Yesterday, I shared the beginning of my journey into being a small scale developer. My partner and I had zeroed in on a neighborhood we loved and found a property with great potential. Now all we needed was financing. Today, we're talking about what happened next.
The Money Chase: Phase 1
Let’s pause here and explain something super basic about how mortgages work, assuming you are (or, like me, until pretty recently were) someone who knows absolutely nothing about them. As a matter of policy, banks like to write loans for properties that are in good shape and in good neighborhoods, to buyers who are likely to pay them back. If the house is too damaged, you might spend a fortune on repairing it and not be able to make the mortgage, much less get someone to take it off your hands. If the house is in a bad neighborhood, you might not be able to sell it later. And if you have a demonstrated history of not paying your debts, that’s an obvious non-starter.
We were good buyers, but we knew that the B street house wasn’t an easy bet for a bank. We just didn’t know how bad it would be.
We started our search at the small community bank through which we’d purchased our duplex. They were thrilled to write us a mortgage, but they didn’t do any kind of rehabbing loans to cover the initial repairs — all of which, together, were just too much for us to spend as low-level investors who couldn’t afford not to break even in a reasonable period of time.
I called another bank. No dice there, either.
Then I called five more.
To give you a sense of how this looked in actual numbers, let’s say I planned to buy this house for $100,000 (that’s not the real number, by the way, but for the sake of simplicity, let’s stick with it for now; the rest of the numbers I’m using here are roughly proportional to the real numbers we were working with.) When we got past the first half-dozen banks who didn’t offer rehab loans of any sort, the ones that would talk to us wanted a 25% minimum down payment, rather than the standard 20% they ask of non-investors. No problem; we’d expected that, and we could afford it.
But these construction loans carried interest rates of 6% or more, even with our great credit scores, and the building needed about $25k worth of work. Still no problem; the building was cheap. 6% on a $100k loan would leave us with a mortgage payment of about $850 a month, inclusive of taxes and insurance. Once all units were renting for a projected $350 a month each, we’d have $1400 a month to cover our expenses; that would leave us with a comfortable $550 a month leftover to make improvements and repairs. And of course, our bank assured us, once the project was completed and all the contractors were paid, we could refinance to a lower rate. The math still looked great. (Way better, in fact, than many of the expensive neighborhoods where we could have easily gotten a building.)
Then the mortgage lender casually mentioned that, of course, we’d need to hire a general contractor. That was their rule; it was just too risky to loan construction funds to a non-professional.
If you know anything about general contractors, you know that they won’t take on a $25k project for a full-building rehab dealing with multiple major systems. We had no idea about this, but we learned quickly when we made some inquiries and were basically laughed off the phone.
We called a few more banks, but they either had the same stipulation, or they didn’t offer rehab funds at all. Suddenly, we realized, it was game over on the construction loan.
The Money Chase: Phase 2
When the construction loan failed, the CDC helped us look into a commercial loan. Those loans were in the 5% range, but they carried a big caveat: they were structured as balloon mortgages.
That meant we’d owe a 20% down payment on the total project cost — $25,000, if you’re following along with the hypothetical math at home — and for the first 5 years, we’d pay that nice, cozy, 5% rate. If we kept the building rented, everything would be easy sailing.
But at the end of those 5 years, the balloon — aka, the entire balance of the loan — would come due all at once. And that meant we’d either have to refinance the property, or... well, for the small amount of money we'd be taking in on the rentals, there really wasn't another choice. The banker’s back of the envelope calculation told us that we'd owe about $93,000 after five years, which was way more than we could save in the intervening years off of the rental income, even if no unexpected repairs came up. But of course it’d be fine, the banker assured us; the refinancing, will definitely come through and the balloon will never happen.
But my partner and I were nervous. I mean, come on: we'd read The Big Short. We recognized that taking on a balloon mortgage would, essentially, be betting against the future, and that the "future" in American real estate is always murky. Would we be able to refinance? Assuming we could, would the interest rates have spiked beyond what the buildings’ market rents could reasonably cover, especially given that we weren’t betting on the neighborhood rents rising rapidly (and more to the point, actually wanted the neighborhood to change incrementally)? If those market rates fell, and the building under-appraised, we might be stuck paying a part of the balloon mortgage before we could refinance to a lower rate. What if we couldn’t swing even that smaller amount?
Let's be clear here: my partner and I are both millennials who graduated from college in the midst of the great recession. We're shaky about this stuff because we've seen it go wrong. Could we really trust that a second housing crisis wasn’t on the horizon?
