Mitigating Risks in Fix and Flip Loans

[Lisa Fortune]

What are the biggest risks associated with fix and flip loans, and how do you mitigate them?

[Mike Klarman]

I've coordinated 30+ projects for investors now, seen the fix and flip process up close.  Saw it go great, and I saw it blow up too.

There's lots of moving parts to buying an asset, fixing it up, and selling it for profit. It can go wrong anywhere and everywhere. Murphy's Law applies like a mother to REI.

First, if you are doing all the project picking/analyzing/Comp Analysis and you don't know the market, and you don't know the formulas, and your numbers are wrong? You'll wind up paying for an appraisal, maybe 600 - 750, and then when it comes back the lender will tell you there's no deal, the ARV is too low or you paid 100k for it but the as-is came in only at 80k so that's the number they are willing to lend you on, in other words this deal just got 20K more capital intensive for you and maybe priced you out. Until you are an expert, you need to work with experts in the market. People who know the values of the properties street by street, They can show you that in the last 6 months there are have 4 sales for a 3/2 in similar square footage. Hard factual numbers. The average of those numbers are 250k and the days on market spans from 35 - 55. So you figure you can get an exit around 250k in about 40 - 45 days on market. You can't shoot from the hip, you will shoot your foot off.

Let's pretend you get by the first step, your asset checks out in the appraisal process. You are buying this thing 10k under market value and the ARV is exactly what you expected. Great. Time for the Loan Process. Most people get stuck on terms, and terms will vary upon lender, credit score, experience, asset location. But you're asking what kills a REI deal? It's not the .5% more in rate, I can tell you that. It's not the difference between 11.5% or 12% or 1 point or 2 point origination. If a deal crumbles and you lose money it won't be because of the financing, given you're dealing with a reputable broker or lender who has closed 100s of deals. The financing can surely trip you up if the lender fails to show with the funds at closing or drops off and ghosts you. That doesn't happen to my clients as I deal with lenders who close billions per year in loans. But the terms will be what they will be on deal 1. Could be 12.5% and 3 points. But if you did step 1 right, that will not kill your deal I promise, however step 3 is the most slippery slope there is.

Let's say you make it out of step 1 and step 2, now it is time for step 3. Getting the project done. God, let's hope the GC estimated right cause there is no opening up loans and adding money, anything outside the budget is on you in cash. And let's hope he/she is not a real piece of you know what. Cause 9/10 are the shadiest, lie with a straight face, ***** in the world. Here is what you get when you hire a GC, someone who wants to call subs and add 2 - 3k on top and then never show up at the house, never manage the quality of work from the Subs, do not manage their time. I've had agents surprisingly show up at houses mid rehab at like 11am and no one was there, then you call the GC and he is like shocked this is happening. They don't care about your job really, to them it is about quantity, not quality. Can they bring in 5 jobs and just charge 5k on top of sub pricing and then never, ever do anything else? That's 25k for zilch. Then you have the problem of the finishes. I'm sure the comps you or the agent looked up had very nice finishes. From the paint, to the floors, to the kitchen/bath remodel I'm sure it all looked great. So if yours does not look as good, then you can subtract 25% off your ARV for sure, maybe more. I've been through that nightmare with clients. On a walkthrough, 90 days in, the house is a mess. Paint sloppy, floors put in first then trampled on for months, sheet rock rough. It's ugly and it was all a very expensive lesson on how to vet GCs and how to develop relationships with the correct ones. I've been through 10 GCs so I took my lumps in order to learn, but now I'll warn others: They'll say they can do anything, if their price is too good to be true - it is, they'll say they work toward a standard but they do not. Think about it, anyone who wants to sit through some lead paint classes and pay the $100 filing fee can get a GC license. With that license you are now allowed to hire 3rd parties to work on houses you do not own. You can call up a painting sub, get a quote for 4k to paint a house, and then just put down 5500 for painting on the invoice. You made 1500 for making a call. So you can imagine that profession invites hucksters who are great on the phone. If you have a GC license and a phone, you can legally hire subs to work on houses. The GC license in now way shape or form guarantees that:

1) They know about the trades they are hiring for

2) They know how to manage, organize, delegate during the job

3) That they will be at your house making sure things get done right

I only work now with people who hold GC licenses, they are insured, AND they need to know the trades and actually be working next to the guys in the house.  I only work with GCs who get their hands dirty.  I'll no longer even work with anyone who does nothing but call others.  In philly I teamed with @Jeff Henderson for that reason.  Our network just found two great deals in Prospect Park, Delaware County outside Philly.  We filled them quickly.  One with a new investor and I got that investor 90%/100% cause his credit was good and the deal was good.  But come late September Jeff will be right beside his team in the trenches 8 hours per day, monitoring, delegating, working, organizing and treating the houses like they are his.  Most GCs won't even look at the comps to see what they'll need to make the subject house look like.  They'll just start with no plan and no vision because they are all about the money not a business relationship.  They do not have the skills so these one offs that go way off track is their business, they know you'll never work with them again.  But thank God for them bright eyed, passionate, new investors are not rare.