During the recent economic decline, as banks have reduced their commercial real estate lending due to pressure from Federal regulators, hedge funds have increasingly stepped in to fill the gap. Hedge funds are turning to hard money lending because they view this method of real estate investment as a way to diversify their portfolios and, at the same time, command high returns, which can often reach the double digits (10 to 12 percent on average) for their investors.

The goal for hedge funds is to find investments that will provide a consistent return without respect to the fluctuations of the stock exchange. For example, in 2012, the S&P 500 saw returns of 13 percent while “Hedge Fund Research” estimated that the average hedge fund in 2012  earned approximately 5.5 percent. On average, the funds that have made the switch over to commercial real estate investing through hard money loans have experienced higher returns. This explains the increasing appeal of commercial real estate investments as hedge funds are recognizing that the reduction in bank lending has opened a pathway to high yield, low risk commercial real estate investments as private lenders. The low risk applies to commercial rather than residential investments because the commercial default rate is typically around 1 percent, while the residential rate has been substantially higher (as much as 30 percent) as a result of the financial crisis.

Like other private lenders, hedge funds charge higher fees and interest rates, generally between 10 and 20 percent, than traditional lenders and specialize in bridge, or short-term, loans, usually for two years or less. The decrease in the availability of financing from traditional sources has lead to an increase in demand for loans to commercial real estate investors with good credit histories who would normally receive funding from a bank. Hedge funds have taken advantage of this demand by targeting the market for hard money loans ranging in size from $5,000,000 up to $50 million or in some cases even higher amounts.

The main threat to this new strategy that is being employed by more than 140 hedge funds is a softening of the economy.  However, hedge fund lenders say that if they can selectively choose loans, with approval of something like 1 to 2 percent of loan applicants and continuing to base loans on current property value and cash flow rather than projected values in an uncertain future, then stability within the portfolios will continue. Together these are the best counter measures to ensure that these investments continue to be a profitable venture for hedge funds and hard money lenders alike.

This blog was written by Bob Amter, President of Montegra Capital Resources, LTD., a Colorado hard money lender.  [google_authorship] has been in the private capital lending business for 41 consecutive years.