Flipping Properties and the Seasoning Issue
By Bob Johnson
You won’t be investing very long before somebody will tell you how flipping property is illegal, and your buyers won’t be able to find financing because of the ,seasoning, issue. You may hear this from your accountant, real estate agent, attorney, best friend or grandmother. It seems that everyone’s become an expert on real estate financing. There’s only one slight problem. They simply don’t know what they’re talking about and they’re wrong.
What is \"Flipping\"?
There are two definitions of ,flipping, when it comes to real estate. The first (and original) definition means buying a property and quickly reselling it for a profit. Usually, the property is distressed in some way, and you’ll be reselling it to a rehabber who will renovate the property. The rehabber will then sell the fixed-up property to a new homeowner.
This is also called wholesaling – buy low, sell a little higher. It’s the Great American Way, and it’s NOT illegal. Not in any way, in any state, at any time. It’s a perfectly legal way of doing business. In fact, the Internal Revenue Service will classify you as a Real Estate Dealer if you do this for a living. If they say it’s legal, it absolutely, positively must be legal.
The second definition for ,flipping,, as coined by our thoughtful and informed press corps, is loan fraud – pure and simple. The Department of Housing and Urban Development (HUD) defines flipping as:
,the practice whereby a property recently acquired is resold for a considerable profit with an artificially inflated value, often abetted by a lender's collusion with the appraiser, (HUD Prohibition of Property Flipping in HUD's Single Family Mortgage Insurance Programs; Final Rule; 24 CFR Part 203, Doc. No. FR-4615-F-02).
It refers to buying a junked house, and reselling it to an unsuspecting consumer for far more than it is worth. Usually, that consumer is a low-income buyer who can’t qualify for a normal mortgage, so they jump at the chance to own their own home. Unfortunately, they find out too late that they can’t afford the payments and the home needs a bunch of repairs that they can’t pay for.
So the home goes into foreclosure. The homeowner loses their down payment and credit rating, and the mortgage insurer loses because they have to pay off the loss. The only ones who win are the criminal who orchestrated this fraud, and their associates who helped make it happen. That’s right, you can’t do this alone – it takes an investor, an appraiser, and usually a mortgage broker all working together to pull it off. Note that HUD’s definition says abetted by a lender’s collusion with the appraiser.
What is the Seasoning Issue?
,Seasoning, refers to the length of time that the seller has owned the property. Home buyers cannot obtain a conforming mortgage if they are putting less than 20% down and the seller hasn’t owned the property for at least 90 days. They may even have trouble finding one if the seller has owned the property for less than a year.
The key word here is conforming. A conforming loan is one that complies with all the relevant underwriting guidance provided by HUD. The mortgage company will usually sell this type of loan on the secondary market. If the loan is for more than 80% of the property value, the lender will require that the buyer pay for Principal Mortgage Insurance (PMI) until the loan is paid down below 80% LTV. Most low-income and first-time home buyers obtain FHA, VA, Freddie Mac, or Fannie Mae government-backed loans, which are protected by PMI provided by HUD.
If the buyer quits making their mortgage payments, the lender will foreclose on the property. If the value of the property is less than what is owed on the mortgage, the lender will turn the property over to the PMI insurer. They receive the amount owed, and the insurer (e.g., HUD) liquidates the property for as much as the market will bear. The insurer absorbs the difference between what the insurance paid out to the lender, and what they could sell the property for.
HUD began actively investigating and prosecuting this type of loan fraud when they began receiving (and paying for) a significant number of properties that were grossly over-valued and had gone into foreclosure.
The HUD Guidance on Flipping and Seasoning
On September 5, 2001, HUD published a proposed rule for public comment to address the flipping/predatory lending problem. Since most predatory property ,flips, occurred within a few days, and with only minor cosmetic improvements (such as paint and carpet), HUD proposed time limit eligibility requirements that would prohibit financing (with FHA mortgage insurance) for any property being resold within six months after acquisition by the seller – with a very few exceptions.
The private sector and mortgage industries responded to the proposed ruling, and a modified final ruling addressing many of the concerns was issued May 1, 2003, published in the Federal Register (FR Doc 03-10778, Volume 68, Number 84, Page 23369-23376). This document can be retrieved from Federal Register Online at: http://wais.access.gpo.gov, or
http://a257.g.akamaitech.net/7/257/2422/14mar20010800/edocket.access.gpo.gov/2003/pdf/03-10778.pdf
The official name of the document is the Prohibition of Property Flipping in HUD's Single Family Mortgage Insurance Programs; Final Rule; 24 CFR Part 203, Doc. No. FR-4615-F-02.
