Welcome to the Fix and Flip Learning Module
In this module you will learn everything you need to be a real professional in the Fix and Flip arena. Each of our modules are designed to start off with the basics of financing and then dive deeper into the core or the product. You may find things being repeated in each module, but this repetition is by design. It is there so that you become real familiar with certain terminology and equations. The other reason is to show that in commercial financing there is a basic substructure to all financing which will help you understand the products better and guide you in the structuring of a deal.
Fix and Flip Module 1
In this module, we will discuss the basics of lending and the criteria that underwriters look for in a borrower. It’s important to understand that the method used in determining the quality of the borrower and the property is pretty well uniform across the board, but the qualifications or values will differ.
Underwriting is an analysis of risk. It is a determination of the risk factor by looking at multiple variables. The underwriter must weigh these variables and determine if the risk is worth the reward. The underwriter will look at the following in guiding their decision:
- The property, in other words, the collateral, is heavily weighted for analysis. It is important to understand that lenders are not in the real estate business. They don’t want to take the property back through foreclosure. It is a hassle for them. They are in the business of mortgage lending and that’s what they want to do. But, having said that, they want to make sure that if they do have to foreclose on the property that they will be able to make their money back. During the property analysis, the underwriter wants to see the strength of its marketability, neighborhood demographics, condition of the property, its present as-is value, and the makeup and condition of the properties in the surrounding area (amount of rentals vs owner-occupied, schools, parks, traffic, etc.).
- The next area for analysis is the Borrower. What is the capacity of the borrower to pay back the loan? The underwriter will review credit strength, financial responsibility, source of down payment, employment strength, and the affordability of the new loan payment. ( there are additional requirements for commercial lending including Fix and Flip which we will discuss later on).
- Title review.which will assure the transfer of free and equitable title free of any encumbrances like liens, judgments, or lawsuits.
- To reiterate, financing is risk-based! But, there are compensating factors if the borrower is on the cusp of approval. For example, if the borrower’s credit is flawed in certain areas a compensating factor maybe experience in owning other properties, higher down payment, or a co-borrower.
It is important to understand that most lenders are not using their own money. They are dealing with Investors, Hedge Funds, Insurance Funds, or Banks. The underwriter is responsible for maintaining the integrity of the investor’s money, and if the ratio of foreclosures and poorly performing mortgages increases the lender jeopardizes the relationship with that investor.
Terminology to Understand Underwriting Guidelines
You will come across some industry terms when reviewing underwriting guidelines, and we will cover some of them here. Some of these may not pertain to Fix and Flip loans but you must get a feel for commercial financing as a whole, especially when talking to a client.
LTV – Loan to Value – This is the difference between the sales price or appraised price and the mortgage amount. For example, A property is purchased for $100,000 and the borrower is putting down $20,000 to obtain an $80,000 mortgage, the LTV is 80%.
80,000 / 100,000 = .8 or 80%
Below is a section that discusses the terms of Adjustable Rate Mortgages
Adjustable-rate mortgage (ARM) – A mortgage in which your interest rate and monthly payments may change periodically during the life of the loan, based on the fluctuation of an index. Lenders may charge a lower interest rate for the initial period of the loan. Most ARMs have a rate cap that limits the amount the interest rate can change, both in an adjustment period and over the life of the loan. Also called a variable-rate mortgage. In most cases, mortgages are tied to one of three indexes: the maturity yield on one-year Treasury bills, the 11th District cost of funds index, or the London Interbank Offered Rate.
Adjustment cap – A limit to how much a variable interest rate can increase or decrease in a single adjustment period.
Adjustment period – The period of time between adjustment dates for an adjustable-rate mortgage (ARM)
Index – When used in a mortgage note or credit agreement, a financial index is the measurement used to decide how much the annual percentage rate will change at the beginning of each adjustment period. Generally, the index plus or minus margin equals the new rate that will be charged, subject to any caps. Lenders use various financial index rates: London Interbank Offered Rate [(LIBOR and Treasury-Indexed ARMs (T-Bills)]
Margin – The number of percentage points the lender adds to or subtracts from the index rate to determine the interest rate adjustments. The margin is constant throughout the life of the mortgage and is specified in the promissory note.
For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In contrast, a 5/1 ARM boasts a fixed rate for five years, followed by a variable rate that adjusts every year (as indicated by the number one). Similarly, a 5/5 ARM starts with a fixed rate for five years and then adjusts every five years.
Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2% the next time the interest rate adjusts, the rate falls to 4%, based on the loan’s 2% margin.
