The file on my first live-in flip borrower taught me more than the loan

I look at deals from the lending side and I'd never seen one of these come across as a borrower profile until this spring. Someone came to me for a second position loan of 60k against a house they were 14 months into living in and renovating. I ended up funding it and it paid off on the sale, but the underwriting was different enough from anything else I look at that I want to put the structure down.

What the file looked like. House bought at 296k, comps supporting 445 to 465 finished, about 52k of work already in and roughly 40k left. First mortgage balance 271k. So on a 60k second I was sitting at 331k against an as-is value the appraiser put at 372k, and a finished value I had no way to enforce.

Three things I had to think about that don't come up on rental or flip paper.

First, exit certainty was better than a normal flip and worse at the same time. Better because the borrower had a tax reason to sell in a defined window, which is a stronger motive than a flipper's, and a flipper's motive is already strong. Worse because the earliest date they'd sell was set by the residency requirement and not by when the house was done. If the work finished at month 18 I had six months of nothing happening and no way to accelerate it.

Second, the collateral is somebody's house. Foreclosure on an occupied primary residence is a different process from taking back a vacant flip, and the timelines and protections vary considerably by state. That's a real difference in loss severity and I priced for it.

Third, the borrower's repayment source was a sale, and the tax treatment of that sale wasn't mine to verify. I underwrote it as though the gain were fully taxable, because whether the exclusion applies to a given seller is between them and their CPA, and I'm not going to hold a note whose repayment math depends on my reading of someone else's tax position.

What nearly broke it: the borrower wanted an 18-month term. That would have matured before their qualifying sale date. I wrote 30 months with a rate step at 24. They paid off at month 26.

What I'd keep: sizing the term off the earliest qualifying sale date plus a real cushion, not off the construction schedule.

4 replies

1renee_dubois Get yours

The 18-month request is the part that would have worried me most, because it tells you the borrower hadn't connected their own financing to their own strategy. They were thinking about how long the work takes. You were thinking about when the money could actually arrive. Those were different dates and only one of them pays you back.

I've seen the same shape on small multifamily, borrowers asking for a term that matches the rehab and not the lease-up. Every unit I've done has taught me that the money shows up later than the work finishes.

Did the rate step at 24 do anything, or was it just a fence?

1karen_whitfieldPG4APRO7

You priced for the occupied-residence foreclosure difference and I think that's the most important sentence in the post. People who lend against flips get used to a vacant asset and a short clock. A family in the house changes the math on the downside, and how much it changes depends entirely on which state you're in.

I hold land and long positions so I'm the wrong person to argue lending structure. But the thing your borrower actually bought from you was permission to keep going slowly, and slow is the whole point of the strategy. If they'd taken the 18-month term they'd have had to sell early, pay tax on the gain, and the loan would have destroyed the reason for the deal.

1paulgrant17PassivePRO5

I'm reading this before my first rental and I want to make sure I have the basic shape right. The borrower took a second loan against a house they were living in and renovating, so they could pay for more of the renovation, and they paid it back out of the sale. Is a second position loan just a second mortgage, or is that a different thing?

1derekj19SB1B

@wren second position means the lender's claim sits behind the first mortgage, so in a foreclosure the first gets paid before they see anything. A second mortgage and a HELOC are both usually in second position. It's the same idea.

@tender the thing I'd want to know from the service side is what you did about draws. 40k of work left and a borrower who is also the occupant and possibly doing some of the labor themselves. Did you fund it all at once and trust them, or inspect against a schedule? Because on the crew side I've watched owner-occupants spend the finish budget on things a buyer will never pay for, and if your repayment comes from the sale price then what they spend it on is your problem too.

The file on my first live-in flip borrower taught me more than the loan

4 replies