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Updated over 6 years ago, 08/01/2018
Bouncing Ideas - Hard Money Lender Strategy for Fix and Flip
Hi there! I'm still in the "information gathering" phase of the deal, but I've spent the last few days educating myself on hard money loans, the costs associated with them, and the problems that people experience in getting the deal done. My first flip in Chicago was financed using a 203(k), which is a drastically different product, so this HML thing is definitely new to me.
Please bear with me, and spare any ridiculous "that's the dumbest thing I've ever heard" comments, LOL. I'm just looking to bounce some ideas around, and make sure that I have a crystal clear understanding of how this works BEFORE I embark on a deal. So this is all hypothetical :). I'm trying to avoid dipping into emergency funds and savings, so some creativity in this business is definitely in order.
The idea is to start off SMALL on the first deal. At first, we were looking to do deals on properties in good school districts, which naturally drove up the possible purchase costs. Though this is a good strategy, in general, it doesn't really fit the model for what we're trying to do. I realized that buying in a good school district is more a "buy and hold" strategy than a "fix and flip" one. So, going small to start will reduce upfront costs, and allow us to build necessary relationships with lenders/contractors/agents in order to get better financing and pricing options on the bigger deals that we'll do later.
Here's a good, hypothetical, example. Please let me know if I have a solid understanding:
Looking at a property that's worth $100k, and a HML that will loan 65% LTV, which is $65,000, does this mean that I'll have to bring $35k to closing? No, and here's why...
Most HML base the LTV on the value of the property AFTER it's been rehabbed. So, let's say that the house needs $25k of work, and I'm able to purchase it for $43k. The appraisal comes out to $100k, which means I'll get the $65k from the lender, as described above. This leaves me with $22k for the expenses related to getting the property up to snuff and ready to sell ($65k - $43k). Well, I need $25k to get the job done, which means I'm $3,000 short. I have 2 choices: 1) Pony up the $3,000 out of MY pocket to get the job done (I don't need to bring this money to closing, but I do need to demonstrate to the HML lender that I have the funds to make it happen), or 2) Simply adjust my budget down by $3k.
Let's say that the lender charges the following:
3% origination fee ($65K *.03) = $1,950
Appraisal Fee - $500
Pro-rated Interest (one month) - $380
Title Search / Title Insurance - $175
Pro-rated Property Ins. - $100
Pro-Rated Taxes - $400
Settlement Fees - $400
Recording Fees - $100
Wholesale fees (if applicable) - $500
Since "No Money Down" is not an option, I'll will need to pay these fees up-front in order to get my $65,000. So, using this example, I'd need to come to closing with $4,505. Bring this money to closing, the closing agent pays the seller their $43k, and then I get a portion of the $22k in funds to access to begin the renovations. The HML lender will provide additional draws throughout the construction process.
So, here's the tricky part that I'm still working on, which is funding the construction throughout the process to keep the work going, because I don't want to wait on the draws to be reimbursed MY OWN money. I'm considering the following:
1) Work with a large contractor who is familiar with the HML process and has the capital to keep the job going while waiting on the draws. I found that LOWES is now in the GC business, and their pockets are deep, so you can imagine that they are going to pay their subs regardless of the lender draw schedule, which is great fo me. I spoke with a project manager who assures me that they do fix and flips all the time, and they are NOT worried about getting paid so long as there is a contract in place.
2) Use the HML to finance the purchase ONLY ($43K), and work with a contractor that offers financing, preferably at a lower interest rate than you'd get from rolling the rehab into the HML. For example, LOWES will finance the entire rehab at 3.99% APR for 36 months, or 60 months at 5.99% This way, I have guaranteed the work by way of financing. Simply make the monthly payments on the construction line of credit, and pay it off at closing, or continue making the monthly payments and use the money at closing to being another deal.
I'm still vetting this scenario, and as i said, I'm still in the research phase. Any thoughts on this? Did I miss something in the process? What would you do differently?
For scenario two, your gonna get a loan and a line of credit, then refi once its done , and then sell? Or are you gonna sell and pay back the two loans?
