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.”
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