Here in Chicago I speak to many buyers and their Realtors who need rehab financing to both buy and repair properties. I wanted to give an example of a strategy that can work to a buyers advantage on a 2 unit, or duplex or as we say in Chicago a “2 flat”. I’m speaking to first time buyers as well that may be thinking of a condo as a sensible first purchase. Instead why not buy your first Investment duplex ?
I am going to urge first time buyers to consider a 2 unit. The reason why is that it can be a better financial move for the long term than a condo or single family. Specifically using an FHA insured 203K renovation loan to buy a less than appealing or damaged 2 unit property and add the funds needed to update & repair the property all in the same 30 year term loan. This approach has many hidden benefits. As a Loan Officer focused on providing renovation financing I like to educate consumers on these little used loans. I always say buy the worst property in the best area and rehab it.
Here are the key points and why I am excited to present this strategy:
- FHA 203K has a minimum 3.50 % down payment rule unlike conventional loans on 2 units. That is a huge advantage for any Buyer but even better for a first time Buyer. A conventional 2 unit loan requires at least a 15 % down payment and that changes to 20 % when you want to add funds to rehab. FHA is always 3.50 % down on a 2 unit including rehab funds.
- The FHA 3.50 % down payment can ALL be a gift from relatives or spouses/partners. Meaning the Buyer does not need to have saved the down payment in advance.
- FHA allows the size of the loan to be based on the “as completed” future value of the property after all documented rehab work will be done instead of just purchase price. Yet the rehab work is done after the property is purchased. So the future “as completed” value can be used up front to approve the loan and Buyer knows in advance what the property will be worth to decide to move forward or not.
- FHA allows the Buyer to add into the rehab dollars portion of the loan enough money to make housing payments for up to 6 months. The great advantage here is that if construction will mean the property can’t be lived in or rented safely for up to 6 months the Buyer has funds to automatically pay the housing payment out of the rehab funds. Meaning the buyer has no worry of paying current housing cost plus a second cost while the 2 unit is not able to produce income.
- FHA allows the Seller to pay closing costs for the Buyer. Specifically FHA allows up to a 6 % credit calculated off the sale price to go toward all Buyer closing costs and pre-paid items like the first year of homeowners insurance, attorney fee, title company fees and so on. As an example if purchase price is $100,000 the Seller can give up to $6000 to the Buyer for actual closing costs. Then Seller would net $94,000 from the sale. Buyer has effectively financed all closing costs rather than using cash.
- FHA allows the potential income from the other unit to be projected by the Appraiser using the “as completed” rent the unit will command after renovation. Even better FHA allows 75 % of the Appraiser projected rent to be used as extra income to qualify for the size loan needed. As an example if projected rent is found by Appraiser to be $1000 a month then $750 is used as extra income in addition to the Buyers salary to be used to qualify for the loan size needed.
- FHA requires the Buyer to live in the 2 unit for one year only. After that time the owner may move out and lease both units to tenants. Then the property can become 100 % rental. This is a huge advantage in that the buyer legally secured ownership of a 2 unit property a year earlier but with a down payment much less than a 2 unit investment property would require. Owner could now be positioned to buy another property.
- One final and very little known aspect is FHA 203K allows a 10 % variance in appraised value. Meaning if the property ends up being mortgaged to 110% of its value that is fine and the loan is approved. In the example below with paying $300,000 + $100,000 in rehab funds it would be expected the property appraise to at least that much. But if it appraised for $360,000 the loan is still approved. FHA has an interest in restoring old or distressed properties is why this is allowed only on 203K rehab loans.
Above are the mechanics of how and why a 2 unit rehab purchase can be a great choice for a first time or repeat Buyer who will live in the property for one year. Now let me do a complete example of a Buyer using this strategy.
- 2 unit selling for $300,000 needing $100,000 of rehab. The work can be to remodel kitchens and baths, remove mold, fix broken walls, upgrade HVAC, plumbing and electric, etc. BTW the $100,000 includes an emergency fund or contingency reserve of 10 % to 20 % of the rehab budget should there be any cost overruns or unforeseen rehab work that is discovered later in process. So buyer is protected should the rehab run over budget. If contingency reserve is never needed then Buyer’s loan is reduced by that amount at completion of rehab.
- Buyer needs a 3.50 % down payment calculated off the purchase price of $300,000 + $100,000 rehab dollars which will be $14,000. Base loan is then $386,000.
- For any 203K FHA insured loan there is a 1.75 % FHA mortgage insurance premium fee charged up front that FHA allows to be added to the base loan or in this case $6755 added to the $386,000 base loan equals a $392,755 final loan size. This is a user fee that funds the FHA mortgage insurance program.
- Buyer can get a gift for the down payment or part of it if need be. In this example the gift from parents is the full $14,000 down payment.
- Buyer has negotiated with the Seller to have Seller contribute $5000 to pay Buyer’s closing costs. Seller then nets $295,000 at closing. Buyer has $5000 to pay closing costs.
- Buyer secures a rehab work proposal from a licensed General Contractor for the $100,000 worth of rehab which is then given to the Appraiser.
- Appraiser takes into account all planned rehab in both the valuation of the property and the expected future rent. In this example Appraiser values the “as completed” property to be worth $440,000 and rent from the other apartment to be $1600.
- Let’s assume the buyers monthly property tax will be $300.00; monthly homeowners insurance will be $100; monthly FHA mortgage insurance fee $273 and principal & interest payment $2049. The total housing payment is then the sum of these or $2722.
- Since Appraiser projected expected rent to be $1600 a month FHA allows the lender to use 75 % of that or $1200 as extra income to be used to qualify for the mortgage. 75 % is used rather than all the rent as there is an assumption there may be a vacancy each year or routine maintenance costs the owner may incur.
- Owner will then occupy one apartment and lease the other to a tenant for $1600 a month. The owner will have a personal cost of $2722 – $1600 or $1122 each month to pay when the other apartment is leased.
- Owner has now a property worth $440,000 per the Appraiser’s valuation which is a 10% increase over the $400,000 transaction cost. Owner has $40,000 in new equity created by doing the rehab work.
- After one year of living in the property owner can lease out the other unit, presumably for the same as the other one at $1600. Then the monthly income is $3200 which is $478 more than the monthly payment of $2722. The property then generates a positive cash flow of $478 each month.
To summarize: We have seen in this example a Buyer who was given a gift of down payment to secure a 2 unit property and the Seller paid $5000 for the Buyers closing costs. In this example the Buyer really had no personal funds to provide at all assuming closing costs were a total of $5000. Yet the Buyer becomes an Owner of a 2 unit income producing property. See how this can be a better deal than buying a condo or single family ?
While I can’t promise the benefits of this example will occur for everyone I have tried to illustrate how it makes financial sense to take advantage of the FHA 203K mortgage when buying a 2 unit property given the FHA rules described above. Even if a Buyer didn’t really want to live with tenants in a sense that is what is happening when purchasing a condo. The real benefit is that after one year the Owner can lease their unit and move on to buy something else and have become a real estate investor with minimal funds and risk.
I hope this post has been helpful and encouraging to those that may have thought a Renovation project was too complex or beyond their ability to manage. My intent is always to inform, educate, and generate discussion. Please call me or email me directly or visit my website for more information on renovation loans. I welcome your comments and questions!