One
of the major obstacles most first time house flippers encounter is how they
will finance that first purchase, and then how they will pay for
renovations. Traditional lenders and
large banks are as unlikely to finance the first home flip project as they are
to finance a start-up business of any kind.
It is common knowledge that most new businesses fail in their first year
due primarily to “lack of capitalization”—that is, not having enough access to the
cash they need to start and sustain the business in its early stages, before it
becomes profitable. House flipping is
like any other business in this respect.
A flipper who is “under-capitalized” is operating with a large and often
insurmountable handicap.
In
business and in real estate, there have always been lenders who are willing to
accept additional loan risk in exchange for higher interest rates and loan
fees. There are some who even claim to loan
based solely on the borrower’s credit score… or finance “zero money down”
purchases… or help lead you through your first flip project. BEWARE. These people are not stupid and they
know how to protect themselves. Their
overarching goal is to maximize their own profits, not yours. Education and careful
analysis are keys to succeeding in any business, and there is no substitute for
doing your homework. If you don’t really
understand the most basic concepts such has an annual percentage rate or lender
“points,” you are probably not ready to take on your first project.
Here
is a true story – a “real life” example of someone I encountered two weeks
ago. A young man with three young
children decided house flipping could be a nice supplement to his regular
income. Let’s call him “Dave” for the
purpose of this story. Dave really had
no experience with house flipping, or investing or home buying in general. In fact, he and his family were renting the home
they lived in. He had little money saved
and no access to cash. But he found a
lender online that said had “good reviews.”
He contacted the lender, and the lender told him they specialize in flip
projects and they would help walk him through his first several projects. All he needed to do to get started was pay
them a $3,000 “membership fee” and he would be approved for up to $250,000 to
purchase a project and up to $50,000 for renovations. Wow, thought Dave. The online reviews are good. They say the lender is “expensive,” but that
is to be expected. “Sign me up.”
WARNING
ONE: If a supposed lender changes you some fee before you have even found your
first project, run for the exit. You
might be amazed at how many trusting souls are willing to pay essentially their
only savings to someone who claims they can make their lives easy for
them. Dave paid his $3,000 and he
received a letter from the lender saying he had been pre-approved for up to
$250,000 in financing and up to another $50,000 in renovation funding, subject to the lender’s underwriting and
other guidelines. Pre-approval
letters, even from the largest banks, reserve the right to underwriting review,
of course. So Dave felt he was ready to
go to work.
Dave
contacted me to find him his first project.
I didn’t know Dave, but I cautioned him that inventory is low in the
Charlotte metro area, like it is in many other regions of the United
States. Dave needed to have his
financing in place before we started looking. The best values are likely to receive multiple
offers, and an offer submitted without proof of cash to close or pre-approval
from a lender is unlikely even to be considered by the seller. Dave assured me he had been pre-approved to
purchase a home up to $250,000, and he sent me a copy of his pre-approval
letter.
In
the next month’s blog post I will specifically describe what was wrong with the
picture painted above. I’ll give you a
hint: it had something to do with Dave’s lack of even the most basic
understanding of finance terms and conditions, and his willingness to trust
that this lender was as interested in his success as they were in their own
bottom line. I will end this blog post
on a positive note: house flipping is alive and well, even in the most
difficult market. But research,
education and caution are a wise foundation for this, or any business. In the next blog post, I will conclude “Dave’s
story.”
