I have a deal that's come my way through a mutual friend who is doing their first flip. They have a hard money loan for 70% of the purchase price, and need the other 30%. They're offering 12% for six month, interest only, on $150K. I've been provided the hard money agreement, which puts me in the second position.
The house is in good shape, in so cal. Purchase price is $695K, ARV is $905K, with rehab costs estimated to be $60K.
I've been provided the holding costs, and they expect the rehab to take 6 months.
As this would be my first foray into RE investing (much less private money lending), I'm looking for some advice. Am I crazy for considering this?
Red flags: This is their first rehab, second position, money tied up for six months.
Positives: Learn the process by participating, put my money to work, rehab is local.
I've seen the property (outside). Any advice is greatly appreciated. Thanks!!
Never ever ever lend in 2nd position on a rehab project. Even if they had done this many times, your money would still be greatly at risk, but given this is their first flip, I would bet your money is lost the minute you wire it! Their intentions may be great, but the costs will be higher than they think, they'll work with less than reputable contractors who will not perform as promised and the ARV may not be what they think because they do not know how to value the market properly themselves.
I've been down this road and it sucks! I definitely wouldn't go down it again!
If you would like to connect through BP I can share some more of my investment history to see if could help you with your new ventures.
60K rehab on a 700K house won't get much of a rehab IMO ...
Second position is never a safe loan, @Bill McGrath . Your risk could be mitigated if these were experienced flippers with a successful track record, buying at a sensible valuation. In this case, I see neither.
The project cost of this flip is over 83% of ARV!! That is, ($695+$60)/$905=83.4%.
We regularly turn away 1st position loans on overpriced flips like this. I know these rehabbers see a spread of $905k-$695k=$210k and they think they will walk away with most of it. We get emails all the time from those that don't run all the numbers and have stars in their eyes over what appears at first to be a huge spread.
Have you run all the numbers? Have you asked them to show you all the expenses they anticipate? I bet not. Most are shocked when they these add up. In fact, at 83% of ARV, if everything goes well, they will only gross about $29k or 3% of ARV. This is easily eaten up by rehab overages, a fair counteroffer on a $905 asking price, construction delays, etc.
Some will say, "Who Cares? $29k is $29k." Not on a $905k home. A more realistic return on ARV in southern California is 12% to 15%, or over $100k on this deal. It really means their project cost should not be more than 75% of ARV (our rule of thumb), which means they shouldn't spend more than about $618k for this property. They will get upset when you tell them this.
"Positives: Learn the process by participating…"
This could be a very expensive process for you to learn, Bill. We wouldn't touch this deal even in 1st position, and I suggest you avoid it as well. No experienced flipper would bring something like this to us.
As a broker of hard and private mortgages like Jeff, I agree with his assessment...up to a point. Labeling a second lien as "never safe" is unfair, though yes, of course they come with MUCH more substantial risks than a first. Still, I've brokered many successful second liens for my beneficiaries on flip properties, and they've been very happy with the result.
However, there are a number of issues with this particular deal, which should lead you to ultimately reconsider:
$60,000 on a $700,000 purchase is in fact a very small estimate unless they are purchasing an REO or Short Sale and buying at a major discount already...so the $60K will end up being simple cosmetic stuff. That does happen (I see it all the time), but almost never from a first time flipper. The experienced developers get those deals. Jeff S already focused on a few of the other issues, but left out one big one every private lender should consider...
...even if you went forward with this deal, you're not getting enough of a return for the risk. Not nearly enough. Second lien holders top out at 65% (maybe 70%) CLTV of AS IS value, and those interest rates are often above 12%. What this borrower is asking of you is not to be their second lien holder...they are really asking you to be their partner on the deal. And as a partner, you should be paid profit participation plus a "pref" interest rate. Simple 12% monthly interest return for your gap financing is quite honestly a slap in your face.
It's funny, but as I was writing the post, listing the red flags and positives, it was pretty clear what the answer was. I passed on this.
@Darren Eady, thanks for the quick response, and I'd love to connect. Good advice is definitely appreciated.
@Steve Babiak, you're right, not much to rehab. I saw the repair estimate, and not any major items, but alot of little things. The house is in pretty good shape, as far as I can tell, but it did spend close to 3 months on the MLS before these investors came in.
@Jeff S, I have run the numbers and seen the holding costs. It's good to know what to expect on a return for so cal. I came up with about the same gross profit as you, $29.5k, but it's what they don't know that concerns me, being the first flip. Thank you much for your input!
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