The Siren Call of the 203k Loan
I had the chance to listen to the Strong Towns podcast about a failed mixed use redevelopment attempt via a 203k loan with Ian Rasmussen. Listening to the story, I felt Ian’s pain. I’ve made a few previous warning comments regarding 203k loans to folks in the Small Builder/Developer Facebook Group. I’m going to take this opportunity to share as much as I can regarding this loan product so folks can make as educated a decision as possible regarding funding source for mixed-use projects.
The 203k loan looks great on paper: really small down payment, you have to be an owner occupant, it can roll in financing for renovations, it can be a multi-unit project, and there can be a decent amount of commercial space included.
There are a couple big caveats, however. Here’s a little history from our experience. We were so strapped for work in 2009-2010 that I dug into the 203k requirements and got approved by HUD to be a consultant. I tried to read the thousands of pages of requirements and mortgage letters that served as periodic updates to the various requirements to the program. What I found out is that if you are a licensed architect, and are willing to swear that you read a bunch of stuff and claim to understand the 203k program, you are qualified to be a 203k consultant. The bottom line is that you can really only get your head around it by doing it. I found that several architects used themselves as guinea pigs to renovate their own homes through the program to figure it out.
Choose Your Bank Wisely
The good news is that in 2010, the vast majority of people involved in the program had no idea how it worked. If you read some stuff, you were basically on par with the more knowledgeable folks in the field. We also figured out quickly that there were mostly only two games in town, Bank of America and Wells Fargo. We saw this program as a way to take on single-family renovations where there wasn’t funding available to do them otherwise.
One of our first loans we assisted with was for a young couple, the wife actually worked for Bank of America in Atlanta. She had heard of the program, and spent a good bit of time searching internally in BoA to finally track down the one woman in the whole institution that was processing these loans for the East half of the country. Think about that – BoA had basically one or two people handling this product in 2010 for half the United States. Our client was only able to push things through because she was a Bank of America employee too.
Further disclaimer, we were only dealing with single-family renovations. After dealing with a few of these, the thought of trying to tackle a mixed-use project seems basically suicidal. The Strong Towns podcast does a good job of capturing the suffering.
It’s Not as Easy as It Looks
There are many problems with this loan. The first is that it basically lays on the complexities of a commercial construction loan onto a residential loan product. There are very few folks in the residential loan market that have the knowhow to understand these requirements. This is supposed to be addressed by the 203k consultant, who plays a big role in the paper work and review of projects for conformance. The fee structure for this work is set by HUD, and it doesn’t adequately cover the time and effort involved. This results in under qualified folks phoning it in. And the loan officers don’t know half of it even on good days. So if the consultant is underpaid and under qualified, and the loan officer doesn’t have an understanding of the requirements, what could possibly go wrong?
Gratefully, as an architect that deals with commercial construction projects on a regular basis, we were able to steer several of these loans through to successful completion. We stubbed a few toes, but got folks to the finish line. Several things we learned along the way were that BoA didn’t really have a firm grasp of the process (at least early on), but Wells Fargo had it down. For better or worse, this meant it was a little easier to close a BoA deal, but you would have to sort it out post-closing, which is not fun. Wells Fargo generally had their stuff together pre- and post-closing, and had a pretty diligent construction admin department that knew the drill.
Back to the Strong Towns podcast. Ian definitely suffered, a lot. But he didn’t really even get halfway through the loan process. He had a lot more suffering ahead of him if he could have qualified for the loan. His loan got rejected for failing to qualifying for a basic requirement for the loan, having more units than the four-unit limit. The mortgage brokers had no idea of this requirement. A 203k consultant should have, but the loan officers were trying to save him this expense until he qualified for the loan. Also, I strongly suspect that any moderately seasoned 203k consultant would have ran from a mixed use deal as fast as possible. I’m not trying to lay blame on Ian, just trying to provide insight into the process.
We spent months and months trying to help people close single-family renovation loans through this program. Eventually, we realized the only way this program had a chance of working was for renovation/refinances. It simply took 10-20 months to close these loans, and the vast majority of sellers would not hang around long enough for a loan to close. If you were an owner-occupant, you could stick around for two years to wade through all the mess to close a loan. Things may have gotten better since, but we wouldn’t know. We gave up on this endeavor as consultants as soon as other work came back around.
Assessing Value: the True Struggle
During the recession, it was usually the appraisal that was the killer. You had to get a dual appraisal that showed that the house was worth buying now, and it would be worth the purchase plus improvement cost after renovations. I’m not sure if you’ve noticed, but the quality of residential appraisers has dropped off a cliff into the depths of a deep dark pit since the recession. The well-intended finance reform laws highly limit the relationship of a bank and appraiser selection. Finding an appraiser that can functionally use Google maps to find your property to show up for an inspection qualifies as badass. Trying to get one of these guys to imagine a renovated building and assess a value is asking a lot. Or as my five year old says “A lot, a lot daddy. Really a whole bunch.”
In Atlanta, these appraisers are all based out of the outer exurbs, where there are far less job prospects. Their understanding of an urban market is nil. Asking them to appraise single family and generate a report for $300-$400 dollars is a somewhat ridiculous request. They can’t figure out how to find your house in town, let alone ascribe a value. Tell them there is part of the building that is commercial and heads will explode. And honestly, the going rate for a commercial appraisal is ten times that of residential. I’m not trying to dump on residential appraisers completely unnecessarily; I’m pointing out that most 203k loans groups only have access to residential appraisers, and be very cautious if you think they have the capacity to appraise something they’ve never, ever seen before and have no capacity to find a single comp anywhere. This is also not a discussion about what they should be able to do, but what they can do.
Coming out of the downturn, it was always the appraisal that killed the deal. You could have a competent loan guy, have a complete set of 203k consultant docs, everything else tee’d up, but if the post-renovation appraisal didn’t pan out, it didn’t matter. Ian never even got to that point of heartbreak of having subpar comps or no comps to justify the value of the building he was trying to buy.
Know What Your Loan Officer Needs to Know
Also, listening to Ian recount his tale, I want to point out that the 203k loan is a highly regulated loan product. This means it is completely regulated by the checking of boxes. If you can provide information to check appropriate boxes, great. If not, fail. Mortgage officers usually do a good job of steering borrowers to provide the “right” answers to typical loan products to get a deal closed. Most don’t know the triggers for failure of a 203k loan, and can’t provide warnings to their clients to stop talking before they step in it, disclosing that a tenant is a relative, discounting rental income, etc, etc. Most of these failures along the way are specific issues with the program, things loan officers have no leeway with. If Ian was aware of these Byzantine requirements, he might have been able to better package his information to better assure approvals.
Our big takeaway is that if you want to do a mixed-use building, be very, very wary of the siren call of the 203k loan. It is not impossible for single-family home renovations, and is technically possible for mixed-use buildings. Tracking down a well seasoned 203k consultant should be an important first step. The bad news is that there may not be one in your city or region – a seasoned consultant or one that is simply breathing. This will quickly translate into a question of the value of your time. Is it worth it for you to take on learning the twists and turns of a poorly understood loan product to try and do a deal? It may be a lot less painful to go out and raise the 20-30% down required to use a local bank.