Would you lend an investor $150,000 for a flip and hope they don’t leave you with a gutted house? We tried this early on in our lending career. I believe it was our third loan ever. We wanted to make borrowing easier, so we didn’t require draws, along with other safeguards, and funded the whole deal up front. It ended badly. I don’t recommend it. We were left holding the bag on a loan where we lent the entire rehab portion at close only to have the borrower gut the property, stop making payments, and walk away.
We learned our lesson and put the proper protocols in place. Draws on fix-and-flip loans became a requirement for our very next loan.
But before diving in to the nuts and bolts of how draws are used, let’s understand what a draw is, exactly, so that we’re all on the same page.
With a fix-and-flip loan, a private or hard-money lender typically lends up to a certain percentage (Loan-to-Value ratio or LTV) of the purchase price. That money is sent directly to the title/escrow company to help the buyer/borrower purchase the home and close. The rehab portion of the loan is distributed to the borrower in increments as work is completed similar to progress payments. Before closing the deal, the borrower and lender determine a rehab budget. Once underway, the borrower then “draws” to pay contractors for work that has been finished. Borrowers submit a draw request to the lender, along with a list of completed items and materials installed. The lender sends an inspector to verify the work and, assuming it’s all complete, wires the requested funds. If only a portion of the work has been completed, then only a matching portion of the funds are sent. There can be many draws or one draw. It depends on the borrower, how he or she wants to divide up the work, and the agreement in place between the borrower and lender.
Using draws and wiring the funds AFTER portions of the work have been completed gives the lender more confidence that the money is actually going towards the property. Additionally, lenders typically won’t disburse draw funds if a borrower isn’t current with their interest payments. So be sure to keep up with your payments.
We often get asked: “If I’m requesting a loan because I don’t have the funds to complete the work, how can you expect me to pay my contractors and then get reimbursed by you?” That’s a great question. Let me explain.
There are two ways that draws can work: 1) the borrower pays his/her contractors and then submits proof of payment to the lender when submitting the draw request. In this case, the lender would send the draw funds directly to the borrower after the completed work has been verified; or 2) the contractor(s) sends the draw request to the lender and the lender directly pays the contractor after the work has been verified. This works best when there is one general contractor running the show. This second option is very appealing to many borrowers, but keep in mind, lenders will often ask for proof that you have enough reserves on hand to pay for at least some of the rehab work yourself before approving your loan. In either of the two options, the lender will require that any contractors who have submitted invoices for completed work sign a document stating that they have not/will not place a lien on the property for any unpaid invoices.
Draws definitely help protect the lender. So, what’s in it for the borrower? Sure, the borrower has a bit of paperwork to deal with when it comes to draws. But ultimately, it can be a huge time saver. Lenders will require that you present them with a draw schedule up front. This is an opportunity to really think through the costs and timing of your project. Hopefully you’re doing that any way. But for those of you who struggle in this area, this could be a useful exercise.
One word of caution: Some lenders will charge you monthly interest on the total loan amount (even the money not yet disbursed in draws). Green Block doesn’t follow this practice. Due to our early experience, we do now require that rehab funds are disbursed via draws, but you are not required to pay interest on money not yet received from us.