Cross-Collateralization in Hard Money Lending

Hard money lenders exist because they underwrite radically differently from conventional lenders. They take more risks, think outside the box, and finance the properties that conventional lenders cannot touch with a ten-foot pole. This flexibility allows private lenders to overcome obstacles that will leave a conventional loan dead in the water, including distressed collateral, low borrower credit scores, no verifiable income, and even certain title defects.

As an asset-based lender, hard money underwriters focus primarily on the collateral, which is real estate. Equity reigns supreme. The more equity is in the property, the less risk there is for the lender. For borrowers, the more equity there is, the more they can borrow. However, did you know that a hard money lender can lend on a property even if the equity in this particular property falls below its underwriting standards? Such transactions are called cross-collateralization, yet another creative financing type that differentiates a hard money lender from a conventional lender.

What is cross-collateralization?

Truth to be told, cross-collateralization can mean two diametrically opposing things. On one hand, it can mean multiple loans secured against the same property. If you have the first mortgage on your home and then decide to obtain a HELOC, you effectively cross-collateralize your home. Such cross-collateralization uses an asset that’s already collateral for one loan as collateral for the second loan.

When it comes to hard money lending, cross-collateralization means something very different. For private lenders, cross-collateralizing is a financing arrangement where multiple properties are used as collateral to secure a loan. In this arrangement, the lender has a claim on all of the properties or assets offered as collateral, rather than just one specific property.

Here’s how cross-collateralization works:

1. Securing Multiple Properties: Instead of using a single property as collateral for a loan, the borrower offers multiple properties as collateral.
2. Mitigating Risk for the Lender: Cross-collateralization allows lenders to mitigate their risk by diversifying the collateral base. If one property’s value declines or if the borrower defaults on the loan, the lender has recourse to other properties pledged as collateral, reducing the lender’s exposure to potential losses.
3. Higher Loan Amounts: By pledging multiple properties as collateral, borrowers are able to access higher loan amounts than they would with a single-property collateral arrangement. This can be advantageous for borrowers being strapped for cash or seeking larger financing for real estate investments or other business purposes. In other words, by pledging several properties as collateral, borrowers gain access to what they typically need the most – leverage.

What kind of properties can be used for cross-collateralization?

Typically, to cross-collateralize with a private lender, you need two properties. The first one is the initial project a borrower needs to acquire or renovate which might not be sufficient to serve as a collateral on its own. The second one will be used to provide the lender with that additional security and give the borrower access to leverage he or she needs. It’s important to remember that to cross-collateralize with a hard money lender both properties need to be:

• Free of other mortgages or liens
• Be an investment property held in an LLC’s name (in certain cases and jurisdictions, a free and clear primary residence may serve as a cross-collateral)
• Residential, commercial, or mix-use properties can be cross-collateralized

What are the risks of cross-collateralization with hard money loans?

Cross-collateralization can be a helpful financing strategy for borrowers seeking to leverage multiple properties to secure a hard money loan. However, they should carefully consider the risks and benefits of this arrangement and seek advice from financial and legal professionals before entering into such agreements. Some of the complexities of cross-collateralization include:

1. Complexity and Risk for Borrowers: While cross-collateralization can offer significant benefits, it also comes with risks and complexities for borrowers. If the borrower defaults on the loan, the lender may have the right to foreclose on all of the properties pledged as collateral, not just the one in default.
2. Structuring the Loan: Lenders typically assess the value of each property offered as collateral. The loan terms, including interest rates, repayment schedules, and loan amounts, are negotiated based on this assessment. Most likely, your lender will require an appraisal for all properties pledged as collateral.
3. Legal and Documentation Requirements: Cross-collateralization arrangements require careful legal documentation. It also requires separate title work and separate title insurance to ensure that the titles of all properties are free of mortgages or any title defects. Borrowers should thoroughly review and understand the loan agreement terms before proceeding.

What are the examples of cross-collateralization in private lending?

A typical scenario involves a low-on-cash borrower who just ran into a great investment opportunity. The deal might be terrific, but she does not have enough money to meet the minimum borrower contribution her hard money lender requires. In such a case, equity from her other investment property can be used instead of that cash contribution. The lender will place liens on both properties. Both of these liens are removed once the borrower pays off the loan. The lender mitigates their risk by encumbering additional equity, while the borrower avoids missing a profit-making opportunity (or the hussle and the expense of getting a HELOC).

Another common scenario we encounter is a rehabber needing more funds to finish the job. They have a loan with another hard money lender coming due, but the renovation process still needs to be completed. By itself, the property has insufficient equity to refinance AND provide its owner with the much-needed funds. However, if that borrower has another investment property she can offer as additional collateral, cross-collateralization is the answer both the lender and the borrower have been searching for!

New Funding Resources is a hard money lender that offers creative financing solutions to real estate investors in Maryland, Virginia, and Washington, DC. Whether you own multiple properties in the DMV area or are just starting out your real estate journey, we are to help. Apply today or call 240-436-2340.