I will do my best to take a stab at this. Rehab budgets are non-negotiable and should not be lowered lackadaisically. If your HML will fund 65% of the ARV, and the ARV is 100K, your purchase price needs to be based off of that 100K (ARV) - ACTUAL REPAIR COST (Not the number that makes the math work) - (Holding cost + Lending Fees + Closing Cost (Purchase and Sale) + Any other fix cost) = Purchase Price. My point is, the only number in your example that should be dropping is the Purchase Price.
A couple of questions and points:
- Is the HML you are using lending 100% of the 65% of the ARV? Or is it more like 80-90%? I don't know any HML that doesn't want the borrower to have skin in the game.
- What is your contingency fund? Nothing goes according to plan.
- I don't know any HML that will give you the Rehab funds upfront, there is always a Draw Request followed by an inspection and a wiring fee. Also, a HML will not give you funds to purchase materials to get the project started. You will have to purchase this yourself.
- I would never suggest financing a rehab with the GC as too many things could go wrong.
Overall, I admire your high risk tolerance, but I think your plan is far over leveraged and it scares the crap out of me. You will need more funds in the deal than you think, and honestly if one thing goes wrong you will be in a lot of trouble fast.
I may have missed some points as I'm typing on the go, but I hope this helps.
Thanks for your reply, it's much appreciated my fellow Chicagoan :)
I will respond in order of your points...with regard to the purchase price, yes, I understand the 70% rule, and the purchase price of $43k was based on the exact math you described. I'm assuming a purchase price of $43 based on the 70% rule ($150K *.70 - $25K - $37K).
1) In this example, the HML is lending 65% of the LTV, not the ARV. So, if the property appraises for $100k, they will loan $65k. Even with an ARV of $150k, they're lending 65% of LTV. This is an actual response I received from one potential HML. I'm not sure I quite understand your question, but maybe you can explain it to me better? This could be an area where I'm missing an important distinction.
2) The contingency would already be built in to the $25k at 20%. So, let's hypothesize that the repair is actually $20,000.
3) This is where I need insight, so thanks for your elaboration. I've read articles on HML that give scenarios of receiving a percentage of the draw at closing. I need to know if this is practical, or just theoretical. Based on what you say, it must be theoretical. I am curious however because the same HML that told me they only loan on LTV, not ARV, said that this is the reason why there are no draws. I really don't understand WHAT that means exactly. Before I respond, I wanted to get some clarity from the BP community.
4) Can you describe what type of things could go wrong with GC financing? Especially when working with a corporation like Lowes. That info. would be handy, and could get my gears moving into thinking of other solutions :)
@Michele B. thanks for the reply!
Yes, loan #1 will be from the HML for the purchase price of $43k at the astronomical rate of 12% for a 12 month term. Loan #2 will be direct financing from the contractor of $25k at 3.99% for 36 months. Both will be paid off after selling the property.
It seems much smarter, to me, to have the $25k financed at a much lower rate, versus rolling it into a high interest HML. I understand over-leveraging, but in this scenario it's the same amount of money financed, just in two loans versus one. Why would I let the HML loan me $65k at 12% when I can get the rehab portion financed under more favorable terms is what I'm thinking. But maybe I'm wrong...
1) In this example, the HML is lending 65% of the LTV, not the ARV. So, if the property appraises for $100k, they will loan $65k. Even with an ARV of $150k, they're lending 65% of LTV. This is an actual response I received from one potential HML. I'm not sure I quite understand your question, but maybe you can explain it to me better? This could be an area where I'm missing an important distinction.
If the HML is lending 65K which is 65% of the 100K, most HML will not lend the entire 65K. They will require about 10% down or $6,500 making the loan amount $58,500.
2) The contingency would already be built in to the $25k at 20%. So, let's hypothesize that the repair is actually $20,000.
Then the Rehab budget is 25K, not 22K. This should make your purchase price 40K, which should be lower in my opinion if you deduct the holding cost, closing cost, and HML fees, etc.