Cash-out refinance – A refinance transaction in which the new loan amount exceeds the total of the principal balance of the existing first mortgage and any secondary mortgages or liens, together with closing costs and points for the new loan. This excess is usually given to the borrower in cash and can often be used for debt consolidation, home improvement, or any other purpose.
Combined loan-to-value ratio (CLTV) – The ratio between the unpaid principal amount of your first mortgage, plus any secondary mortgage, and the appraised value. Expressed as a percentage.
Comparables (comps) – Properties similar to the property under consideration for a mortgage that have approximately the same size, location, and amenities and have recently been sold. Comparables help an appraiser determine the fair market value of a property.
Bridge Financing – A Bridge Loan is generally a short term loan that is used by business borrowers until a longer-term loan can be arranged or a scheduled event occurs which provides the funds to repay the loan. Bridge loans may be used to, among other things, acquire real estate, make improvements, put tenants in place, etc. Bridge Loans may also be referred to as Interim Loans and generally carry higher interest rates and fees than Conventional Loans or Permanent Loans (Permanent Mortgage Loan)
Capitalization Rate or “Cap Rate” – The Cap Rate is utilized in commercial real estate financing and sales transactions. It is the percentage derived by dividing the income generated from the use of the property by the value of the property. It is used to determine debt service coverage for a loan or potential return on investment. It also used for appraisal of properties whereby appraisers will use an assumed “Cap Rate” (according to market conditions) to determine the value of the property when using the “income approach” to valuation.
Commercial Real Estate Appraisal – An estimate of the “market” value of Commercial Real Estate prepared by a licensed appraiser. Appraisers may be licensed by the State and may also be designated as an MAI appraiser (usually required by banks). When making business loans collateralized by real estate lenders will generally require the appraisal to conform to the Uniform Standards of Professional Appraisal Practice (USPAP), which sets forth guidelines for valuing the property. Generally, appraisers use three methods for determining values: the “cost approach,” which refers to the value of the land and the cost to construct the building and improvements, the “sales comparison approach,” which analyzes the sales of similar properties in the area, and the “income approach,” which analyzes the income generated or projected to be generated by the use of the property and applying a capitalization rate to that number. Appraisers will often use and reconcile all 3 approaches to arrive at a value.
Debt Service Coverage Ratio (DSCR or DSC) – The amount of cash flow available to meet the annual principal and interest payments on business loans and investment real estate loans. Formula: Debt Service Coverage Ratio = Net Operating Income ÷ Debt Service
- When dealing with commercial financing DSCR is the most important attribute for approval. Net operating income is a company’s revenue, minus its operating expenses, not including taxes and interest payments. It is often considered the equivalent of earnings before interest and tax (EBIT).
- DSCR=Total Debt Service / Net Operating Income
Example – a borrower shows his net operating income is $2,150,000 per year and while his debt service is $350,000 per year. The DSCR can thus be calculated as 6.14x, which should mean the borrower can cover his debt service more than six times over given his operating income.
DSCR= $350,000 / $2,150,000 = 6.14
Environmental Site Assessment or Phase I Site Assessment – Environmental Site Assessment or Phase I Site Assessment A study of real estate to determine any unique environmental attributes, encompassing everything from endangered species to existing or potentially hazardous waste to historical significance. Generally, it involves visual inspection, interviews, and checking local records.
Environmental Site Assessment Phase II – Environmental Site Assessment Phase II-A Phase II report will normally be performed when a potential environmental condition is indicated after a Phase I report. The Phase II will include sampling and evaluation of suspect materials or areas on the site.
Environmental Site Assessment Phase III – Environmental Site Assessment Phase III A Phase III will set forth plans for the mitigation or remediation of the environmental conditions on the site
Hard Money Loan – Loan typically issued by a non-Bank lender based on the quick-sale of a piece of commercial real estate, an opportunistic opportunity to acquire property at a bargain price, and possibly a distressed financial situation that may not qualify for traditional conventional financing. Hard money loans generally are short term “Bridge Loans” and carry high rates of interest and points.
ARV (After Repair Value) – this is the value that the appraiser places on the property by taking the as-is value, reviewing the contractor’s list of improvements (scope of work), then comparing it to like properties in the area to come up with improved value.
In this module, the areas where we expanded on and showed examples are the zones of importance. Understanding the what the underwriter looks at and weighs the risk of every file based on collateral and the financial fitness of the borrower. As you work through these modules, you should concentrate on thinking like an underwriter because that will give you the confidence when structuring a deal for submission. Always prepare a summary as you review the borrowers documents so that you can provide that as an opening statement for submission. This will give the Underwriter and processor an overview of the file and compensating factors. Providing the underwriter with an overview of the deal help them understand the transaction and allows the deal to flow smoothly.
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