Getting Rehab Funding Right
In the real estate world, cash is king to a seller. While it might be the seller's preferred method of getting paid for a property, there are certain advantages and disadvantages for the buyer.
Purchasing with cash when negotiating a real estate contract, means that by the time of closing, the buyer will have unconditional liquid assets sufficient to pay all of the costs associated with buying a piece of property, including the sales price and closing costs.
As sellers prefer a cash offer, with no financing contingencies, they are more likely to accept such an offer than a similar, or even better offer, from someone with financing contingencies. Accordingly, a buyer that really has the cash to close, can frequently get a better deal than a buyer relying on a lender.
Many buyers, however, thinking they can change the contract at a later date, make a cash offer, but in reality, they are not able to close with their own cash. They assume that once their financing is approved, it will be easy to change the contract from cash to a financed transaction. This is not always the case, and the buyer must understand that the seller is under no obligation to amend the terms of the contract.
There are instances where buyers have had cash offers accepted, even though they did not have the cash, and the sellers refused to change the contract. In these cases, the buyer lost their deposit, as they were not able to conform to the terms of the agreement of sale. The lesson to be learned is that cash means cash, not something else!
At a cash closing, the buyer will be advised of the exact amount that they need to bring for the transaction. In most cases, those funds must be wired to the closing agent or transferred by bank or certified check. Therefore, if you are involved in a cash purchase, make sure to have your funds cleared and available prior to closing, or you will not be in a position to close.
Learn more about all cash offers versus financing in our Real Estate Investment Strategy section.
State and federally chartered banks and credit unions are generally referred to as conventional lenders, giving conventional mortgages. According to Webster's Dictionary, conventional means "used and accepted by most people; usual or traditional." Investor rehab loans are neither of these things, as they are often unusual and very specific. Conventional loans are very hard to find for rehab properties.
While conventional loans are generally the least expensive mortgage loans available, they take a long time to obtain, even from a conventional lender with whom you may have an existing relationship. Even if you are able to find the rare conventional lender willing to offer investors rehab loans, the loan process may take an extremely long time to work through. Most sellers selling to house flippers are willing to sell at a lower price in exchange for a fast closing, and many are unwilling to wait for the slow wheels of the conventional lender to turn.
While the loans from a conventional lender may be less expensive than a loan from a private or hard money lender the conventional lender will require a larger down payment on the property compared to a typical non-conventional rehab lender.
Most conventional lenders will only lend a percentage of the current value of a property, while most hard money and private rehab lenders will lend on the after repaired value of the collateral property.
Government Insured Loans
The Federal Housing Administration (FHA) offers rehab funding to investors through its 203k loan program. This program lends both purchase price and rehab funds, but it is available only to consumers buying owner occupied properties, not investors.
While they have some limitations, FHA 203k loans can be used for multi unit property investment situations as long as the borrower plans on living within one of the units. This can be a great way to get low cost financing for an income property. Buyers must also keep in mind, that when buying a 3-4 unit property, the FHA will require that you keep at least a liquid three month payment reserve which will tie up some cash. They will also require that the rental units on the 3-4 unit building sustain the mortgage on its own. An investor taking out this kind of rehab loan must be willing to live by the rules.
An alternative program offered through the Federal National Mortgage Association (Fannie Mae) offers its loans to both consumers and investors, through its HomePath program. However, there are a few restrictions to the HomePath program.
- The HomePath program is only offered to investors buying Fannie Mae owned homes.
- The cost of repairs can only be up to 35% of the after repaired value (ARV) of a property, and cannot be more than $35,000 in total.
Accordingly, the HomePath option is only available for a limited selection of properties, and those properties cannot require extensive repairs or expensive improvements. The program is designed for people buying bank owned, short sale or distressed properties needing primarily cosmetic repair, which are not usually desired by house flippers.
Owner financing means that the seller of a property "lends" the money to the buyer of the property, takes a mortgage on the property sold, and gets paid back in installments according to the terms of the agreement between the parties.
For the seller, this represents a good stream of income if they can afford to not get the cash for the sale of the property all at once. For the buyer, it is frequently a favorable arrangement, because the transaction can close quickly and the seller will typically not charge the fees that a lender would. Additionally, owner financed properties will not require an appraisal.
However, the problem is that very few sellers have sufficient resources to find a place to live and maintain their lifestyle without the lump sum cash that they would receive from the sale of the property. In addition, sellers who do have the resources, may not want the hassle and risk of being the lender.
If the buyer defaults in making payments to the seller, they must go through the legal process to obtain repossession of the property, which may not be worth what it was when the property was first sold. It also may not be in the same condition as when it was originally sold, which can become an issue when they try to sell it again.
While there are advantages to both the seller and buyer for seller financing, the disadvantages may outweigh the benefits in many cases. Generally, very few sellers are willing to carry the loan.
Hard-money lenders do not rely on the creditworthiness of the borrower. Instead, they look to the value of the property. The lender wants to make sure that if the borrower defaults, there will be sufficient equity in the property to repay the debt. Accordingly, a hard money lender will usually lend you less than a conventional lender (usually 50 - 60%) of the value of the property.
If you are unable to get a conventional loan from a bank or mortgage broker, you may benefit from dealing with a hard money lender. Before doing so, make sure that you understand the fees and costs associated with the loan and the loan terms. Frequently, a hard money lender will be more than happy to foreclose on the collateral property that is worth more than the debt owed on it.
Typically,hard money lenders are not regulated by any government agency and do not need to be licensed. There are many legitimate hard-money lenders, however, as in many professions, there are some less than honest hard money lenders. Make sure you know who you are dealing with.
Hard money lenders are not regulated by any government agency and do not need to be licensed.
A private lender will generally review a potential borrower and the collateral property using the three "C's" of the lending world - Credit, Capacity to pay and Collateral.
This means that the private lender will need to qualify the borrower financially by reviewing the borrower's credit history to assess the borrower's habits in paying back creditors. The better the credit score, the more inclined a private lender will be to make a loan. The private lender will also review the borrower's income and cash flow, in order to determine the borrower's capacity, or ability, to pay the contemplated loan.
Learn how to calculate your DTI ratio.
While the hard money lender looks to the collateral as its primary source of repayment, the private lender makes loans that it expects the borrower to pay, with the collateral serving merely as the backup plan to repayment if something happens unexpectedly and the borrower does not repay. Accordingly, the private rehab lender may be willing to lend a greater amount than other lenders on projects, as they may be more confident that it will be repaid.
Private money rehab loans for investors are certainly more expensive than conventional loans, as they involve much more risk and time. Private lenders, however, may have more flexibility in tailoring their loans to the borrowers needs than conventional loans. Additionally, private lenders will be able to close loans more quickly, allowing rehabbers to capture good deals as they come on the market.
Like hard money lenders, private lenders are generally not regulated or licensed, so again, the borrower needs to do their homework to know who he or she is dealing with.
Which ever financing method you select, we encourage you to use our house flipping business plan template to get your finances organized. The financing strategy in section three will ensure that you get the money right on your next flip.
Learn more about the difference between a private lender versus a bank mortgage.