We tossed the idea around, ran a thousand scenarios through a spreadsheet and talked for days about why we were doing this at all. And what we decided was that this loan was designed for a commercial developer, and that’s not what we were interested in becoming. We wanted to be the kind of quality, personal landlords who could promise, within reason, to keep rents stable with the surrounding area, keep good tenants in place, and be a positive part of the neighborhood. We simply couldn’t guarantee that with a balloon hanging over our heads. It would just leave us too fragile.
So it was game over on the commercial loan.
The Money Chase: Phase 3
By this point, we’d been chasing the money to buy this building for the better part of four months. The CDC was patiently trying everything they could to connect us with lenders and creative solutions and wild ideas, but nothing seemed to be working. Grants just weren’t available. Tax credits wouldn’t help us get the money we needed up front. My partner and I even considered scraping the bottom of our savings to self-finance the renovations, but when we ran the numbers, it just made no sense; for all our advantages, I still work for a non-profit, he still works on the staff for a university, neither of us had family help, and no one in this transaction is exactly a millionaire. We wanted to do something good for this block, on a modest scale that was sustainable for us. But it seemed that, unless we went all-in, changed everything about our lives and, formed a housing nonprofit — or, I don't know, found a pot of gold? — we just weren’t equipped to do it well. And if we couldn't do it well — and by "well" I mean, with an emergency fund and an ethical rent ceiling and a commitment to maintaining and gradually improving the building over time — we didn't want to do it at all.
As the months dwindled on, we decided to grab a drink with a friend one night and tell him our tale of woe. He couldn’t believe it — for the amount of money we’d need to put down just to make this building habitable, we could buy a multifamily on a much nicer block tomorrow. With our credit scores, we could get a low-rate $250,000 loan for a turnkey building way easier than we could get a mortgage for this cheap fourplex on a bad block. We could collect more rent and have fewer surprise repairs. Why didn’t we just make the smart choice and walk?
We knew why, of course. We didn’t want to be the landlords of a luxury building whose rents we'd need to keep sky-high just to make the mortgage; we wanted to provide affordable housing that's accessible to most St. Louisans. We didn’t want to invest more money into an already hyper-invested area; we wanted to be a part of a positive change for a region and a group of people that deserved better than what history had given them. B Street wasn’t failing because the buildings were irreparable, or because the people who lived in them were evil jerks who didn’t deserve good homes. There was so much potential there. It seemed to be worth persisting for, even if our patience was running thin.
But then our friend looked at us, and he asked us one more question: how can you be sure that this building will even appraise for the amount of money you’d need to put into it, just to make it livable again?
This was how we learned about the phenomenon known as the appraisal gap.
If you’ve never been through purchase of a home before, you may not know about the stressful steps towards the end of the home-buying process and the havoc they can cause in a declining neighborhood, but here’s the quick and dirty version: A buyer makes an offer on a house for what they believe the home is worth; the seller accepts the offer, and the contracts are drawn up. But if they buyer has a mortgage lender, that bank’s going to require an appraisal of the building’s value before they’ll write the loan; after all, they don’t want to loan you way more money than the building is actually worth, lest you need to sell it before the mortgage term is done and can’t get a future buyer to pay the bank back what they've put in (and lest you don’t have the funds to pay the difference yourself.)
If the building appraisal comes in somewhere around the offer price, everyone’s happy. But if the building appraises too low — let’s say my hypothetical $100,000 four family appraised for only $50,000 — and the seller wouldn’t accept the lower amount, I'd have to pay the difference in a lump sum, or (more likely) the deal would fall through.
And because appraisals are largely based on the recent sale prices of surrounding properties, this is a common scenario in declining neighborhoods. Those boarded up buildings on B street that have fallen into foreclosure? They’re going to knock down the value of my fourplex. The school district with the low graduation rate? That’s going to be another couple thousand dollars off the top. And if the building needs $25,000 worth of work to bring it up to a basic standard of living, but there aren’t any comparable $125,000 fourplexes for blocks and blocks? Well, that was a bad sign for our future on B Street.
My partner and I went home and pored over the local buying history for comparable buildings. Surprise: they didn’t exist.
And that was the moment we realized that there was no way we could responsibly afford to buy this building. We called the CDC, and we said we were extraordinarily sorry, but we would have to walk.
That didn't mean the story was over though...