Using your self-directed IRA or Solo 401(k) to make short term loans to property flippers can be a great way to grow your retirement savings.
This popular form of investing is well-suited for self-directed retirement plans for 3 key reasons:
- This type of lending isn’t in the business model of commercial banks.
- Individual investors and small private lending funds have always been the primary lenders in this space.
- You can invest locally in your own market and work with other investors you may know and trust.
The returns for these types of loans can be powerful. Your IRA money isn’t tied up into a long-term investment, and can be turned quickly or reallocated to other types of assets per market conditions.
And like all private mortgage lending transactions, your investment capital is secured by a real asset that produces consistent, predictable returns.
Of course, this all only works if you make the right loans to the right borrowers when executing the right projects.
Here’s 4 ways you can set yourself up for success by practicing due-diligence with short-term IRA loans for house flippers.
1. Choose the Terms for Your Short-Term Loan
Before underwriting your private loan, it’s important to decide on the terms that’ll be included in your short-term loan to flippers.
Because there’s risk involved — and because the term of the loan is typically pretty short — these types of loans can be somewhat expensive.
Most short-term flip loans will be for a 6-month term, with a possible extension to 1 year (under certain conditions).
It’s common to charge 1-3 points, which is equivalent to 1% of the loan value. These points can be paid up front as a fee, or rolled into the loan balance.
The amount of the loan can vary as you find suitable to your risk tolerance. Some relatively standard approaches may include:
- 60-70% of After Rehab Value (ARV)
- 70-90% of acquisition plus rehab costs
- 70-90% of the purchase price
Keep in mind that if the project fails, you want your outstanding loan balance to be less than the property is worth, even if the home has been gutted to the studs in one or more rooms.
The loan value should be commensurate with the risk involved and the experience of the borrower.
Payment plans vary significantly, and may include such formulas as:
• Points up front, no monthly payments, full payment due at sale or end of term.
• No up-front cost, interest only payments monthly, balance due at sale or end of term.
• Points up front, no payments for 3 months, interest only payments monthly, balance due at sale or end of term.
• Some lenders won’t charge points but require a minimum of 6 months interest payments no matter how quickly the property is completed and sold.
Not all loans will deliver the full amount of borrowed capital up front. It’s common to set milestones for the rehab process, and release funds only after each phase has been completed.
This strategy mitigates risk, as the property will be worth more the further along the rehab process goes. Your loan-to-value ratio can remain positive across the rehab timeline with this approach.
2. Evaluate the Property Condition
The current condition of a property to be flipped is a good starting point for your underwriting process.
If the rehab needs are relatively modest, there may be less risk and the project may complete more quickly. A higher loan-to-value ratio may be appropriate.
If the property needs significant work, you’ll want to be careful about how much money you’ve lent relative to the actual current value of the property. A lower loan-to-value and staged release of funds may be more appropriate in such situations.
Condition is also a measure of risk. The more work a property needs, the more likely it may be that unseen issues may turn up and increase the cost of the rehab.
It’s also possible that a project may take longer than expected to complete if significant work is required. This is particularly relevant if any of the necessary work requires permitting or specialty contractors that may be more difficult to find and schedule.
3. Properly Estimate Projected Sales Price
One of the keys to flipping properties, and to underwriting flip loans, is to properly estimate the post-rehab property value — often referred to as after rehab value or ARV.
This target sales price drives the potential for profits on the deal, and serves as security for your loan if the project is completed as planned.
If your lending strategy is based on a certain percentage of the ARV, then getting the estimate right is critical. Researching comparable sales of similar properties is the best way to estimate the ARV for a project, but this isn’t always possible.
A neighborhood may not have recent sales of updated homes with similar characteristics. If the rehab work is too nice for the neighborhood, the price the flipper thinks they may get could be optimistic.
While it’s important to get the flipper’s estimated ARV, you’ll want to do your own analysis. If your numbers are very different, that in and of itself says something about the likely success of the project or the flipper’s experience.
As the lender, your estimate of ARV is what matters when gauging your risk tolerance and willingness to lend on a project.
4. Gauge Your Borrower’s Experience
One of the most critical factors in evaluating a short-term flip loan is the experience of the flipper:
- Someone who’s been through several successful flips is more likely to complete their proposed project on time and on budget.
- They should have a realistic expectation for the level of unanticipated costs that can crop up once you start tearing walls out.
- They should have contractors they know can get the work done.
- They should have processes and procedures in place to manage and track the project from start to finish.
By comparison, a new flipper may make mistakes that cost time and money. It just happens with a complex endeavor such as a home rehab. This means the project budget needs a conservative eye, and your loan-to-value threshold may need to be lower.
The following factors can help you qualify a new flipper:
- It’s okay to ask your potential borrower about their experience. Ask for a project plan in advance.
- Confirm that they know what repairs may need to happen, and that they have the necessary contractors for each phase of the project lined up.
- If they’ve done flips in the past, analyze those in terms of performance on key metrics like completion on schedule and on budget, or how close the sales price was to their pre-project estimate.
The more confidence you have in your borrower’s ability to execute their plan, the higher the likelihood that both of you will see success and profits at the end of the project.
Due diligence is always an important step when making investments with your self-directed IRA. Learn how to practice due-diligence with real estate note investments >