Although the final ruling is several pages long, the primary points are:
The time limit eligibility requirements were shortened, but still prohibit financing with FHA mortgage insurance for any property being resold within 90 days after acquisition by the seller,
Between 91 and 180 days, the lender must document the resale value if the resale price is a certain percentage over the purchase price – initially 100 percent, but subject to future revision by HUD. The value may be verified by a second appraisal, or by having the seller prove that the increased value is the result of rehabilitation to the property.
Between 91 days and 12 months, HUD may require the lender to obtain additional documentation if the resale value is 5% or greater than the lowest sales price of the property during the preceding 12 months.
This was originally intended to be used sparingly to address specific circumstances, or locations where HUD identified property flipping as a problem. Of course, many lenders are now applying this provision nationwide, creating havoc for rehabbers.
As an investor, you should clearly understand that this ruling applies only to financing that carries FHA mortgage insurance. These are usually loans designed for first-time homebuyers, through Fannie Mae, Freddie Mac, or the Veterans Administration. They generally require as little as a 3% down payment (or even no money down for certain VA loans).
These are almost always conforming loans that will be sold on the secondary market. The government-backed FHA mortgage insurance provides a safety net to the investors who buy these mortgages. If the loan goes bad and the property doesn’t have enough value to pay off the mortgage on resale, the property is turned over to HUD and the FHA pays off the mortgage balance. The investor is protected by ,the full faith and credit of the United States government!,
When Will Seasoning Be An Issue?
Seasoning is only an issue when you are selling to a homeowner who is trying to obtain financing that carries FHA mortgage insurance.
If you’re wholesaling properties, you’ll be selling to investors – not first-time home buyers. Seasoning will not be an issue.
When you are selling to homeowners who have little money for a down payment, and may have marginal credit – their first choice will be to try to obtain a government-backed, FHA-insured loan.
Confronting the Seasoning Issue Head-On
As the saying goes, ,the best defense is a good offense., Document everything. Keep track of all your costs – closing costs, insurance, materials, labor, utilities, etc. These all get added to your ,basis, in the property, and serve to document the fact that you have, indeed, increased the value of the property.
If you’re rehabbing, you should consider obtaining an After-Repaired Value (ARV) appraisal before you start work, to document the expected resale value of the property. Provide this information to the lender along with your other documentation. This information, combined with the appraisal ordered by the buyer’s lender should prove that the increase in value is justified.
In the worst case, pay for a second appraisal yourself when you sell the property. It must be done by an appraiser approved by the lender. But, a second appraisal will meet the HUD requirements in proving the property value.
Get a copy of the HUD ruling. Read and understand it completely. Get a signed permission from your buyer to talk to their lender’s underwriter. And then don’t be afraid to call and talk to that underwriter if any issues or questions arise. Be polite and respectful, but don’t be afraid to quote verbatim sections of the HUD ruling that support your position.
Just remember, the lender wants to make the loan. They’re just paranoid in that HUD is requiring that they collect and document certain specific information to prove that the increase in property value is valid.
Avoiding the Seasoning Issue Entirely
The simplest way to deal with the seasoning issue is to avoid it altogether. There are at least three strategies that you could use to get around the seasoning issue:
Sell to Investors – Seasoning is only an issue when selling to home owners. So, don’t sell to homeowners – sell only to investors! (You can find more tips and ideas at: http://www.buying-investment-property.info/)
Use Non-Conforming or Portfolio Loan Products – Lenders usually enforce the HUD rulings on loans that they are going to resell on the secondary market, because these loans are covered by FHA Principal Mortgage Insurance (PMI). Other types of loan products are available that are covered by Primary Mortgage Insurance (also PMI) provided by insurance companies, rather than the government. Some of these lenders conform to the HUD rulings, but others do not. The loan products that do not conform will not usually have a seasoning requirement.
Many lenders keep loan products rather than selling them on the secondary market. These are called portfolio loans. Actually, some of the largest consumer mortgage companies keep a surprisingly high percentage of their loans rather than selling them on the secondary market. Many of these portfolio loan products have no seasoning requirements.
Help your buyer find a source for non-conforming loan. This doesn’t necessarily mean that it will be a sub-standard loan or be any more expensive than a conforming loan. It only means that the loan won’t be insured by FHA-backed mortgage insurance. Non-conforming loans are available from a wide variety of sources, for buyers with all types of credit (A-D).
Use Lease/Options – Seasoning is only an issue if you have owned the property for less than 12 months. One way to delay the actual purchase is to enter into a lease with option to buy. The buyer won’t actually purchase the property until several months or years from now. But, you’ll receive a monthly rental income until the time that they exercise their option to buy the property. If they can find a nonconforming lender before the option period is up, they could execute the purchase option early with no penalty.