“If agents had a heart, they would say — how could we strengthen you as a buyer? One way is to stop looking at the same properties the competition is,” said Snover, a loan originator with Flagstar Bank in Andover, Massachusetts. “They’re not buying properties that don’t look good from the street.”

With stagnant inventory and fierce competition for homes, however, being willing to rehab a fixer-upper could give buyers an edge. Lenders expect consumer interest in renovation loans to remain elevated in the near- and medium-term, especially in light of many companies’ move to keep at least some of their workforce remote.

Purchase-reno loans aren’t for the faint of heart

Even with COVID-19 shutdowns and surging construction costs, homeowners in 2020 turned to renovation loans roughly as much as they did in 2019. In 2020, lenders originated $51.7 billion in renovation loans, compared to $51.6 billion in 2019, according to an analysis of 2020 preliminary HMDA data by iEmergent.

Those figures do not count the homeowners who refinanced in order to fund renovations — or the ones who put the new home office addition on a credit card.

For borrowers who wish to take the fixer-upper plunge, there are two primary programs used to finance a home renovation. The 203K, administered by the FHA, covers the cost of the home plus the cost of the repair, and requires between 10% and 20% of the total loan amount be set aside as a contingency. The 203K requires a HUD inspector and consultant and can’t be used for “luxury” items such as pools. The loan requires a 1% origination fee from the borrower, who also pays closing costs of between 3-to-6%.

The Fannie Mae Homestyle program, for conventional borrowers, requires that repairs be completed within 12 months. It also requires a contingency be set aside for cost overruns, but doesn’t require a HUD inspector or consultant. It similarly requires the borrower to pay closing costs and origination fees.

Both programs offer financing based on the “as completed,” or future value of the property, based on an appraisal which takes into consideration the planned additions. The Homestyle program can be used for investment properties, though the 203K loan is only for primary residences.

There aren’t many limits on the types of renovation projects for a Homestyle loan, as long as they add value to the home.

In both programs, the lender typically pays the contractor directly, after conducting inspections to make sure the renovations add value to the property.

The programs, which both allow for downpayments below 5%, can be difficult to navigate during normal times, as projects grow or change mid-stream, after construction begins. There are often surprises when removing walls or floors, and that’s before factoring in rising construction costs. It’s a challenge for borrowers who must hew to a fixed budget and stick with a project plan.

One major pain point is the soaring cost of building materials – wood, steel, metal, gypsum are all more expensive since the pandemic began. 

Lumber is up from $328 this time last year to an eye-popping $1,326, according to Chicago Mercantile Exchange random length lumber futures. Lumber alone has pushed the cost of new builds more than $24,000, according to the National Association of Home Builders.

Ed Currie, a loan officer at Associated Bank, quickly rattled off the current price of lumber, which he keeps updated on his desktop computer.

“It looks like a Google chart from 1999,” Currie said.

So, what happens when the price of lumber doubles while you’re replacing a wall in your house? According to Currie, the borrower either has to cough up extra cash, or limit the scope of the fixer-upper project. Only very rarely, he said, does a borrower ask for more cash.

“If you have overages, if lumber costs go up, that’s on you, you need to cover that,” said Currie.

That also adds to sellers’ typical apprehension toward construction loan financing. Sellers get “a little squeamish,” Currie said, because they don’t want the transaction to be dependent on a future appraisal.

Buyers are soldiering on, however. Currie said Associated Bank saw about a 50% increase in renovation loans last year, mostly driven by an influx of buyers who were turned away from larger lenders who paused construction and renovation loans in 2020.

Despite the turmoil in the lumber market, no changes were made to the renovation loan programs. Contractors, who do not typically get paid until they’ve completed a portion of the construction project, have started requiring “lumber allowances” upfront.

Some homebuilders are waiting out the surging lumber prices, said Nate Noel, a real estate agent at Baird & Warner, who also has a construction company, HNN Builders, in the Chicago area.

“They’ve dug the foundation and clients are holding off 3-6 months in the hope that lumber prices will go down because it’s a $50,000 difference,” said Noel.

Competing with the flippers for fixer-uppers

Even for fixer-uppers, competition can come from a different profile of home-shopper — those representing investors, who wish to purchase the property, quickly renovate the home and sell it for a tidy profit (or convert it to a rental property).

Where sellers are wary of the complicated construction lending process, CIVIC Financial Services offers an alternative. 

CIVIC purchases the house on behalf of investors and handles the construction financing in-house, all without the “red tape” of the conventional lending process, said Whit McCarthy, the company’s senior vice president of correspondent lending.

Whereas a typical borrower could be waiting for callbacks from contractors and municipal permits in order to close on the fixer-upper, CIVIC can close on a run-down house in two weeks.

Investors are motivated by the ultimate return on the investment, which McCarthy explained is a function of “buy for X, put Y into it and sell for Z.” Disciplined investors only want transactions with a specific margin — if X and Y are too great, and Z is not enough, the deal isn’t worth it for an investor.

“There are plenty of scenarios where there’s no margin in the deal,” said McCarthy.

Investors constrained by their margins could still be outplayed by homebuyers willing to offer more for a fixer-upper they intend to live in.

“It increases your buying power for those run-down houses that are always being bought by developers and general contractors to flip and fix or turn into rentals,” said Noel. “Homebuyers don’t need the 20% margin that developers need. They just need to live there.”