Last week, we published a blog post explaining what was going on in the fix-and-flip lending market and the difficult decisions that many of us needed to make in light of this new reality. There remain many uncertainties, but one thing is beginning to become clearer. Simply put, it’s unlikely things return to how they were before COVID-19 once the dust settles. As such, we are preparing for this new reality and are advising borrower clients, the best we can, on how they too should be positioning for success going forward.
This article provides an idea of what we expect the market to look like in the near term, how it might change, and what actions active real estate investors can begin taking today to increase their chances of success going forward.
We like to say that there’s no such thing as “good news” or “bad news” - it's all just “news.” As one of our core values, full transparency is something we ardently believe in. In that spirit, the new reality is that it's going to be more difficult to be in this business as an active real estate investor than it was just 4 weeks ago.
We believe the net result of this will be a consolidation of operators who are able to thrive in this post-COVID-19 environment. If you are one that can manage to this new reality, this means less competition on the buy-side, less competition for construction tradesmen, less competition for private capital, and less competition for all of the other “supply” sides of the equation.
Getting your own processes in order, aligning capital partners, and adjusting your strategy to this new reality will inevitably create massive opportunities for those that understand things are going to be different going forward than they were historically. As Mike Tyson famously said, “Everyone has a plan until they get punched in the mouth.” We all had a plan going into 2020-- and we all got punched in the mouth. No point in denying it at this point, and it’s time to come up with a new plan.
The following analysis on how we see the market taking shape may be a bit unsettling. It is our intent to paint what we believe to be a realistic outlook so you can plan accordingly. We remain incredibly bullish on the market, but we do believe it will need to be maneuvered differently to find success. This post is meant to lay out a playbook for those ready and willing to go boldly into this new reality--and come out the other side victorious.
More Skin in the Game
Over the past few years, lenders have been willing to offer borrowers higher leverage. This resulted in lower down payments and higher advance rates on construction draws. Loan-to-cost ratios were as high as 90-95% and loan-to-ARV ratios as high as 70-75%. This meant borrowers needed less of their own capital (or private equity from others) in order to acquire and renovate properties.
We expect this to change in the near-term and into the foreseeable future as lenders and their capital partners will be taking a more conservative approach. The new reality will likely involve:
- Initial advances for acquisition in the 65-70% range
- Total Loan-to-Cost ratios (LTC) in the 70-80% range (defined as the total loan amount divided by acquisition price + renovation budget)
- After Renovated Value (ARV) ratios in the 60-65% range
Let’s look at an example to understand what this means in real dollars.
For simplicity’s sake, let’s use an example where the purchase price is $100,000 and the renovation budget is $100,000.
In the old world, a borrower could get up to 90% of the purchase price and 100% of the renovation budget. This assumes the ARV was high enough to stay under the 70-75% Loan-to-ARV threshold. This meant the borrower would need $10,000 for the down payment (plus closing costs). Let’s just assume 25% of work needed to be completed for the construction draw advance, meaning the borrower needed an additional liquid $25,000 to advance the project for a total of $35,000 in cash to complete this project. At the end, once complete and all construction draws were advanced, the borrower would have a $10,000 equity position in the project.
In the new world, using the same example, the borrower will likely need, conservatively, 35% or $35,000 for the down payment (plus closing costs). Because ARV thresholds are also coming down, it’s more likely that the borrower will need to contribute some capital to the renovation budget. For this example, let’s assume 20% ($20,000) of the renovation budget will come from the borrower’s equity. So now the borrower will need $35,000 for the down payment, plus $30,000 for each construction draw, or a total of $65,000 to advance the project. Once the project is complete, the borrower will have a total of $55,000 ($35,000 of down payment + $20,000 for the renovations) of capital tied up in the project until it is sold.
The difference in this example is that the borrower will need an additional $45,000 to complete this project. While this may not seem like a considerable dollar increase, it represents a 450% increase in the amount of equity a borrower will need to bring to just this one project. For borrowers accustomed to doing multiple projects at a time, this begins to add up.
Another way to think about this is to consider how much liquid capital you currently need to operate your business. Let’s say that historically you’ve kept $100,000 liquid for down payments and construction draw advances. In a post-COVID world, you’ll need to keep $450,000 liquid to complete the same amount of projects.
Let’s take a look at some strategies that may help you navigate this new need to have more liquidity on hand.
Strategies to Implement:
- Raise More Cash: This is easier said than done, but selling assets in the pipeline and raising additional private equity capital is going to be paramount to growing your business going forward. The sooner you begin this, the better position you will be in to take advantage of any opportunities afforded in the future.
- Be More Selective: Projects that had tighter margins may have made sense given the amount of leverage previously available. However, now your equity will not go as far as before, so ensuring that you are picking projects with the highest margins will help maximize your return on equity.
- Find Partners: The reality is that these constraints will be impacting everyone in the business. If you’ve gotten to know peers in your market, now may be the time to start outlining new strategic alliances. Give yourself some time to get to know one another, draft responsibilities, and set clear agreements to protect everyone’s interests.
