Mortgage Financing for a Fixer-Upper

On this article page, we discuss financing a fixer-upper property

The General Thought...

For some, buying fixer upper homes in need of some tender loving care or TLC seems like a good way to get into property ownership at a lower cost. The thought is buy the property at a good price, invest some time and money, add your personal touches and hopefully create some equity. 

This strategy can work for those with the required resources and experience (see 5 Big Mistakes below). And properly done, it can enhance other property values in a neighborhood and turn a nice profit. 

In this article, we will talk about and reference:

• Renovate to keep as a rental
• Renovate to sell / flip
• Renovate to occupy
• Down payment requirements
• Tax considerations
• Financing the improvements
• Location considerations

Lending Considerations

First of all, it is useful to understand that lending money is always about managing risk for the lender, risk that you'll pay them back as agreed and they don't have to seize the asset instead.  As it relates to mortgage lending, lenders don't really want to foreclose a property because it takes time and effort to get the property back from the owner, list it for sale, then actually get it sold where they can finally get (some of) their money back.  

A good mortgage broker will help you understand your project and package your loan request in a fashion that minimizes risk for you and the lender.

With fixer-upper properties, the risk is that you will run out of money before you complete the property, especially if you don't have enough skills and resources to see the project through, and that the lender will have difficulty selling the unfinished property.

From a lender's point of view, there is also a big difference between financing renovations for profit (business / commercial application) and financing renovations for use (personal application), and the fixer upper mortgage lending terms are quite different, with financing for profit much harder.

Buy-Renovate-Hold vs. Flip

If you intend to buy a property, fix it up, and either live in it or rent it out (buy-renovate-hold), that's a straight forward mortgage and perfectly acceptable to a residential mortgage lender.  

• Money is even available to help with the renovation costs.  
• Down payment requirements will be as low as 5% if you plan to occupy and 20 to 25% if the property is to be a rental.

If you intend to buy a property, fix it up, and then sell it for a profit (buy-renovate-sell,  a.k.a. flipping houses), then mortgage lending gets a little tricker as do the tax considerations.  

Let's start with how mortgage lenders will view the two lending scenarios, and how they make money.

Mortgage terms for 'residential use' (buy-renovate-hold) are much better than those available for flipping for a number of reasons:

1. Residential "A" lenders make their income based on a 'spread' between the interest rate that they charge you and their cost of funds (say interest paid on a GIC deposit) over the expected term of the mortgage.  If that spread amounts to say $10/day profit for a typical 5 year mortgage, that's $18K to them. Conversely, if a flipper only intends to hold the mortgage for 4 months until they sell, $1200 profit is not worth the lender's time nor effort, not to mention the risk.
2. Flipping is an activity with the sole purpose of generating income.
3. While your flip might involve a residential property, a mortgage loan will be temporary at best and has nothing to do with 'residential use', that being to finance a home for the occupants.  

Flip vs Hold Tax Considerations

Besides the financing distinction between renovating a property as a business (flipping) vs. keeping for residential use, there are significant tax considerations to understand in as well. 

Let's start with the Canadian Revenue Agency (CRA). They are pretty clear when it comes to determining how they are going to tax you. If the "original intention" of your strategy is to buy-renovate-sell, they view that as a business activity and assess income tax when you sell on your profit at your highest tax rate. If your original intention is to buy-renovate-hold, whether to occupy or keep as a rental property, then you should be able to get the more favourable capital gain tax treatment when you sell, which is about half as much tax associated with flipping.  

Sometimes borrowers get into project with the intent to hold, but things change and they decide to sell instead. To be sure this strategy might succeed on one or two, but if/when the CRA comes calling, your paper trail had better line up.  Over the years, a number of borrowers have inquired about getting into a 3 or 5 year variable rate residential mortgage that allows them to break the mortgage early for only a 3 month interest penalty charge.  "Penalty," you say - read on and compare!

Fix-Up and Flip Lending (Renovating for Profit)

If flipping houses is your ongoing business (or regular evening and weekend hobby/job), at some point your lending options are going to shift you to commercial / private lending for your renovation mortgage where the profit you represent to the lender becomes much more apparent to you. Or you will need to find your own 'angel' investor and share profits with them.

In this lending model, you will discover not only do you pay all the legal fees to put the mortgage in place, but also pay a "lender fee" and a "mortgage placement fee" (explicit or embedded in a higher interest rate). The higher rates and fees are all intended to make the lender's required profit and cover their costs over a much shorter lending term. At the end of your project, they want their money back, and you need to either sell or arrange "A" lending if you are going to keep. This is called the lender's "exit strategy."  If the exit strategy appears unlikely or murky at best, no loan for you. Remember, they really don't want to have to foreclose.

Let's look at an example:

• Flipper needs $300K up front in addition to their $100K down payment to acquire a property for $400K. In addition, the borrower needs 3 progress draws to fund the improvements (new roof, all new flooring, new windows and doors, new kitchen and bathrooms, etc.) totaling a further $150K, so $450K in total lending.
• Upon completion, the flipper's research indicates he should be able to sell the property for $625K, and get paid within 45 days, yielding a nice gross profit of $75K.  
• Renovation is expected last 60 days, for a total hold or 'carry' of 105 days.

In our example, it turns out that the best lender offer for $300K plus $150K draws is at 9% interest-only payments, 2% lender fee, 1% mortgage fee, plus legal costs including lien check at every progress advance.

• Legal: $2500 (including progress inspections and lien checks at each draw)
• Lender fee: $9000
• Mortgage placement fee: $4500
• Interest: $74/day on initial $300K and an average $18.50/day on draw amount for 105 days: $9700
• Total financing costs: ~$25K

In our example, the $75K gross profit expectation is now reduced by $25K for financing (ouch), and a further amount for property taxes, insurance and utilities over the construction period (say $2K), costs to sell (say Realtor fees of 3% of sale price, $19K), yielding a profit before taxes of $29K. Recalling the tax consideration discussion above, the CRA is standing there with a hand out for as much as 50% of the remaining profit leaving you around $15K net profit for the project.

Professional Flipping is not for Rookies.

As you can see by the numbers, professional flipping and fixer-uppers are not for rookies.  Besides the cost to finance, the controllable factors that really kill profit are unexpected cost overruns, longer than planned carry period (time to renovate and sell), and .... paying too much for the property in the first place!  

Conclusion

When you are seeking a mortgage related to a fixer-upper property, please use a mortgage professional who has 'been there, done that'.  We can provide insights on your project, get you asking the right questions, plug you into tax advisors, and show you the best lending choices. Keep in mind that the more prime the location of the property, the better the lending choices will be. We can also help you understand other financing options such as joint ventures.

Below, we have a section on Five Big Mistakes in Property Renovations. If you would like to contact us, we'd be happy to provide a no-obligation consultation on your project or objectives.  If you like this information, please share it with your friends using the social sharing icons.