[Special thanks to BiggerPockets member and moderator Chris Mason, a lender and mortgage expert with Bay Equity Home Loans in California, for updating the information in this article.]
As real estate investors, we are always looking for new and better solutions to improve our investments. Most investment properties take money, and often that means cash we don’t want to give up or don’t have to give up. There IS a solution to this problem. Whether you’re an investor whoprefers to pay all cash for your real estate investments or one whouses financing to buy the property and pay cash to fix it up, or whether you usehard money lending, there are other options that you should consider.
What is the HomeStyle Renovation Mortgage and How Does it Work?
The HomeStyle loan is a Fannie Mae (FNMA) loan that basically allows an investor to purchase a property and include the renovation costs into the mortgage. It’s quite similar to a hard money loan, but the significant difference is that the loan is a permanent loan (15 or 30-year fixed). It’s also traditionally a LOT cheaper. Since the loan is FNMA backed, it’s going to conform more to the market interest rates and fees for a conventional mortgage.
Here is the most basic example to wrap your head around the idea of this product:
- Sale Price: $100,000
- Renovation Budget: $25,000
- Total Investment Needed: $125,000
- 80% LTV, 30-Year Fixed Mortgage*
- Traditional Mortgage Rate (5% +/- in 2015)
- Loan Amount (80% of $125k): $100,000
- Cash Down Payment: $25,000
- Escrow Account Setup for $25,000 in Renovation
- Great Property, Fixed, for 20% Cash Investment
Versus:
- Hard Money Loan
- $125,000 Total
- 70% LTV
- $37500 Cash Needed
- 3-5 Points Up Front
- 10-18% Interest
- 6-12 Months Payoff
As you can see, you get most of the benefits of a hard money loan wrapped into a single close, long-term financed mortgage without the expense.
Intrigued? You Should Be! Let’s Continue With More Details.
Who?Fannie Mae is America’s largest secondary lender. Many of their tradition guidelines that apply to conventional loans also apply to their HomeStyle product. One thing to keep in mind is that not all FNMA qualified lenders are qualified to also sell their HomeStyle loan product, so you must ask.
What?The HomeStyle loan is designed for investors and owner-occupant buyers as an alternative to the FHA 203(k) loan, as well asfor second home buyers. As far as lending limits, most mortgage brokers will tell you that up to an investor’s fourthloan can be a HomeStyle. While we know that some investors can obtain up to 10 FNMA loans with increased qualifications, a borrower can only use the HomeStyle up to their fourthloan. We have not tested this yet, but that’s what we’ve been told.
Many of the same lending guidelines that apply to qualification for a conventional FNMA loan apply to a HomeStyle loan. Most traditional conventional loans allow lending limits of 80% LTV. For investors using a HomeStyle loan, there is a maximum LTV of up to 85% with mortgage insurance, or 80% without. For owner-occupant buyers, the limits are significantly higher (also with MI).
Related: The Five “C’s” of a Perfect Loan Proposal
When?Now! But remember, the HomeStyle mortgage process takes 45 and sometimes up to 60 days to close. Plan accordingly with your contracts. These are more intense than the standard, 30-day conventional mortgages, so make sure that you have the time and personal commitment to work the process.
Where?HomeStyle can be used on single family residences for investments and 1-4 unit properties for owner-occupied homes.
Why?To preserve CASH! You can substantially increase your cash on cash return using this product versus other investment scenarios. You can increase your portfolio faster.
The FNMA HomeStyle Renovation Mortgage Lending Process in Detail
1. Find a qualified Fannie Mae HomeStyle lender.
As mentioned, not all lenders or mortgage brokers are qualified or set up to provide the HomeStyle mortgage. It takes quite a bit more staff and processes for the lender to be able to provide these. Make sure it is a lender that you feel comfortable working with. This is a process; you need to be comfortable with your lending partner.
I strongly urge you to use a mortgage broker or lender that is in the area of the property. This process involves a few extra people. Having a direct relationship with someone who wants to keep you happy for referral business and repeat business is important. Celebrating with a blender of margaritas when your house is done is even better. Once you have your lender selected, you will need a pre-approval letter to present with offers.
