Why a high-interest loan may be advantageous to a house flipper

October 9, 2013

Pierce said he reluctantly obtained an $80,000 bank loan to purchase and renovate this house in Capitol Heights. His preference is to use private loans, which despite having high interest rates, close sooner and are less cumbersome. (Justin Pierce)

Pierce, a real estate investor in Northern Virginia, writes an occasional column chronicling his experiences buying and selling houses in the Washington region.

I’ve been known to pay 12 to 16 percent interest to finance my flips.

Many people are shocked when they hear this and they inform me that I could get funding from a bank for less than half that cost. I am aware of this fact. I have good credit and a good business history. However, the standard bank loan process is just not conducive to the high-risk, fast-pace world of wholesale real estate buying.

Banks and retail buyers want inspection and guarantees. Real estate flippers often move on gut, personal knowledge of the market and less than perfect information. Less than perfect information is compensated by deeply discounted purchase prices. Institutions and bureaucracies like to have blocks checked and redundant fail safes such as inspectors and appraisers. Some of my deals don’t even allow time for an appraisal.

There was a time when the local banker knew the community, knew its needs and knew the people who could get things done. The banker would take those factors into account when an application for a loan was submitted. A banker may not be real comfortable with the business proposal but he may have had confidence in the applicant because of past performance and a personal relationship with the borrower.

This is the type of relationship I can now only find with private lenders — people who lend their own money. Therefore, I must pay the high rates associated with private money or risk missing out on a deal altogether.

Now banks are much more corporate, especially after the financial collapse of 2008. For several years, banks were particularly wary of anything real estate related. They didn’t even want to touch it — most of the national banks still are. But that doesn’t really matter. If you’re a small firm doing business locally there is no reason to go to one of the national banks, in my opinion.

Financial institutions have begun to warm up to the idea of funding real estate again so I recently went to one of the local banks to fund a deal.

The first thing that normally kills the option to fund a flip deal with a bank is the fact that banks move so slowly and their application process is so cumbersome.

This specific deal was small. I could have funded it myself but I thought this was an opportunity to build a new banking relationship. It was also a HUD foreclosure so I knew I had time to go through the lending process. HUD foreclosures usually take three to four weeks between contract ratification and actual closing. So with cash in my account as backup, I went ahead and committed to the deal and submitted an application with the bank.

I was very happy with the bank. They were friendly and helpful. They seemed to want my business and I couldn’t have asked for anything more considering the state of financial institutions right now.

However, the process still took three weeks to get approved. They required a stack of papers signed and a great deal of financial information. They also required an appraisal which took a couple weeks and added a great deal of uncertainty to the process. No matter how much homework you do, you never know if an appraiser is going to agree with you. A real estate appraisal is not an exact science.

The upside is that the interest rate was only around 5 percent. The bad news is most deals won’t wait three weeks for approval. It is also risky to put up earnest money deposits and invest time and effort into compiling a project plan without any real assurance that the committee at the bank or a real estate appraiser will support you.

When it comes to real estate flipping, the price is everything. We essentially tell the seller that we can’t pay them top dollar for their home but we do offer speed, certainty and convenience. Financing contingencies are not looked upon well in this business. We put up large earnest money deposits with no contingencies. One bad appraisal could cost thousands of dollars, hours of our time and be highly embarrassing.

Another problem with my recent bank-financed deal was that officials required me to escrow the money I was putting into the deal. In this case, it was the money that would be used for fix up. So I lost access to my money and the opportunity to earn interest on it. I then had to pay for the fix up out of pocket and once it was done I could apply for a draw to recoup the costs.

In this case, the fix-up budget was $50,000. I agreed to pay half of that. Bank officials required me to escrow $25,000. I then had to pay for the fix up out of pocket. Once the fix up was done and verified, they would give me a draw. This essentially required me to have the fix-up money in the first place. This can be painful for any small business trying to juggle cash flows. On a larger deal this would not be at all possible and it greatly diminished the benefit of financing.

This little deal I just financed will work out great and it will be nice to have such a small cost of capital for once. However, most deals just won’t provide the luxury of financing with this bank.

I was recently considering a home in North Arlington. The home is in rough shape. It looks to me like it has major foundation issues and it looks pretty certain that the home is a tear down project.

The contract the sellers have on the home was falling through and they offered me the home and lot at a great price, but they needed a quick closing. I told them that I would pay them even less than what they offered but I would close in a week. This type of movement wouldn’t even be close to an option with most banks that I’ve dealt with. I didn’t even consider contacting my banks. I reached out to my private lenders and private investors to raise the needed $500,000 for acquisition and construction.

I do wish I could use bank funding more. But because I need speed, certainty and an easier process, I will likely continue to pay high interest rates on my projects.

Follow Pierce on Twitter at @justinpierce1.

Read Pierce’s previous posts:

Setback may push Temple Hills renovation beyond Oct. 1 deadline

Crews make up for lost time in pop-top project

With plan approved, race is on to reconstruct house for fall sale

Pop-top renovation becomes pop-back plan

Gone are the low lying fruit of real estate investing

 

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