3) This is where I need insight, so thanks for your elaboration. I've read articles on HML that give scenarios of receiving a percentage of the draw at closing. I need to know if this is practical, or just theoretical. Based on what you say, it must be theoretical. I am curious however because the same HML that told me they only loan on LTV, not ARV, said that this is the reason why there are no draws. I really don't understand WHAT that means exactly. Before I respond, I wanted to get some clarity from the BP community.
I will give you an example. if the HML lends you 65% of the After Repair Value and you have 10% ($6,500) in the deal, your loan amount will be $58,500 that you are paying interest on. You have $25,000 of that $58,500 in escrow for your rehab that will only be paid out in draws as this protects the lender from you taking the funds and moving to Canada or giving a smooth taking GC a $24,999 down payment. You draw from the escrow account as you complete phases of work. (5K after exterior is complete, 5K after Rough Electrical and Plumbing, 5K after flooring, cabinets, etc. 10K at completion) This protects you and the lender from a contractor taking off with your cash and not even hammering a nail at the job site. Keep in mind, with each draw you have to have the funds wired into your account which is typically about $200-$250 per draw in my experience.
4) Can you describe what type of things could go wrong with GC financing? Especially when working with a corporation like Lowes. That info. would be handy, and could get my gears moving into thinking of other solutions :)
1) In my opinion there is a conflict of interest as the contractor that is financing is incentivized to take longer on the project. The longer it takes the more interest they make. 2) You are already paying 11-12% interest on your HML. Why would you want to pay another high interest rate to someone else? 3) Any halfway decent contractor is going to recognize that you are an investor and realize that you are leveraged to your throat in debt. There will be little to no meat on the bone to slap a mechanics lien on the subject property, so they may request that you personally guarantee the loan. I am sure that this has worked out for someone out there, but these are just a few points off the top of my head that stand out.
Ahhhhhh, I see now what you meant in your first bullet point. My response was contradictory to my example because I was thinking of what I was actually told by a potential lender about not lending on ARV but LTV. So let me revise, and clarify.
If the ARV is $150k and a lender will do 65% ARV, then they will loan $97,500. If the "as-is" value of the property is $100k, but I get the property for $43k, and it needs $25k in repairs, I only need $68k. In this scenario, what determines how much skin in the game I need? Aside for the lender points, buyer transaction points, and holding fees.
Alternatively, if the lender says they'll loan 65% LTV, then they will only loan $65,000. I'm still trying to understand how this eliminates any draw requirements. Maybe I should just call the guy and ask, LOL.
Originally posted by @Sharon Evans:
@Michele B. thanks for the reply!
Yes, loan #1 will be from the HML for the purchase price of $43k at the astronomical rate of 12% for a 12 month term. Loan #2 will be direct financing from the contractor of $25k at 3.99% for 36 months. Both will be paid off after selling the property.
It seems much smarter, to me, to have the $25k financed at a much lower rate, versus rolling it into a high interest HML. I understand over-leveraging, but in this scenario it's the same amount of money financed, just in two loans versus one. Why would I let the HML loan me $65k at 12% when I can get the rehab portion financed under more favorable terms is what I'm thinking. But maybe I'm wrong...
I work with hard money and I am from 5-9% interest, with closing costs of 5%. Paying 12% interest on one, and 4 on the other plus closing costs on the two loans. OUCH I think you need better lender. Personal opinion.
Thank you so much!! I think this clarifies a lot. The problem is that I haven't spoken directly to lender yet, so a lot of this was cloudy, but I think the question that is missing from my scenario was the down-payment component.
I downloaded a worksheet for calculating the numbers for a flip. In the calculator, it asks "LTV or Down payment?", which led me to believe that a down payment was not required if the lender is using LTV not ARV. I wasn't paying attention to the LTV reduction based on the loan balance.
