The profit margin is the most crucial aspect of every fix and flip or construction project. Without profit, you don't have a deal. Even if you're planning to hold the property and refinance, it's the same issue — it's just then a matter of how much equity you'll build into your ownership.
If you're starting to flip homes, we suggest looking for a minimum gross profit margin of 25%, with 30% or more as the gold standard. For example, suppose you buy a house for $200,000, put $100,000 of rehab work into it, and then sell it for $400,000. Your gross profit is $100,000, giving you a margin of 25%.
A lender has their own way of measuring your profit margin using their loan to the after-repair value (LTARV) ceiling, usually 65-70%. But a 70% LTARV doesn't mean you have a 30% profit margin unless they provide 100% of the funds for the deal.
Remember, this isn't your take-home profit because you need to pay for the finance costs, legal, insurance, and taxes. However, a profit margin of 25% or more gives you a good return with some buffer if your project gets delayed or exceeds budget. The lower your profit falls below 25%, the more likely a lender will reject your deal, and for good reason. They don't want you to lose money, nor do they want to have to foreclose.
Rental Yield
If you're buying a rental property and need a rental loan, the issue is less about profit — because you'll be holding the property — and more about yield. DSCR comes into play in this case, which stands for "discounted service coverage ratio." This means that the lender wants to know that your rental property is netting off enough revenue — after maintenance, insurance and taxes — to be able to service your loan, sometimes with a buffer. The standard ratio required is typically 1x-1.2x; 1x, meaning your net rental revenue should exactly cover the interest cost, and 1.2x, meaning you need 20% more net income than your interest.
Again, this safeguard is not just there to protect the lender's risk; it's there to protect you. If your DSCR ratio falls below 1x, that effectively means you're losing money on the property after interest, so you should strongly consider whether it will be a good investment.
Assuming you have a profitable deal and the experience to handle the project, the next question will be regarding liquidity. Put simply, do you have the cash available for:
The downpayment.
Closing costs.
The first few months of interest payments.
The first few weeks of renovation/construction expenses.
A buffer if things go wrong?
If you have this cash to hand, it's a simple case of showing proof, and you're off to the races. If not, you must demonstrate how to fund or consider wholesaling the deal.
Although your creditworthiness is less significant with an investment property than with a mortgage, most lenders still pull credit and expect you to have a decent score. As a ballpark, a score above 700 will not impact your ability to get finance with 99% of lenders. A score of 660-699 may lead to slightly higher interest or more money down, but you should still be able to find a lender.
When your FICO falls below 660, things get more challenging but not impossible. Around a third of our lenders are happy to work with borrowers with poor credit, but they'll need a supporting factor to lend. This could be one or more past investment experiences, a larger downpayment, or other assets owned.
Here's our tip for working with lenders when you have less-than-stellar credit: be honest and communicate well. We've seen countless examples of investors trying to "massage" their credit history, but lenders are experts at getting to the bottom of credit issues for a reason. On the one hand, being honest and upfront is a great sign that lenders can build a partnership with you. On the other, even if that means getting a "no," you're far better off hearing that early so you can move on to a lender that can work with you.
The two last reasons that often cause a loan to decline relate to the property. Only some lenders consider these issues deal breakers, but even if they don't, it may make getting finance a little more complicated.
The first issue is location. In terms of the state your property is in, you don't have too much to worry about. Though a few states have fewer lenders — like Rhode Island, the Dakotas, and Arizona — due to legal issues, hard money lenders are active in every state.
The main location question can be distilled to the following: is your property rural? If your property is not in or close to a city with a population of 35,000 or more, finding finance becomes harder. Some lenders will lend rurally, but as these properties are typically harder to appraise and sell, they often increase the downpayment required.
Similarly, if you're looking for a new construction loan, an infill site is much easier to finance — and at the best terms — than developing an outlying site.
Finally, the value of the property matters, as does the size — both in terms of square footage and acreage.
On the low side, you want to have a property worth at least $150,000 ($50,000 per door if multifamily) and at least 500 sq.ft. or more. Lenders rarely lend less than $100,000 per loan except with experienced investors who can provide volume, and they want the property to be large enough to refinance without issue.
On the high side, things are less clear-cut, but the bigger the house above a certain point, the riskier it becomes. Larger homes — relative to their neighbourhood — are harder to sell and can lose value more quickly. So long as your home isn't on more than 1 acre (per unit), is smaller than 3,000 sq.ft., and is not more than double the average selling price in the locale, you shouldn't have any issues. Above this, you may need to find a lender specializing in those properties.
Now, every deal is unique. But if you're facing one or more of the above, it's a helpful reminder to reassess your project and ensure you have considered all the risks.
And with the right lender and a profitable (or yielding) project, these issues don't have to become deal breakers. That's where Hardback is here to help. Rather than calling a dozen lenders to find one that can fund you, you only need to apply once, and the lenders willing to fund will come directly to you.
