scrutinizing the loans and choosing them so you don’t have to if you don’t have the expertise or time (for a small fee of course). More importantly, it allows you to diversify into a portfolio of hundreds of notes, which insulates you from the mistake of a single note or single city dragging down a large part of your portfolio. Also, the funds allow you to generally withdraw your money on a quarterly or bimonthly basis (after an initial lockup which is usually one year). If you intend to invest for more than a year, this lets you exit a lot earlier if you need to. (Whenever you reinvest your money in individual notes, you’re locked in for an additional year).

Leverage: the double-edged sword
 

If you do go with a fund, make sure you check if they’re using leverage or not. Funds that borrow money have a little bit higher yield. However, the cost is turning an almost bulletproof investment into a more fragile one.
 

First, in the last recession, some leveraged funds had their credit lines revoked by banks (who were having a panic of their own). This caused painful losses. (One fund was conservatively leveraged at 20% and conservatively underwritten at 65% max LTV. It still took 40% losses of principal, when the bank revoked their credit line.)

Second, with or without the line being revoked, a leveraged fund can only withstand a certain number of bad loans before it drops below breakeven and can’t pay back its own loan. If a deep recession causes this to happen you’ll again take large losses. The higher the leverage and the less conservatively underwritten the fund, the more risk of this happening there is.

For me, at this stage of the cycle, stretching for the slightly higher yield isn’t worth the additional risk. If your risk profile is different than mine, you will probably feel differently.

 

Expected to perform

The other things to look for is the uncured default rate (defaults which weren't later fixed by the borrower). If it's much higher than competitors, then you're probably taking unnecessary risk. In good times it might not matter so much if they can recover your principal. But good times don't last forever. And when they come under real stress, a higher than usual uncured default rate can become dangerous.

 

For example, some investors reported very high uncured default rates on loan portfolios of notes on platforms like Patch of Land. (Update 2024: Prior to them going out of business).

In comparison, many other platforms and funds in the industry do report all their loans.

 

Here's the data from the original version of this article (written in 2017) . That was during an expansion and I like using this as a baseline for performance during an expansion.
 

• Platforms:
   

  • Peer Street less than 1%

  • Fund that Flip: less than 2%
     

• Funds:
   

  • BroadMark Capital less than 2% (across both of its funds).

  • Arixa Capital secured income fund less than 1%.

  • Additionally some local hard money loan companies and other funds also are under 1%.

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Doing Due Diligence

Those are just some of the high-level things I look at.  In part three of this guide, I share my detailed personal due diligence checklist when evaluating funds.