Ep. #24 - Rehab Lending: Down Payments, Appraisals, Reserves & Credit Scores

Welcome to Episode #24 - Rehab Lending: Down Payments, Appraisals, Reserves & Credit Scores.

What do these things have in common? You'll need to maintain high numbers for each to secure funding from most rehab lenders.

When you start out in investing in Real Estate, you'll likely do your first few deals with a conventional lender under your personal name. I believe you can play that game up to 10, and if you're married and both work (with sufficient income), you can potentially do 10 each in this manner for a total of 20! But at some point, likely much sooner than 20 - you'll need to opt for some sort of commercial or rehab lending.

This will be especially true if you pursue the BRRRR method, which I explained in Episode #14 is Buy, Rehab, Rent, Refinance, Repeat. You see conventional lenders work fine for move-in ready / Turn-Key properties - that do not require any significant rehab to make rental ready. But the best BRRRR deals will have extensive rehab required. And as such, you'll need either substantial Private Lender funding or you'll be working with a Rehab / Hard Money Lender.

That what this episode is about... What you'll need to have a handle on to secure Rehab Lender funding for your BRRRR projects - Down Payments, Appraisals, Reserves & Credit Scores.

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Down Payments... Now you can find and secure Private or Rehab Lender funding that gives you 100% of both the purchase price and rehab budget. But this doesn't normally happen on your first projects. To get Private Lender funding (outside of close friends and family), you often need to be able to show a track record of several successful deals.

And most Rehab Lenders offering 100% funding often charge ridiculous amounts in points and fees to secure such loans; require extensive experience that you're not going to have early-on; or you must find a deal that is so amazingly great, they don't come along often in the current market. So most Rehab Lenders offering 100% funding rarely actually provide it on typical deals.

In the vast majority of cases, you are going to have to come out of pocket with a Down Payment of 10% to 25% (maybe even 30%) of the purchase price, plus all fees and closing costs - and they'll fund 100% of the rehab. So on a $150,000 house, you're looking at about $35,000 out of pocket (depending on the ARV) - if they fund 80% of the purchase price and fees for closing costs come in at about $5,000 (and they can easily be twice that or more).

What most often determines your percentage of the purchase price that must be paid as a down payment, is the After Repair Value (ARV) of the completed rehabbed home. For example, many lenders will not fund above 70% of the ARV for the total project cost. So let's say that a $150,000 house required $50,000 of rehab to then be worth or sell for $250,000. And 70% of $250,000 is $175,000, which may be the most they're willing to pay on the project in total. Well, if your purchase price is $150,000 and the rehab budget is $50,000, that's a total project cost of $200,000. So you're $25,000 over what the lender may be willing to pay with those numbers on a project like that.

So to get this deal funded, you'd need to pay at least $25,000 out of pocket, which is just a little below 17% of the purchase price. If the points are at 2.00% ($3,000), appraisal is $750, attorney fee is $900 and all the other fees and closing costs are less than the remaining $1,350 - you'd be out of pocket for just below $31,000 on this deal.

Once the project is complete, you do a cash-out refi at 25% of the $250,000 ARV ($187,500). After refi closing costs of say another $2,500 and you pay off the $175,000 owed to the rehab lender, that leaves you with something like $5,000 after accounting for interest only payments on the original loan and other holding costs during the project. So no - not the best BRRRR deal in the world... You left something like $26,000 locked in the property; but you've got $5,000 or so in-hand to put towards the next one.

This sort of BRRRR deal is tighter than one I would target, as I seek to get ALL my money back (plus profit) at refi. But depending on what it can be rented for, you may still be getting a nice return on the money left in the property, so you don't always have to get it all back out.

Even if you got nothing back out but can put aside an extra $2,600 per month in savings, you'd be able to do one deal like this per year. And after only 10 years, you'd have 10 properties likely worth over $2.5 Million - your a millionaire! Now sure, putting aside $2,600/mo may be easier said than done - but if you do better deals and get most or all your money back from each, then it's less that you'd need to save. You may literally only need to save the money once, and each property can then fund the next. I've gotten all my money back plus profit larger than what I put in multiple times - so that was my next two or 3 deals funded from one.

Also, each property will lower your tax burden, so you may find you start getting refund checks that make saving for the next purchase even easier - plus the cash-flow that gets larger with each property. Its a snow-ball effect that gets easier and easier. It was much harder for me to get my 1st and 2nd properties than it was my 10th or 11th. By whatever means you'll need to plan for having 20% plus closing costs ready to take down each new property. And this is also a protection, because as much as I love debt (see Episode #21) - you don't want to get over leverage by putting little to nothing down.

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Appraisals... This all of course assumes that the property appraises for both the as-is purchase price and the after repair value (ARV). If it fails to appraise for what you're buying it for and/or the appraisal does not agree with your target ARV - it changes everything. You may not be able to get the deal funded. You might have to pay more out of pocket; or you might end up with more money locked in the property. You could even end up having to put in additional cash at refi (this has happened to me twice) - thankfully not early on, or it could have been catastrophic.

You live and die by the appraisal, which is why a lot of investors go for 5 unit properties and above, as they're valued based upon net income instead of comparable sales. You more fully control the valuation of 5 units and above (lower expenses / raise rents = increased value); whereas its somewhat out of your control on 1 to 4 units that just looks primarily at what similar nearby properties have sold for recently.