2. Put a house under contract.
Restrictions: Not many. It should need some repairs, at least enough to justify this process and a couple of extra costs. What can it need? Just about anything. Windows, yes. Doors, yes. Bathroom, yes. Kitchen, yes. Roof, yes. An addition onto the back of the house? Even for this,yes. Free-standing stove, no. Mini-blinds, no. (More on this later.)
3. Get a contractor and an inspection (required by most HomeStyle lenders).
Most contracts permit a 10-day inspection period or other amount of time that is negotiated to have a professional inspection. This can be money well spent to make sure that you have located all or most of the necessary renovation items that you will need to take care of during the process. A qualified inspector can make reasonable suggestions on what and how to repair certain items.
But the important part of this process is to have a renovation contractor develop a Scope Of Work (SOW) with you. The contractor will also need to complete a contractor profile. These are required parts of the loan paperwork. The lender needs a SOW, also called the Scope Of Repairs (SOR), to know what you plan to do to the house and that those items will actually bring it to a livable condition. Here are some items that you will be required to provide to your lender:
- Scope of Work with itemized repair budget
- The cost of the renovation cannot exceed 50% of the purchase price of the property
- Copy of contractor’s license from the jurisdiction of the property
- Copy of contractor’s insurance (general liability and workman’s comp usually)
- Contractor profile form from Fannie Mae
- Copy of contract between you and your contractor (here is an example from FNMA)
- Notification of work needing permits (can’t moonlight these; permit work must be permitted)
*Note: Everyone always asks about self help. FNMA allows it on SFR owner-occupied, but it’s INCREDIBLY rare for any lender to not have this overlaid. Self help always ends up being fraud, so realistically, you’d have to find a lender that’s NEVER done FNMA Homestyle and doesn’t know that it’s always fraud (which it always is, 100% of the time), to swing it.
4. You will need to provide your lender with documents.
These will simply entail the traditional documents needed for a conventional loan and a few other items related to the renovation.
5. Your hard part is done. It’s a time process now.
Some of the next steps include an appraisal that is ordered and managed by the lender or mortgage broker. Rather than a traditional appraisal, they are going to appraise the property based upon “subject to repairs” or the “After Repaired Value” (ARV). This is important to the lender and to you in orderto justify that the cost plus renovation do not exceed the value of the property repaired. The lending process is going to maximize the loan at either 80% of the ARV, or 80% of the cost of the property and renovations. (If you have another LTV, i.e. 85%, substitute as needed.)
6. You’ll get the Feasibility Study performed.
Usually the appraiser is qualified for this step and can do this process, but it can also be done by another party chosen by the lender. These inspectors are usually HUD consultants. The validation of the SOW/SOR is done by the consultant. This is called the Feasibility Study. As mentioned, the appraiser or other party will review the SOW/SOR while at the property to justify that this set of repairs will bring the property to a livable and safe condition. They will also validate the cost of each of the items being repaired in accordance with market prices.
7. Underwriting takes place.
Once all of the documents have been received for the loan, the lender will underwrite the loan for final approval. Additional questions are regularly made at this point, and then the loan is set for approval. The underwriter, under FNMA guidelines, WILL add a contingency budget of usually 10% of the total cost of the renovation and sometimes up to 20%.
8. You’re ready to close.
Once everything has been done with this process, which typically takes 45 days and sometimes longer, you are ready to close on the sale. The closing will take place as usually set up in the state of the property. An escrow account is set aside with the renovation proceeds, usually with the lender. Instructions will be given, and additional contacts will be presented for the duration of the process.
9. You are ready to begin renovations.
It’s up to you and/or your contractor to start the renovations as outlined. Initial funding must come from other resources. The lender will NOT give you starter funds for the renovation. Typically, the owner will need to provide the contractor with starter funds to fund materials and initial labor. Once formidable progress is completed on certain tasks of the SOW, a draw request can be made for reimbursem*nt. Most renovation loans come with a limit of up to five draws.
A form is submitted to the lender, and an inspection is made by typically the same consultant whovalidated the SOW. The reimbursem*nt process can take a few days on each draw, so be prepared. Ask the lender in advance how long these take with them. Continue this process to completion. Most draws are written to the borrower and the contractor, and almost always the final draw is written to both. You may be able to work with your lender to advance the draws to one or the other with special instructions. Once the renovation is complete, the final draw will be released upon receipt of the following: a HomeStyle Completion Certificate, a Project Inspectors Final Report, anda Release of Lien and Title Update.
