Understanding current financing requirements will save anyone interested in rehabbing real estate foreclosures a great deal of heartache down the road.

Let me explain, I had a client contact me looking for a residential loan officer because he wanted to refinance a single family home that he purchased as a foreclosure about six months ago. I asked my client why he wanted to refinance and he said that he had gotten a great deal on the property, purchased it with hard money, completed a rehab and was now ready to rent the property. However, he discovered, attaining conventional financing was problematic because banks were not loaning on actual value, but rather on purchase price within 12 months of closing. Banks wanted to see a minimum of one year of seasoning or ownership.

Here is my client’s situation:

Lien at time of foreclosure: $150,000

Market value at time of foreclosure: $200,000

Winning bid at time of foreclosure: $150,000

Hard money loan: $150,000 — 75 percent of market value

Rehab costs: $50,000

Value after rehab: $350,000

My client, who will be called Fred, appeared to have purchased the foreclosed single family residence with a zero down payment. However, the numbers are misleading once you understand the structure of the financing.

Fred attained what is known as a hard money loan. A hard money lender will base the dollar amount they are loaning off of the actual value of the property not the purchase price. Like a bank, the property acts as the collateral for the hard money lender. Since this was a foreclosure, the first lien holder — a bank in Fred’s case — was only able to recapture their debt on the property, which amounted to $150,000. The property, although run down, still had a market value of $200,000. Since the hard money lender based the loan to value off the market value, Fred was able to get a $150,000 loan or a 75 percent loan to value.

The problem is that Fred has to pay six points, or percent, of the loan amount up front, along with a 15 percent rate, amortized over 20 years due in 12 months. The hard money lender takes the first position should they have to foreclose on the property. Fred has to pay $9,000 in points to the hard money loan upfront along with a payment of $1,975 each month. If we compare that to traditional market financing today, you will see that Fred is paying a ridiculous amount of money each month in debt service.

At the time of this article, a prime borrower with an excellent credit score and strong assets can obtain a conforming 30-year fixed loan, amortized over 30 years at a rate of 5.25 percent. In terms of payment, that translates to $828 a month at a $150,000 loan amount. If you do the math, you will see that Fred is paying a $1,147 premium a month for the hard money loan. However, Fred sees it as an opportunity to purchase a house under market, rehab it and make money renting the property.

Fred rehabbed the property for $50,000, which took six months. Now Fred has a total of $67,850 ($1,975/mo/payment times six months equaling $11,850 plus $6,000 loan points plus $50,000 rehab cost) of carrying and rehab costs in the project and is looking for conventional financing. In theory, it seems like a safe a bet because the value of the property is $350,000 after rehab costs, but Fred has run into one small problem — market timing.

Conventional lenders are making it difficult, if not impossible, for investors to attain financing on non-owner occupied properties. Furthermore, lenders, specifically banks, are not lending on properties that have been seasoned for less than a year. This puts Fred in a precarious situation because he has a hard money loan that is due at the end of 12 months. The longer Fred keeps the hard money loan, the higher his carrying costs, which go up to $79,700 after a year.

Fred has a couple of options. He may choose to sell the property and forego placing a tenant in the house. Regardless, if Fred finds a buyer and sells the property at 12 months of ownership, the numbers above are used and he gets $350,000, Fred will only achieve a profit of $120,300 ($350,000 sales price — $150,000 purchase price — $79,700 carrying costs). Now that is not a terrible profit after a year, but that is making one large assumption in this marketplace — that Fred finds a buyer.

If Fred does not find a buyer the hard money lender could foreclose and he will be left out in the cold with a $79,700 loss. However, Fred’s story has a happy ending. In reality, Fred is lucky and actually has enough money to payoff the hard money lender.

In today’s market, unless you have a lot of money, a clear exit strategy and know exactly what you are doing, now is not the time to try to make money in rehabbing foreclosures, with the hope that a bank will be able to refinance you out of a hard money loan a few months down the road. Understand what you are doing and what kind of financing is available. Investor mistakes are not forgiven in today’s real estate market.

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