In
the April, 2023 edition of this blog, I began a discussion of I began a true
story about a prospective flipper I called “Dave.” Dave was a novice flipper who thought he had
his financing in place for his first project—a purchase price up to $250,000
and additional renovation financing up to $50,000. The hard money lender who had issued the
pre-approval letter in exchange for Dave’s payment of a $3,000 “membership fee”
stated in the letter that the pre-approval was for financing “up to 70% of ARV, with interest of
18% per year for a 5 month loan term,” PLUS 6.5 points. They might agree to a 3 month extension of
the loan term, in exchange for the payment of an additional 1% of the entire
loan amount per month. Dave didn’t
understand anything beyond the notion that he had been approved for a purchase
up to $250,000 and construction financing of up to $50,000. He told me he had informed the lender he had
no money of his own for the project; and when he contacted the lender for some
clarification at my insistence, the lender told him that “nothing down” deals
are possible. He just needs to find one
that will work within their criteria.
Simple, right?
Let’s take a look
at the not-so-fine print. What is 70% of
ARV? ARV means “after repair
value.” Loaning based on a percentage of
ARV would therefore mean a larger loan amount than loaning on the purchase
price. But who decides on what that ARV
amount is? Answer: the lender’s
appraiser, of course; and the lender’s appraiser in this case charges $550 per
appraisal. Even more importantly, 70% of
ARV may not be as generous an amount as one might think in the real world—at
least not in the real world as it exists in Charlotte, NC. Let’s take a real world example:
We found a house
in a decent area that needed significant renovation. That house was priced at only $235,000 and I
estimated ARV might realistically be as high as $357,000. Assuming this lender’s appraiser agreed on
ARV, 70% of ARV would therefore be .70 X $357,000 = $249,900. This is the total the lender would loan on
this project. So, to keep things simple
for now, if Dave bought this home for $235,000 and the lender was willing to
loan up to $249,900 for the project, you would think he would have $14,900 left
toward renovations. I will return to
this later, but to keep this example simple for now, recall he needs at least $50,000
for renovations. So in this case, Dave
would need to find at least $35,000 for renovations from some other source. Again; I will revisit this notion because
there is another twist.
But what about
lender fees? How much would they be and
when would they be due and payable?
Again; keeping things simple, $249,900 loan amount at 18% would be a
total of $44,982 per year in interest.
$44,982 divided by 12 months = $3,748.50 per month in interest. If the project could be completed and resold
in only 5 months, total interest on the loan would be $18,742.50. In addition, there would be 6.5 points
payable. $249,900 X .065 =
$16,243.50. Thus far, we have interest
and lender fees for this project of $18,742.50 + $16,243.50 = $34,986.00.
So in this
simplified true life example, we have $14,900 above the purchase price available
from this loan for renovations, and we have $34,986.00 in interest and lender
fees. Therefore, the lender fees far EXCEED
the funds Dave thought would have been available for renovations. Most renovations would actually have to be
paid for by Dave, not this loan. And
this does not include appraisal fees, closing costs or broker commissions
payable on the resale of the home. In
theory, if Dave had the cash to pay for renovations—which would almost
certainly have exceeded $50,000 for this home in any case-- it might be
possible for Dave to make some small profit in the end. That would have gone something like this:
Purchase Price: $ 235,000.00
Loan interest and
points (5 months) 34,986.00
Renovation Costs
minimum
50,000.00
Subtotal costs: $ 319,986.00
Broker commissions
on resale (customarily 6% of sale $) 21,420.00
3 months of
interest at 1% per month to extend to 8 mths 7,497.00
Appraisal and
closing costs estimate 2,500.00
Total $ 351,403.00
==============
ARV: $ 357,000.00
Total costs above: ( 351,403.00)
Balance: $
5,597.00
==============
In this overly
simplified scenario above, Dave might have actually made $5,597 or so on this
project, after paying for most renovations from his own pocket. Of course, if renovation costs exceeded
$35,000—and they would probably have in this case due to the extent of updating
needed—we would have barely broken even on the project. The lender would have made about $42,500 on
the project; and nothing would have even gotten off the ground if Dave did not
have $35,000 from some other source for the renovations.
But there was
another very important detail about this real life transaction. This lender would have required Dave to
prepay all interest on their loan, and their points when Dave closed the
purchase of this project. On the day he
closed his purchase, Dave would have bought a house for $235,000, and
immediately secured a loan against it for $249,900. IN ADDITION, this lender would have required
Dave to place in escrow the total
estimated renovation costs of $50,000 on the day he purchased the home. FURTHER—and this is the twist I referred to
earlier—this lender also required that all their interest and fees be prepaid
ON THE DAY OF CLOSING. So we have a
purchase price of $235,000 and a loan of $249,900. But we have lender fees of $34,986 that need
to be paid on the day of closing.
$235,000 purchase price PLUS the advance payment of lender fees of
$34,986 = $269,986 PLUS $50,000 in renovation costs going into escrow =
$319,986 needed by Dave on the day of closing of his purchase, just to buy a
home for $235,000. Recall that the loan
maximum was $249,900. So Dave would need
to deposit $70,086 ($319,986 - $249,900 = $70,086 on the day of closing or this
lender would not fund the $249,900. Huh? What about those “nothing down” deals that
sounded so good when Dave paid his $3,000 “membership fee?” And to add insult to injury, even if Dave had
been able to pay all these amounts and successfully finished and re-sold the
home for $357,000, he would make only $5,597 for his heroic efforts.
The simple truth
is that the above scenario is not much of a formula for financial success. And if this were the only way to finance a
flip project, the reader could be forgiven for concluding that house flipping
cannot offer much financial opportunity—especially in the current real estate
market in which inventory is low and purchase prices for even homes in need of
significant renovations are up. What is wrong with this picture, of course,
is that the hard money lender took all the profit the flipper would have otherwise
made on the project. Fortunately,
there are alternatives to hard money financing.
In the next
installment of this blog post, I will show you that there are alternatives for
the Dave—especially as an owner-occupant of the home in which he intends to
invest.
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