10. Congrats! Your house is renovated and ready to move into, sell, or rent.
I’m sure that there are investors whouse these loans to flip with, but most investors are using them to keep the property as a rental.
If you are building a portfolio of rental properties, this can be a great way to impact your cash on cash returns, minimize the number of loans taken out on the property, and maximize your buying power.
Other Items Learned Along the Way From Experience
If you are buying a Fannie Mae property (and other sellers with deed restrictions), you have likely noticed a deed restriction in the contract that prohibits you from encumbering the property for more than 120% of the purchase price within three months. Many listing agents do not know about the HomeStyle loan and do not understand it. If you are going to do a renovation that willexceed this requirement, which isn’t hard to do, you must realize that this will make an impact. Fannie Mae may have the option to change this restriction. Sometimes, it isn’t realized that this limitisexceeded until the closing company reviews. Remember the contingency budget that was added so this doesn’t put you over.
Most appraisers and consultants are swamped. This process will sometimes take more than 45 days. Open communication with all parties will solve many issues during the contract to close process. Keep everyone on task and informed.
FHA also has a renovation mortgage that is very similar to this, with some exceptions. They are for owner-occupied houses only. There are different restrictions on what can and cannot be included in the renovation. There is currently a $35,000 limit on the renovations. The LTV will be enhanced by the use of the FHA 203(k) product versus the HomeStyle.
Using this process instead of a traditional turnkey investment property typically yields a better equity position. The purpose of going through the renovation process on your own instead of having someone else do it is to save equity. If you can renovate the property to be worth $135,000 for the cost of $125,000, you just made $10,000 in equity. This is where our clients have shined.
Related: Your First Investment: How to Use Future Rental Income to Qualify for a Duplex Loan
If you use the 80% LTV mortgage on a single family, or the 75% LTV on a 2-4 unit property, you will avoid mortgage insurance. If you have an LTV of 85%, which is allowed even for an investor, you will have mortgage insurance premium (MI).
Use this worksheet, Form 1035, to determine maximum eligibility or work with a qualified lender on the process.
What is considered to be a permanent improvement to the property? Since the mortgage is designed to carry for the extent of typically 30 years, the lender wants to know that the improvements made to the property have “shelf-life” and stay with the property. Therefore, things like appliances are considered personal property and cannot be financed into a HomeStyle. The same goes for items that typically have a short life, like mini-blinds, etc. Consult with your professionals when developing the SOW/SOR on these items.
The use of other subcontractors for things like the roof or electric can be used, but should be managed by a single general contractor. I believe that there are exceptions to this rule, but I would imagine that it would become much more difficult to process.
If your renovations are going to exceed the original cost, you can use the contingency budget with the contractor completing a Change Order Request Form.
As previously mentioned, the contractor must be licensed in the jurisdiction of the property. Even if they are licensed in the jurisdiction of their business, they must also be licensed where the property is located. This will also be necessary for them to pull necessary permits for the renovation.
You also may be eligible to use a renovation mortgage as a part of a refinance. Seek the expert advice of a qualified lender.
The balance of the contingency budget will be applied back to the borrower’s loan balance if not used during the renovation process.
The fewer draws needed to complete the renovation, typically the faster the project will go. Even though lenders should be able to process these in a few days, you are waiting on the consultant to check on status each and every time that you request a draw, which usually comes at a fee of approximately $150.
When making your draw requests, the consultant usually wants to see that the entire portion of a line item on the SOW/SOR has been completed. If you are requesting money for the painting of the property, make sure it is complete and that you aren’t requesting just part of it. For the paint example, some contractors may work on a main level of the house, then the finished basem*nt. If both get painted, both need to be done if that is how it is charged on the invoice.
In searching for your lender, be sure to find one that not only has this product available, but also has experience working with them. There are several more forms and processes to be completed, and experience is critical.
You can also review the HomeStyle Renovation Consumer Tips pageor their Product Overview.
Investors: Have you used the HomeStyle loan for your real estate business? Any questions about how it works?
Leave all your comments below!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
