This popular form of investing is well suited to individual investors using a self-directed retirement plan.
- Big banks do not offer these types of loans.
- 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.
Short term notes fit well within a retirement investing investment portfolio.
- The interest rates are typically higher.
- Your IRA money can be turned quickly or reallocated to other types of assets based on market conditions.
- 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.
Following are 4 ways you can set yourself up for success by practicing quality due diligence for short-term IRA loans to house flippers.
1 – Evaluate the Property Condition
The current condition of a property to be flipped is a good starting point for your underwriting process. The amount of work required can help you understand the timeline for the project and the relative amount of risk, both of which are important in determining whether to lend and on what terms.
If the rehab needs are relatively modest, there may be less risk and the project may be completed more quickly.
If the property needs significant work, you’ll want to be careful about how much money to lend 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 gauge for unknown risk. The more work a property needs, the more likely that unseen issues may turn up and increase the cost of rehab.
A property needing considerable work may take longer to turn over. Timing can be a concern if the project requires permitting or specialty contractors that may be more difficult to find and schedule. Be sure the length of the loan is appropriate.
2 – 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.
3 – 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.
4 – Choose the Right Loan Terms
Once you have evaluated the project and the borrower, it is time to set loan terms that provide a good return for the amount of risk involved, protect your investment to the highest degree possible, and allow for the borrower to profit if they execute as planned.
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.
Milestone funding is a good way to protect yourself and keep the borrower on-task. 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.
5 – Stay Engaged
You should regularly check in with your borrower to ensure the project is progressing according to plan and on schedule. If there are issues, you want to know sooner rather than later.
Your loan terms should include conditions that allow you to inspect the project if you are local, or require the borrower to provide video walkthroughs and updates periodically.
Taking the time to fully evaluate a short-term lending opportunity before issuing funds, and monitoring the project during the rebab are the best steps you can take to ensure a successful outcome.