When we found our house on Zillow we knew that it was gutted. We did not know the extent of the gut or what had been completed thus far. We had no idea the position of the seller.
But more importantly, we did not know how the heck you pay for a place like this.
When a house doesn’t have walls, plumbing, or electric it’s not really a house. It’s more of a big wooden box. Therefor in order to finance its purchase you cannot do it with a conventional loan. We quickly Googled construction loans and there it was: the 203k Rehab Program. We instantly had about 1 million questions.
The 203k Rehab Program is technically a HUD insurance program that backs your loan incase you flop during the rehab process. Whenever you wonder how/why something works when buying a house always think first “is this because the bank is trying to protect itself?” and the answer is yes 110% of the time.
First things first. Read the FHA website where you can get all kinds of basic information.
I am going to structure this post in the way in which we discovered information / the steps we took to get where we are (just a few weeks from closing!)
1. Why 203K Rehab Program
When you find a home that needs a lot of work, or is not habitable, HUD understands a few things:
The average person/family is not able to purchase a home and then pay out of pocket to rehab the home.
Taking this initiative can be very expensive (but also financially rewarding.)
Because in many cases the house is not habitable for up to 6 months the average person cannot float 2 mortgages/rent payments.
In order to alleviate these pain points this program allows you to finance (take a mortgage) for the acquisition (sticker price) + construction all in one mortgage (one payment.) They also allow you to wrap four months of mortgage payments into the mortgage principle. We took advantage of this so that we could continue to live in our apartment while we performed construction (ie. had a working toilet) without making two huge monthly payments.
Now there are two variations of this program. There is a fast track version for smaller projects (new roof for example). I will not include this version of the program as I know almost nothing about it.
2. The Cost
The cost of the 203k Rehab Program is MUCH more expensive than the conventional loan or even the FHA loan on its own. There are several additional fees from both the bank and through HUD. For example: we paid $10k JUST FOR TAKING THE LOAN to HUD. We also have to pay a HUD inspector prior, during, and after construction to verify work requirements and completion (note this is how we found out we HAVE to paint the house). The nice thing is that some of these costs are upfront but they can ALL be financed into the mortgage. The initial HUD contractor fee will be credited back to us at closing.
3. The dreadful PMI
We are taking advantage of an FHA program which comes with a huge disadvantage. Because we are only making a 3.5% down payment we are far from having 20% equity in the property.
Equity is the difference between the value of your home and your mortgage. The more the property is worth, and the less you owe, the more equity you have.
Remember that the banks #1 goal is to protect themselves. When you do not have 20% equity in the property you are higher risk to the bank. If you cannot pay your mortgage payment the bank may not be able to sell the property for enough money to cover their losses.
This is where the PMI comes in. The PMI is an insurance payment that is bundled into your mortgage payment. The amount you pay is determined by how much equity you have. The closer to 20% you have, the lower the payment. Our PMI adds $400, yes $400, a month to our mortgage payment.
For many banks once you reach 20% equity (with standard mortgage payments or extra principle payments) the PMI is reduced and then removed. I would not trust your bank to do this automatically although in theory they will.
Keeping your PMI until you hit 20% equity can take a very long time and would be extremely expensive. Don’t worry. I will review the exit plan with you later.
4. Choosing a Bank
You will find that only some banks are certified to participate in this program. The bank recommended to us by our realtor was not on the list. I contacted them anyway and turns out they do participate in the program so the list may be inaccurate. It's always important to shop around to review rates and fees of different banks although I am certain almost no one does this because it’s so much work. Confession: we didn’t.
More importantly I would inquire about how many of these loans the bank originates. We went to a bank that does quite a few and we were still set up to work with a specialist three states.
These loans are COMPLICATED (but don’t worry, you can do it!!)
When you are seriously considering purchasing a home contact a bank asap and get pre-approved (regardless of the type of loan that you need.) This will give you some idea of what you can afford.
5. Know your 203k Limitations
The program has a cap on the amount that you are able to borrow depending on where the house is located. What is cool is that you can also use this loan for multi-families and the bank will count potential rent income towards your current income to help you qualify.
This is a crazy awesome no-brainer way to break into real estate investing and also crazy scary.
The max loan for our county is $598k and boy did we use it all. It is important to emphasize that this is the max loan amount. Our project exceeded $598k but our down payment and seller credit dropped us below the cut off.
6. Working with an Agent
Good luck. Best case scenario you find an agent with 203k experience (we didn’t). Next best case you find an agent who REALLY knows the neighborhood so you can have a better idea of your ARV (After Repair Value). Knowing what your home is worth AFTER construction is really and important part of my exit strategy.
7. Running Initial Numbers
When we first sat down with the bank (before making an offer or even seeing the house) the mortgage person asked what the cost of rehab would be. We literally looked at each other and shrugged. I piped up and said “$75k?!”. He wrote it down and that became the basis for all of our math.
If I had to do it over I would have worked backwards. First have the bank tell you your maximum loan amount is or know how much you are comfortable borrowing. Then cross reference with the max loan amount for the 203k Program in your county. Subtract the acquisition amount (the max you will pay the seller) from the max you can borrow. That number is your construction cost. Just use the max and plan for the worst.
Best case is that your construction costs are less than the max and you don’t need to borrow as much (you will know this and can make the change long before you close.) This is easy to fix later but allows you to plan for your max costs, ie. your max down payment. Turns out we aimed too low and needed to recalculate everything several times.