In addition to there being less leverage available, you should also begin planning to pay more for the leverage that is available. The market is still adjusting and trying to find the new “normal,” but it is safe to say that the 8-10% interest rates are likely a thing of the past. See this previous post to understand why.
As of this writing, pricing hasn’t officially materialized yet in the market. We’re in discussions with our institutional capital partners and are getting real-time feedback from lenders on our platform on what the market is likely to bear. From where we’re at today, it seems that 12% interest and 2-3% in points is where we’re headed in the near term. Different lenders may structure pricing differently with loan application fees, servicing fees, closing fees, and so on, but expect to be in this range, plus or minus a point or two.
Let’s look at another example to put this into context.
Let’s assume you borrow $100,000. The below table provides a simple overview of the increased borrowing costs you will likely incur.
Assuming you borrow the money for 12 months, the new pricing will add $3,500 to your project cost for each $100,000 you borrow, equating to a roughly 25% increase in your cost of capital. Again, while the dollar amount may seem manageable, on a percentage basis this could have a real impact on your margins.
- Update Your Models: When determining profitability and how much to offer on new projects, you should assume higher borrowing expenses. You should begin factoring this into projects currently in pipeline.
- Expand Your Lender List: It may seem counterintuitive for a lender to tell you to shop around, but that’s exactly what we’re saying. This is impacting the entire market, but don’t take our word for it. Speak with others early and often. Our number one priority is to ensure our customers are successful. If you hear something that sounds too good to be true, it’s probably because it is. Continue to push to ensure they can deliver on what they’re telling you.
- Negotiate with Sellers: Begin explaining the situation to your sellers. The reality is that the world has changed and in order for projects to pencil, you’re going to need to buy lower. They can try to find another buyer, but everyone is going to be in the same boat pricing deals with higher costs of capital. We believe that it's time to start resetting expectations with sellers.
Tighter Underwriting Requirements
Another thing that changes when credit becomes less available is that underwriting standards increase. You should expect lenders to require more information regarding your liquidity, financial statements, tax returns, and prior experience. In addition to there being less leverage and higher costs, lenders are going to narrow their borrower base to the highest quality. This means fewer people are going to qualify for funding, and those that do are going to need to jump through more hoops to get funded.
In addition to more thorough underwriting, we expect some noticeable differences in how loans will be structured:
- Interest reserves: Most lenders will require 6-12 months of interest payments be rolled into the loan. The net effect of this will be less capital disbursed at closing. This will further increase the amount of capital you will need to bring to closing, but it will have some benefit in helping manage cash throughout the project.
- Interest on Undrawn Funds: Before COVID-19 hit, lenders had begun offering borrowers loan structures allowing them to only pay interest on funds drawn. We expect this feature to largely go away, meaning you will likely pay interest on the full loan balance even if undrawn. There may be some exceptions to this for larger holdback loans, but don’t be surprised if there are higher fees or points for these structures.
- Less Construction Risk: We’re starting to see less appetite for projects that have heavy rehab components. Specifically, if the renovation budget is greater than the acquisition price, there will be less funding available. This might result in an outright “no thanks” from lenders, or it could mean much less leverage with higher pricing. We also suspect that lenders will be more diligent on construction draws with more defined milestones, proof of payments, lien waivers, title rundowns, and so on.
- Get Your Files in Order: Start pulling together your prior experience (HUDS), financials, tax returns, bank statements, credit files, photos of prior work, background on your team, and anything that helps you build your case. Create a Dropbox that you can easily share with lenders to demonstrate your creditworthiness and professionalism. Standing out from the pack will give you an edge when lenders are determining where to allocate their more limited capital.
- Plan for Longer Closing Windows: The 5-7 day closings may become less realistic given the amount of additional diligence a lender will be doing. It’s also likely they will be co-underwriting new loans with their capital partners while this market is reshaping. You should plan accordingly and start setting these expectations with your sellers. Be sure to structure your contracts accordingly.
- Find Projects with Cosmetic Rehabs: This is easier said than done, but narrowing your search for new projects that have less extensive renovation budgets will be important to get leverage in the near term. You may want to evaluate your acquisition strategies to make sure you’re focusing resources in channels that are more likely to yield these types of projects.
While this may be a tough pill to swallow, we believe this is where the market is headed, at least in the near term. We want you to be prepared to take advantage of the opportunities the market will present. In time, the credit markets will return and liquidity will become more available. We will continue to work tirelessly to arrange the most competitive financing available and provide you certainty of closing with total transparency.
We’ve also started hosting bi-weekly small group conference calls with an elite group of real estate investors that are well positioned to thrive in this new reality. Reach out to your account executive to be invited to one of our upcoming calls, where we’ll discuss the latest updates we’re seeing in the market and share best practices amongst peers.
Wishing you success in the post-COVID world.
Fund That Flip