The 2nd loan would not have any closing costs, as it would be a line of credit from the contractor, say Lowes. It could be paid off at any time during the 36 or 60 month term, the same way you would pay off a credit card. But I understand where you're coming from. What is the down payment requirement on your loans?
i usually see 5-9% interest at 70-100 LTV, depending on equity partner and size and type of loan, with 5% or lower closing costs.
@Ken Eck I downloaded it from a site (will PM you). If you have any skill with Excel, you won't have to pay for the version they sell...you can just modify it (see attached images). You can change the macro to either tell you the maximum purchase price based on your numbers, or to base your profit on a known purchase price. Hope this helps.
95%+ of HMLs out there require a down payment. The ones that don't are very expensive.
I don't like using the term "LTV" when it comes to hard money; it's often confusing. But often lenders use that to refer to ratio based on as-is valuation or ARV valuation. Keep in mind that this isn't what you perceive those values to be, more so what the actual value comes out of from the BPO/appraisal.
Here are the terms we'll use:
Loan to Purchase (LTP): The % of leverage the lender will do on the purchase price (and inversely your down payment). Most lenders will require down payment. Let's say 90% LTP / 10% down, as that is the typical scenario that I see, even for new investors. If lenders care about as-is values, then they'll lend to the lower of the purchase price or as-is value at 90%. If as-is value happens to be lower than the purchase price, you usually end up having to put in more down payment (same as a conventional loan), or you can ask the seller for a reduction in price. I've never seen a lender lend solely on as-is value without caring about purchase price (i.e. the 65% LTV scenario you mentioned).
Loan to Cost (LTC): This takes into account the rehab as well as the purchase price, i.e. your big costs for the project. If a lender lends 90% LTC, then they'll finance 90% of the purchase price and 90% of the rehab. I often like to break it out into two numbers as opposed to just LTC as there are a lot of lenders out there who lend different percentages on purchase and rehab (i.e. 90% purchase and 100% rehab).
Loan to ARV (LTV?): Lenders also place a limit on the entire loan amount based on the ARV. This isn't really an issue with purchase-only financing, but it can come into effect if you're financing the rehab as well. Most lenders lend around 70% of the ARV. If you have a good deal (i.e. follow the 70 or 75% rule), this won't really affect you.
@Michele B. I've seen you advertise your loan programs a few times and thought you'd like some feedback. If people look only at your interest rates, your terms are really attractive. However, 5pts is extremely expensive. Most flippers imagine themselves in and out of a project relatively quickly (3-6 months), and in those cases, the points hurt more than the interest. If it's a quick flip, I'd personally rather do 14% interest and 0 points than 9% interest and 5pts. If you had a program that allows you to shift points into the interest, it would make you much more competitive. However, points and interest are just one portion of hard money terms someone should look at... there's also the junk fees, down payment, length of loan, closing speed, extension costs, flexibility with 2nd liens, etc.
BTW, most new investors should be able to achieve 12% and 3pts at 90% LTC for a 1-yr loan. I assume your pricing is towards the higher tier for new investors? Since most flips finish under 6 months, I'd still rather take 12% and 3pts over 9% and 5pts as that ends up being cheaper, considering the rest of the terms remain the same.
@Sharon Evans Sounds like a small shop if they're looking at properties themselves. They definitely don't have a high default rate if they're making borrowers put down almost 50% down payment. Good for them, but bad for you.
I'll PM you some better options.
@Nghi Le
Also, I’d be interested to know your thoughts on financing the rehab separedly, at a lower rate?
If I'm pre-approved for $50,000 in construction from a huge corporation, like Lowe's, at an interest rate of 4% for 36 months, it seems much smarter to finance the purchase with the HML and the rehab with Lowe's.
I should mention that there are some competitive advantages in working with Lowe’s because the material costs aren’t marked up, and their subs are more incentivized to complete the project on time because they’re being paid by Lowe’s, not me.
I understand being over-leveraged, but I would just pay the Lowe's line of credit off at closing, the same I would if it were financed with the HML at 12%. I guess I don't see why this method is any more risky than having it financed through the HML?
