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Should You Use a 203(k) Rehab Loan for Your Next Investment?

by Editor | ezLandlordForms
203k Rehab loan and building tools

If buyers look hard enough, there’s a lot of money flowing through the housing market that can be used to turn property dogs into real estate diamonds.

Some of this money comes from the Department of Housing and Urban Development’s 203(k) construction loan program. These FHA rehab loans are available for 1-4 unit properties through local direct bank lenders and brokers, and can be used to buy an existing property or even pay for improvements to your own home.

In 2012 alone, approximately 21,391 buyers borrowing anywhere from $5000 to more than $500,000.00 borrowed over $1.7 billion in federally guaranteed loans to rehab houses through 203(k) loans.

To some people, the money and possible upside potential of a 203(k) loan sounds too good to be true. You choose a property, hire sensible and fair contractors, and get the federal government to insure the loan. Your completed property should then appraise for far higher than your costs, right?

And if you have a flair for public service, you can congratulate yourself. You’re helping what once was a tired, near-dead house (or even neighborhood) to get back on its feet. You’re bringing a property back to life!

But before you race to your local loan officer to find out where to scribble your name, you need to be aware of a variety of pitfalls and setbacks that can befall 203(k) borrowers every day throughout America.

You could pay a lot up front for inspections

The good thing about many decrepit properties is that you can often get them cheap, given the hole in the roof, the non-functioning water system, the moldy attic or the missing furnace.

But the same attractive purchase price that brought you to the property in the first place can turn against you.

During the typical home inspection process for a 203(k) loan, all of the big property condition issues need to be identified so you can find contractors to make the repairs. A home inspector can help identify many of these problems, but some issues are beyond their level of expertise.

Unlike most routine purchases where the seller has to show the buyer that the water, electric and other basic household systems are functioning, 203(k) loan properties are often owned by banks or the US government.

So in most cases, the properties are sold “as is,” leaving the buyer to poke around the property and figure out what’s working and what’s not. Any and all well inspections, septic inspection, rodent or wood destroying insects inspection, mold inspection, roof inspection, plumber, electrician, and any other kind of expert review that is necessary will probably have to be paid for by the Buyer.

A well and septic test can cost $300 or more. Sending a HVAC guy out to do a furnace check can cost another $75-$150. Bringing a structural engineer out to take a look at a suspicious foundation can easily run you another $400. The home inspection alone can be another $250 to $450, depending upon where you live.

So if at any time during this early part of the process the buyer decides to withdraw from the deal (legally), there will be no reimbursement for these inspection costs that can total hundreds or even thousands of dollars. They are simply gone, vanished into the thin air that can be the 203(k) program when people think they’re getting something for nothing.

So the rule of thumb here is that buyers need to have some initial financial flexibility to both start and complete the 203(k) process. You will have to lay out some money early in order to reach your destination.

The process will always take longer than you want

It doesn’t matter how many 203(k) loans your loan officer has completed, every 203(k) is a little different. Each house has its own can of unique flavoring, and each property will have its own hurdles that have to be leapt by your loan officer one-by-one.

Some properties have infestations. Others have hidden mold that only a property inspection reveals. Others have old wiring that is not only old, but dangerous and must be brought up to code. Some homes might only reveal water intrusion issues when a 20-year flood hits the area when you’re half-way through the 203(k) process.

All of these problems take time to address, so expect a loan turnaround time to be at least 45 days. Some full 203(k) loans (over $35,000.00) can take 3-5 months.

So don’t plan on moving into the property in time for a new baby to be born, or line up your purchase perfectly with the end of a lease term. You’ll be disappointed, and left to scramble.

Your loan officer can say he has done 203(k) loans quicker than that, maybe even finished one in under a month. But that’s not the norm, and you should have reasonable expectations. You’re probably just getting the pitch of a confident loan officer who wants your business, regardless of the facts.

Why does the process take longer?

To start, the appraisal takes longer than a typical home purchase appraisal. First, the appraiser has to appraise the property to confirm it is worth what you are paying for it as a “project” house. And then the appraiser has to confirm that, after the repairs are done, the finished property will be worth more the money you are borrowing.

So after 15 contractors have given you estimates and completed your final list of contractors, the appraiser and your lender review the documents to make sure all work is accounted for.

Finding and finalizing contractors

One of the most time-consuming parts of the 203(k) process is screening contractors and keeping them on schedule and within budget. In order to get a 203(k) loan move along, the buyer has to get estimates from and choose contractors to do all of the various work needed.

Each property inspection issue of any consequence has to be line item listed and estimated for repair.

This can be difficult if the buyer has few or no contacts in the construction industry, and the loan officer doesn’t provide trustworthy referrals for general contractors. The contractors that a buyer chooses have to show that they are qualified, and should be able to produce both state and city licenses to do the work, depending upon where the property is located.

The process is a lot smoother if a buyer is a DIY-er with some contacts in the construction business, or keeps in touch with a favorite uncle who happens to be a licensed contractor and will do good work on the cheap.

But problems start to bubble up when the appraiser or loan underwriters look at the contractor bid your uncle provided which says a new furnace will be purchased and installed for $750.00.

That won’t fly with the lender’s underwriters. Back in the bad old days of the real estate bubble (2002-2008), lenders didn’t care so much about contractor credentials and prices. Even if a buyer went belly up, properties were appreciating by 8-20% per year in many areas so lenders they could just sell the property and save their investment.

But not any more. Lenders and underwriters want to make sure that all of the necessary repair work has been accounted for by the buyer, and that contractors have given estimates to complete all of the work.

They don’t want the buyer knee-deep in an unfinished rehab property 10 months after closing, bickering endlessly with a contractor who claims that the job will take an extra $10,000.00 to complete that was not in the budget.

So what is the best way to approach a 203(k) loan?

Most importantly, don’t look at the loan as free money. Like everything that is of value, it takes time, effort and commitment to start and complete the loan. If you choose a good property, work with a loan officer with solid 203(k) experience, take the time to get good contractors who make fair estimates, and have a little money in your pocket to apply  towards the process, you’ve just magnificently improved your chances of success. Then, patience!

Related Reading:

Renovation Investing Tips, Tricks & Cautionary Tales

The Hard Facts about Hard Money Lending

Planning to Buy a Fixer-Upper? Proceed with Caution

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