Rehab Loans – What Are They, Why Use Them

Loans come in many formats, and serve multiple purposes, however the rehab loan has some unique characteristics. The name itself is somewhat self-explanatory…………a loan used to finance the rehab of a property. However, that’s only part of it, as often it finances more than just the rehab.

Rehab loans offered to real estate investors are also commonly referred to as Fix & Flip loans, Fix & Rent loans, hard money loans or even bridge loans. They usually serve as a tool of leverage to real estate investors that purchase properties (of all types) that need updates or improvements (whether minor, cosmetic or full gut rehabs). A way to leverage a little of the borrower’s money by utilizing the lender’s money for much of the purchase & rehab costs associated with the property.

Purpose of the loan:

• Assist in the acquisition and rehabbing of properties
• Provide leverage of the borrower’s money – a way of stretching (or multiplying) their available funds
• Create a resource to help the investor scale the growth of their real estate investing business

Characteristics of the loan are:

• Length
• Leverage
• Rate
• Fees
• Type of Borrower and Guarantor(s)
• Escrow
• Construction Draws
• Inspections
• Appraisal
• Collateral
• Exit Strategy

The length of the loan is typically very short and can range from as little as 6 months to as long as 18 months, depending on the property type or complexity of the improvements being conducted on the property used as collateral. The design of the length of the loan is to permit the real estate investor ample time to have the improvements conducted and prepare for an exit from the loan.

Leverage of the loan and the loan amount is standardly tied to either the total cost of purchase and rehab amounts (none as “cost”) OR the completed after repaired value of the property (referred to as ARV). When leverage is tied to the costs of the project, it is referred to as a Loan-to-Cost (LTC) loan. If the leverage is tied to the after repaired value, it is referred to as an ARV loan. Typically, a rehab lender extending the loan will determine the loan amount to be the lower of either the leverage of the cost or the ARV. In almost every case the lender will require the borrower to have some of their funds into the transaction (skin in the game). This could range from as low as 10% to as much as 30%. Additionally, the borrower may also need their funds to cover areas tied to the loan that the lender may not finance, such as: closing fees, lender fees, appraisal, inspections, insurance, etc.

The rate of the loan will typically be much higher than other types of loans, usually in the range of 8%-16%, depending on the percentage of leverage extended, the property type, the borrower’s experience, financial & credit profile and complexity of the improvements to be conducted. It is normally an interest only loan with the principal paid at the termination of the loan. Because the rate is considered to be high, exiting from the loan as swiftly as possible is suggested.

Fees associated to the loan are often:

• An origination Fee - Equal to a percentage of the loan amount. This percentage is called “points” (1% = 1 point), and can range from as low as 1 point to as much as 6 or more
• Processing/Underwriting Fee – To cover the cost of creating a file for the transaction and communicating with the parties involved (borrower, realtors, settlement agents, insurance agent, etc.) during the processing/underwriting period of the loan.
• Application Fee or Commitment Fee – Some lenders charge a fee to receive and process the application from the borrower, or to issue a formal commitment letter to the borrower
• Appraisal Cost – The appraisal on this type of loan is normally a 2-part appraisal to determine the property’s value tied to its current condition (AS IS Value) and to determine the property’s future value (ARV) after the improvements have been conducted.
• Inspection(s) Fee – The inspections conducted are tied to an initial inspection verifying the current condition of the property and additional inspections conducted when the borrower is seeking a “draw payment” for improvements conducted. Depending on property type, some multi-family or commercial style properties may require additional inspections inclusive of environmental inspections.
• Pre-Payment Fee – Some lenders may charge a fee if the borrower chooses to exit from the loan (pay it off earlier) than originally designed, while other lenders may not have this fee associated to this loan.
• Minimum Interest Fee – Although not as widely used, some lenders may have the borrower pay a minimum amount of interest on the loan even if the loan is paid off in a very short period. Read the fine print to see if this characteristic applies to rehab loans that you are considering.
• Payoff Fee or Exit Fee – At times a lender of this type of loan may have the borrower pay an exit fee, or loan payoff fee. Perhaps in place of, or in addition to a fee for releasing the lien on the property.

Lenders do not always disclose the fees to the borrowers and instead assume the position that the borrower will take the time to read the terms and conditions (including fees) of the loan prior to signing the mortgage documents.

Type of Borrower and Guarantors – It is common that the loan is issued to an entity (LLC, Corporation, etc.) instead of an individual. In issuing the loan in this format, and with the collateral not being the guarantor’s primary residence, the loan naturally becomes a commercial transaction (even though the collateral may be a residential property), and normally is not classified as a consumer loan. The guarantor(s) of the loan are typically the members of the LLC, or shareholders of the Corporation that the loan is issued to. Unless the lender takes the steps to report to credit bureaus, or the loan goes into default, these styles of loans typically do not appear on personal credit reports.

Escrow – Any funds that are a portion of the loan that are earmarked for rehab costs are usually placed in escrow to be drawn from as the improvements are conducted and verified. This means that the borrower must be prepared to front the cost of improvements between construction draws, and then are reimbursed when the draw is issued.

Construction Draws – As the improvements are conducted the borrower can place a request with the lender to receive a construction draw. The lender would in most cases either conduct an inspection of the completed work to be paid for or hire a third party to conduct the inspection.

Inspections – Two types of inspections occur in these loans: (1) Initial Inspection, conducted near the early stages of processing of the loan to determine the current condition of the property as well as verify the improvements that are scheduled to take place in accordance with the scope of work detailing the improvements and related costs. (2) Draw Inspection, conducted as the improvements are occurring for verification and release of funds in escrow for the cost of the improvements.

Appraisal – A two-part appraisal is completed by a licensed appraiser to determine the current AS IS value of the property and the future value of the property taking into consideration the improvements that will be performed based on the scope of work for the project.

Collateral – The collateral for the loan is almost always the subject property that the borrower is purchasing/rehabbing. The lender will place a lien on the property that will be recorded in public records (usually the local Recorder of Deeds office). This alerts anyone researching that in order for title of the property to be transferred to another party, the lien on the title must first be addressed.

Exit Strategy – Since the loan is designed to be a short-term (usually high interest) loan, there must be an exit strategy from the loan. This exit strategy could be the sale of the property after the rehab is completed (flipping the property). The exit strategy could also be to refinance the property and gain a replacement loan, which is usually a lower interest, longer term loan. This is often the case when the borrower intends to hold the property and use it for rental income.

Benefits of the loan are:

• The use of other people’s money in place of more of yours
• Create the opportunity to conduct transactions that without the use of the loan you would not be able to
• Be able to perhaps have multiple projects operating at the same time
• The opportunity to target more costly projects or neighborhoods that without the loan you might not be able to

Qualifying for a rehab loan:

Unlike standard conventional loans, rehab loans often carry much less documentation and hoops to jump through than conventional loans. A rehab lender may simply use the following criteria in determining the initial approval of a borrower:

• Past or Recent Experience related to Flipping or Holding Properties
• Current Financial Profile (liquidity & real estate owned)
• Credit Profile (The lesser the experience = the higher the desired FICO score. The greater the experience = the lower the required FICO score)

Experience can carry a lot of weight when qualifying for the rehab loan. When the lack of experience exists, then something must take its place, such as either a stronger FICO score, or greater liquidity, or both.

Although sometimes perceived as expensive or costly, rehab loans can be a very effective tool for the real estate investor. Especially those seeking to use other people’s money to start or grow their business.

While there may be multiple rehab lenders, not all are the same, nor are the terms of their loans the same. The wise borrower will conduct research to determine which lender(s) is the better fit for their style of investing and geographic location before committing to a loan.