First Time House Flippers: Beware of the “Hard Money Lender”

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.”