8. Find a House, See It, and RESEARCH
Not so 203k specific… if you want to make an offer do your RESEARCH. The more information you have on the house and the seller the better you can negotiate. For instance… Lindsay Station had been owned for a bit over a year by the current seller. We knew that he is a single male who appeared to be a manager at a car dealership (thank you Facebook.) Google street view allowed us to see construction photos and when the roof was replaced. We then dove into public records and found the purchase amount (from the deed) and his final loan amount (from his mortgage information)… Turns out he also started with a 203k Loan.
Now we know his mortgage amount and probably the least he is willing to sell the house for. You also have a timeline, >1 year of time and management, which in a persons eyes also has value. We also know that the taxes are paid. There are no additional liens (mortgages) on the property and he has not been served a failure to pay notice. So far everything is looking good an we have an idea of what we should offer.
If you have a good agent they will also be able to gather more information from the seller agent. For instance, we were able to find out why he was stepping away from the project and some of the offers that he had declined thus far. This information was super helpful. One thing to remember is that if you are with your agent and theirs, let your agent do all of the talking.
9. Find a General Contractor (GC)
I have literally no advice to give you in this category. I would start by asking your trusted realtor and family/friends/Facebook yada yada. We happen to know someone who works as a GC but wanted to dive into these types of projects on his own. It's a learning experience for all of us and so far has been really great. In our case our GC lined up all of the sub-contractors we would need for the scope of our project (plumber, electrician, insulator, plaster.) We all went to the house together for walk throughs and our GC gathered and negotiated quotes. If you see a number and are not sure, ask 1 million questions.
We are really comfortable with our GC and were very transparent about the amount that we are able to borrow within the confines of our loan. He was able to work with us to help us stay within budget.
* An offer being accepted and finding a GC does not need to happen in a specific order. We were lucky to have our offer accepted at the same time that we found a GC which made the process a bit smoother.
10. HUD Contractor
This part was very confusing to us. The HUD contractor oversees the money set aside in the mortgage and is assigned once an offer is accepted. Their fee is based on the cost of the project. For us the fee was $1k and we paid with a personal check. That amount will be credited back to us at closing. If you then back out of the property you lose the money, forever.
Our HUD contractor met us and our GC at the house for a walk through where we discussed two things: required work and wants. Required work is what has to be done to meet FHA standards. For instance walls need to be covered but you do not need trim. In our case we made it clear that we wanted to strictly bring the house to code (and FHA standards) and the rest of the finish work we would perform outside of the loan. We also decided to leave the master bath out of the project in addition to any exterior work. We would also do things like use 2×4 for exterior hand rails to pass inspection.
The HUD contractor takes all of their notes and writes up an estimate. The estimate groups costs into categories (exterior, electric, heat, plumbing, kitchen, etc) and there is a number and letter for each item. The number is the estimate. The letter indicated wether its required.
Next, you review the numbers and submit any changes. Once you review and your revision are complete it goes to your GC to submit their bids. Meaning, they put in the actual quoted costs plus their fee (15-20%) as line item that match. The amount they enter can be 100% different than the number entered by HUD. For instance the HUD contractor way under estimated the cost of insulation, but over estimated our cost for a new kitchen. There is a final HUD review to make sure the costs are reasonable.
11. Some Random Details
You have a 6 month timeline to get the work completed. Apparently they are flexible and as long as you have any delays clearly documented it is not a problem if the project goes too long.
It is important to remember two things: If you are able you can spend personal money to perform more projects or to upgrade things as you go. We plan to do a lot of this. And secondly, any money you do not use will be taken off your principle.
Whatever you borrow for construction costs the bank adds 10% for unforeseen costs. In our case the entire house is exposed so their is a low chance of needing that. The HUD contractor suggested that we use that money to buy things like appliances or an extra project. This money is accessed differently than the general fund which I will discuss in section 12.
12. Getting Paid
A tricky part of this game is getting paid. NO FUNDS are available upfront. This means that you need some cash in reserve to start the project. Each time you want to access the money the HUD contractor needs to come and inspect what has been done. This means that it is important to have a conversation with your GC about your ability to front money or their line of credit with subcontractors.
When you entered those bids with your GC in section 10 (above) that is what you get paid for the project, period. For example… if your GC entered $15,000 for a new roof and the roof cost $16,000 you only get $15,000. The remainder of the money needs to come from you or from a different line item. The inverse is also true… If the roof costs $14,000 you still get all $15,000.
Money can also be distributed partially though a project. In the example above if you needed to access money and the HUD contractor determined that the roof was 50% complete they would disburse 50% or $7,500.
Each time the HUD contractor comes to write a check he gets $350. We had 5 of these ($1,750) built into our mortgage. If we need more we pay out of pocket. The check is a two party check which means both you and your GC need to sign it before it can be cashed.
What is kinda cool is that your GC does not need to submit invoices to prove that the roof actually cost x. It all comes back to the line item. This allows you to play with the numbers a bit and add a cash buffer up front. For instance, we decided with our GC to inflate the first few projects by a few thousand dollars. This would help pay for the next phase of projects. We also added his fee to every line item but he agreed he would collect his payment at the end. I think we are in good shape and have enough cash to enter phase one.
IMPORTANT NOTE: The 10% reserve DOES require receipts. Therefor the HUD contractor suggested that we take things like kitchen appliances out of the Kitchen line item and buy them using the reserve. We are going to do just that in addition to paying for central air.
We will update this section more when we actually get there.