Multiple times I have been hampered with appraisals that came back low on the as-is value or ARV - or both. Thankfully my being a Realtor and now having extensive experience makes this less frequent - as I've largely been able to get the appraisers to consider and accept my suggested comps. But you have to be realistic going in - with an eye to what an appraisers is likely to come back with as a value for a given property.

Once I even forced a second and third appraisal to be preformed on the same property and got the value increased by $60,000 (very rare for a lender to allow that) - but I'm a Realtor and had done several prior deals with them, so they valued my knowledge and experience. The first appraisal was ridiculously low (demonstrably so); and the same appraiser then did another to correct his mistake - which even though a little higher, was still obviously low. So I got a 3rd clean appraisal from a different appraiser, that was $60,000 above the first - and even it was still $10,000 lower than it should have been (in my opinion), but it was good enough.

A bad appraisal can easily kill a great deal, so you have to be up on this. Know your comps. Be realistic. Don't compare properties that are not really alike, too far apart, crossing major highways or tracks, with different amenities and level of finishes, and on... It will come back to bite you.

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Reserves... Most Rehab Lenders are not only going to require that you put down a certain amount into the deal as a down payment. They are also going to want to see a certain amount of cash on-hand in reserve. So most often you'll need to be able to show cash in the bank totaling your down payment, closing costs and something like 6 months of interest payments on the loan.

So that $31,000 you needed to have to take down the example deal I gave earlier, could easily now be $40,000 or more. I've done deals where I needed to show $75,000 in the bank.

Now thankfully, some lenders will allow reserves to be in the form of retirement funds (401K / IRA), giving you credit for some percentage of the amount present within these accounts. Some will consider cash-value life insurance. Some will allow for a percentage of business account funds - which is great for a self-employed business owner like myself.

And since you often need to be able to provide a few months of bank statements to validate these funds - and they ask questions about any large deposits or withdrawals on those statements. I've setup separate bank accounts with sufficient reserve funds present to do almost any deal - and I just keep it there with little to no activity on those accounts. This makes it easy for me to show reserves without having to answer lender questions about transactions on the account.

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Credit Scores... Credit and Reserves are a balancing act for me.

I'll even carry a credit card balance (most are zero interest promotions anyway) - instead of using reserve funds to pay the card off. As I need to be able to show reserves on-hand more than I need to show zero balance on my credit cards - especially when the balance is at zero interest.

But this is always a concern, because Rehab Lenders often require a certain credit score (typically between 680 and 720). Above 740 you can almost walk into any bank and put your foot on their desk while you tell them how much money you need to fund your next deal. My scores were all above 820 - before I started using my credit on BRRRR deals.

You see, whenever I buy an HVAC system, flooring, appliances, cabinets, counters, foundation repair, and on... I'm likely to put it on a credit card with a zero interest promotion of 12, 18, even 24 or 36 months. It's literally FREE money. And each time I successfully pay off a promotion, they increase my limits and give me another promotion for a longer term! I just divide the total by the number of months for the promotion, and put that amount aside in a reserve account each month.

I then setup an automatic payment of the minimum amount due for that card. This means I never miss a payment, and it means my reserve account grows and can be used to show cash on-hand for the next project I seek to fund. If the system for that card allows it, I setup a final payment in advance from the reserve account for one month before the promotion ends. if it does not, I set a reminder in my calendar. Either way, I get FREE use of that money for X number of months - while building both business and personal credit.

The drawback is that those zero interest promotional balances often reflect on my personal credit if the card is in my name or if I'm the guarantor for a business account. Since I'm self-employed and pay myself the minimum, and since I'm often using 100% of the credit line - this has a negative impact on my credit score.

So the days of an 820 score are long gone for me. Despite having zero late payments, no liens, no judgements and no collections on my credit reports - I must manage my card balances and utilization percentages, as well as the number of credit inquires - to make sure that my scores remain above 680 (with my target being above 720).

Now I know that Dave Ramsey and other credit / debt adverse people will cringe at hearing how I use credit. However, your credit scores are either an asset or a detriment. If your scores are above 800 - then you are allowing an asset to go to waste. Some time ago, I wrote a blog post on Bigger Pockets about how ironic it was that I own millions of dollars of Real Estate and have multiple profitable businesses also potentially worth millions - yet my credit scores are often lower than some of the tenants who live in my properties. That should tell you the credit reporting and scoring system is majorly flawed.

And I'm not trying to brag or be condescending, but how can a person who has never had a late payment, no collections, no liens or judgements in over something like 25 years (with a net worth in the millions) - have a credit score lower than his Section 8 tenant with a part time minimum wage job?

The system doesn't like people who leverage their credit. But if you learn how to do so, it is a source of great amounts of FREE money - that will accelerate your growth as a BRRRR investor. Just make sure to learn how to do it right, because YES - it can also ruin you if done improperly - Dave Ramsey and others are not entirely wrong. They're just not speaking to a person like me. I wouldn't recommend jumping out of a plane either, but we can all agree that it can be done safely - if you know what you're doing. And that's far more risky than leveraging your credit. Are you going to tell me that can't be done safely?

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So that's it for today... I just wanted to provide some insight into what you'll encounter when using Rehab Lender funding on your BRRRR projects. Beyond what I've stated here, you'll also need to know how to estimate your rehab budget - as it's most often required to get funding, and you cannot change it later in many cases.

So go out and find an amazing BRRRR deal, and if you're looking for funding, go to: andlandlord.com/contact - I'd be happy to connect you with one of my lenders.

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