Why not Construction Mortgage for Investment Properties?

Question

Last year I bought my first home using a Future Value of Appraised Home - a construction mortgage.

It was a 5 BR/1.5B on 0.4 acres (big lot for the area), in the Scranton, PA area that was quite dated and needed a lot of improvements. I wanted to put about $60K into it. I bought the house for $108K, and $60K to draw from for a total of $168K, which is what the house would appraise out at.

Besides the point, but a comp, not quite as nice home, just sold for $225K, which makes me feel great about my investment.

Getting to my point, I'm wondering why I haven't seen much discussion on BP regarding construction mortgages as a way to use the rehab money with significantly less interest than a HM lender, or other option?

As I'm preparing for my first deal, I met with my loan officer at a local bank and I assumed that this loan was only available on a primary residence, such as my house. He told me that wasn't the case.

Just curious if I missed this, or overlooked it on this site, but wondering why that isn't a more utilized financing method?

Alan Kline · Answer

Good conversation. I look forward to hearing more @Bryan Zayac. please keep us posted

Bryan Zayac · Answer

@Mike Wood The construction loan was for my primary residence. However, I only had to put down 20%, so no different than an investment property, maybe even a little better if not 25%.

I have a second meeting this afternoon to discuss this topic again and hopefully move forward.

@Berny Petersen Bought for 108K and future value appraised out at 169K.

I was under the impression that this was not a typical loan when talking with another loan officer at a different local bank. But then asking a few others, I found out it wasn't that all that different from other loans, and that they were available.

Granted, I do have a strong relationship with the loan officer who helped with it, but at the time only had an average credit score, and a fair amount of debt, so I would think the underwriter would have the final say.

I'll let you all know how this meeting goes shortly, and as I speak with loan officers from other banks regarding this loan availability.

Berny Petersen · Answer

I think the biggest reason that loan isn't discussed more is because it's not available - usually. Lenders are not going to loan money using collateral that does not exist. Future value is a number based on an asset that does not exist today. That's why terms like 65% of ARV are so common, and hard money and private money lenders exist. The lender loans on a current value he feels confident he can recoup in the event of default.

What was the appraised value as/is? Was your relationship with the lender a strong component of that loan? I've had a lender in the past include some rehab money in the primary mortgage, but only because I bought it under what it would appraise for as/is, and because we had a very strong working relationship. It was not just a loan product that they offered.

I would use a loan like that every time if I could find one. If anyone knows of one that exists in GA please let me know!

Mike Wood · Answer

@Bryan Zayac I believe that a construction loan is going to be significantly harder to get than a hard money loan.  Every construction loan I know of requires significant cash or pre-existing equity in the deal (my bank requires 20% of total costs) when it comes to investment properties).  Gone are the days that the banks would loan on future appraised value for investment properties. Also, the banks want a well qualified buyer, so personal credit and income play a huge role in the approval.

Was you construction loan for your primary residence? If so, did the bank make you put up a bunch of money? If not, I doubt they would do the same for an investment (ask them).

Chris K. · Answer

@Bryan Zayac:

When I think of a standard construction loan, I think of bigger projects. For example, drive around Wilkes-Barre (or Scranton) and you will see construction for commercial buildings or large residential buildings. Those projects costs millions of dollars and requires substantial amount of leg work before you can start construction. And even with the most carefully planning, construction projects often have to deal with various delays and potential legal disputes (e.g. dispute between owner and GC, disputes between GC and subcontractors, disputes between subcontractors and sub-subcontractors, etc.). In light of all those risks, lenders would like to know that the investor has actual experience dealing with all these issues.

Now for a smaller fix & flip, the due diligence concerns are less. In those cases, my guess is that the willingness of the lender to lend money depends on whether they think they can recover the money in the event of a default. They will consider many different factors including the current collateral that the borrower has already pledged to the lender. Those matter since in the event of a default, the lender (hopefully) included cross-default and cross-collateralization language that allows them to declare default on all collateral securing the debt.

Note that what the lender wants is different than what the lender's employee wants. In most cases, loan officers want to give you as many loans as possible since that leads to more money for them. Underwriters want to deny as many loans as possible since they are the ones that typically get into trouble if the loan defaults. The higher-ups that manage the officers and the underwriters want to avoid having to explain to their higher-ups (sometimes the board of directors) why they approved the defaulting loan. During all this process, one issue that comes up is whether the loan product that the lender offer is: (1) a standard product; or (2) an unusual product. If the first, then the chances of anyone getting into trouble is less since lenders understand that defaults happen. If the second, then the higher chance that someone will get "punished" for the default. Issuing a loan to a borrower is a delicate song and dance between all these factors.

Long story short, the main issue with constructions loan for a small fix & flip is that most banks don't offer it as a standard product. If they offered it to you, that likely means they have faith in your ability to pay back the loan if it defaults (whatever the reason may be). But it's not an option that is available to all investors (compared to say a FHA loan or Freddie/Fannie loan).

Disclaimer: While I’m an attorney licensed to practice in PA, I’m not your attorney. What I wrote above does not create an attorney/client relationship between us. I wrote the above for informational purposes. Do not rely on it as legal advice. Always consult with your attorney before you rely on the above information.

Bryan Zayac · Answer

@Chris K.

I'm referring to a construction mortgage on the future value of an appraised home. In my case, the loan was interest only during the construction phase (9 months), after that was P&I payments began.

What makes you say the investor won't have the ability to do the due diligence? I would expect that when purchasing a fix & flip, or other deals, that there is a thorough understanding of the scope of work and how much the rehab will cost, and the ARV. All of which are necessary for the construction mortgage. Lay out what you are doing, if it appraises out, you're set. The work is already done for the most part when you're planning whether or not you are going to do the deal, correct?

I specifically did not do the FHA 203(k) loan for the purpose of not wasting the time of my loan officer, whom I have a great relationship. In fact, when it was discussed, he suggested I talk to private lender on that.

Thanks for your response.

Chris K. · Answer

@Bryan Zayac:

Interesting question!

If you are talking about a true construction loan (very short term, typically a balloon on year 1 or right after construction --- whatever comes earlier), the simplest answer is that many banks don't like to do it due to the risk factors. Now I never worked on a matter that involved a construction loan that small ($160k). But for many of the bigger projects, most investors won't have the ability to do all the due diligence and convince the bank that they have the ability to pull off the construction. A few banks in our area gives out these loans, but you really need to come in with a proven track record. Even better if you can get some sort of partial guarantee someone (e.g. some franchisors will guarantee some amount payment to the lender in the event that there is a default).

If you are talking about a FHA 203(k) loan, that a different animal. That said, many loan officers don't like to do it because it takes a lot of effort on their end. So there, it will depend on your relationship with the bank and its officer.