@Sharon Evans I'm just starting out in this adventure and would be very appreciative if you could send me that link as well. Wish I could offer some value to this conversation as opposed to just asking for something but I am not there yet. Thanks for your consideration!
Originally posted by @Nghi Le:
95%+ of HMLs out there require a down payment. The ones that don't are very expensive.
I don't like using the term "LTV" when it comes to hard money; it's often confusing. But often lenders use that to refer to ratio based on as-is valuation or ARV valuation. Keep in mind that this isn't what you perceive those values to be, more so what the actual value comes out of from the BPO/appraisal.
Here are the terms we'll use:
Loan to Purchase (LTP): The % of leverage the lender will do on the purchase price (and inversely your down payment). Most lenders will require down payment. Let's say 90% LTP / 10% down, as that is the typical scenario that I see, even for new investors. If lenders care about as-is values, then they'll lend to the lower of the purchase price or as-is value at 90%. If as-is value happens to be lower than the purchase price, you usually end up having to put in more down payment (same as a conventional loan), or you can ask the seller for a reduction in price. I've never seen a lender lend solely on as-is value without caring about purchase price (i.e. the 65% LTV scenario you mentioned).
Loan to Cost (LTC): This takes into account the rehab as well as the purchase price, i.e. your big costs for the project. If a lender lends 90% LTC, then they'll finance 90% of the purchase price and 90% of the rehab. I often like to break it out into two numbers as opposed to just LTC as there are a lot of lenders out there who lend different percentages on purchase and rehab (i.e. 90% purchase and 100% rehab).
Loan to ARV (LTV?): Lenders also place a limit on the entire loan amount based on the ARV. This isn't really an issue with purchase-only financing, but it can come into effect if you're financing the rehab as well. Most lenders lend around 70% of the ARV. If you have a good deal (i.e. follow the 70 or 75% rule), this won't really affect you.
@Michele B. I've seen you advertise your loan programs a few times and thought you'd like some feedback. If people look only at your interest rates, your terms are really attractive. However, 5pts is extremely expensive. Most flippers imagine themselves in and out of a project relatively quickly (3-6 months), and in those cases, the points hurt more than the interest. If it's a quick flip, I'd personally rather do 14% interest and 0 points than 9% interest and 5pts. If you had a program that allows you to shift points into the interest, it would make you much more competitive. However, points and interest are just one portion of hard money terms someone should look at... there's also the junk fees, down payment, length of loan, closing speed, extension costs, flexibility with 2nd liens, etc.
BTW, most new investors should be able to achieve 12% and 3pts at 90% LTC for a 1-yr loan. I assume your pricing is towards the higher tier for new investors? Since most flips finish under 6 months, I'd still rather take 12% and 3pts over 9% and 5pts as that ends up being cheaper, considering the rest of the terms remain the same.
I have seen so many people say they are paying 14% with 70 LTV and 6 or more points. I do more than just flips most of my loan packages are for those in commercial, those who have cash flow issues, or those who need equity partners. Our company does a lot of loans that people have been told NO by one or more other place and we get them loans. Our Motto is " Making your Dreams Reality".
@Sharon Evans I am still trying to learn about investing, but Bigger Pockets has a hard money directory here: https://www.biggerpockets.com/hardmoneylenders/georgia . Thanks for the post. It has help clarify some things about HML.
Sorry for disappearing... haven't been as active on BP the past couple of weeks.
A lot of people recommend the BP Directory, but I've noticed that it's missing a lot of lenders. And there's not really a review system. I think it works better in some states than others.
I'm always up for exploring options with lower rates, as long as it doesn't increase the hassle factor and risk significantly. I'm not familiar with this line of credit option from Lowe's. Is it a true line of credit where you pay interest on what you use and you're able to charge it over time and not all at once?
Are you tied down to using specific contractors if you go through this route? Do they give you retail pricing or wholesale pricing (both Lowe's and the contractors)? Is being paid by Lowe's better than being paid by you? What does the approval process look like for each "draw"?
I'd say perhaps give it a try and then post a review of your experience here on BP.
