Loans of Your Own

For most remodelers, the offer of financing consists of matching up the customer with a lender, whether that lender is a big finance company or a local bank. The remodeler makes no money on the deal, but also assumes no risk. The payoff is in the quality and volume of work they get, as well as in happier customers.

But some remodelers have chosen to bring their financing activities in-house. These companies have deep enough pockets — and strong enough nerves —to assume all the risks and rewards of financing by lending their own money to customers.

One such company is Custom Design & Construction (CDC) in West Los Angeles, Calif. Its owners have built up a supply of capital that enables them to finance projects. Randy Ricciott, CDC production manager, says that his staff makes homeowners aware of the financing option during the initial conversation, and that 50% to 60% of them opt to take it.

CDC doesn't technically fund projects itself. Instead, the owners have formed a separate legal entity, Custom Funding. According to Custom Funding's Bill Simone, the main benefit to this legal distinction is the ability to defer taxes. When CDC sells a financing contract, Custom Funding purchases the contract at a cost that just covers the cost of construction. On paper, CDC operates at break-even. Job profit is included in the payments that Custom Funding collects over time, as borrowers repay their loans. That means it pays taxes on the profit only as it collects the money. “The owners aren't paying any less tax,” Simone says, “they're just deferring it.”

Although the company will write loans based on a full 30-year amortization, it usually only carries loans for a year or two. It writes the note as a second mortgage. In the past, homeowners typically went to the bank to refinance, rolling the first and second mortgages into a single loan. So far, he hasn't seen this changing with rising interest rates. “Psychologically, people don't seem to like carrying first and second mortgages,” he says.

One advantage for customers is that CDC can give homeowners what Ricciott calls “almost instantaneous” pre-approval, and thus can quickly close deals before the homeowner has second thoughts. The underwriting process is also quick. “We have the wherewithal to run credit checks with all the major credit bureaus. We do a property profile, including chain of title. And we use our real estate expertise to do our own appraisal. Because we know the value of the existing residence and the value of the work, we can confidently predict whether, at the completion of project, the improved real estate will carry the value of the note.” Once CDC has all the information in hand, it can complete the underwriting in less than an hour.

Because companies like CDC loan their own money and make their own loan decisions, they can often loan more than a traditional lender would for a given project. “In-house financing not only gives us the opportunity to do projects that we wouldn't have otherwise, but also allows us to deliver a project that completes the homeowner's vision,” Ricciott says.

The core requirement is capital — and lots of it. Assuming that you will finance 60% of your jobs, Simone advises having three to five times your monthly sales volume in cash on hand. In other words, if you sell, on average, $100,000 per month in work, it would be good to have $500,000 in the bank. “The average life of the loans we hold is in excess of 72 months, so it's a long time on the street. It takes that much capital to continue to sell jobs before those things pay off,” he says.

Like any smart lender, Simone advises not financing any more than the equity in the house will carry. If there is little or no equity in the house, however, and the homeowners have high incomes and great credit, he may finance the job profit. On a $200,000 job where costs are $120,000, he will ask for a $120,000 down and finance the rest.

Of course, sometimes things don't work out for even the most careful lender. If you lend money, you have to be willing to risk losing it. Managing that risk requires more than just deep pockets. It also requires the ability to accurately judge someone's creditworthiness and the willingness to be creative when borrowers get into financial trouble.

Although some of the founders of Custom Funding had the advantage of a banking background, Simone says that's not a prerequisite. What is needed is an understanding of credit ratings and property values before and after improvement, and the ability to judge buyer character. Even with those qualifications CDC has still had to take some losses. “Not everyone is going to pay. Things that could cause a loss or default include local market conditions, employment loss.”

Which begs a question: What's the chance of recovering your investment if the first-lien holder forecloses? Simone says it's a real concern. “If you really want to protect your interest, you might have to show up at the public auction with enough cash to buy the house.” He says that's another reason you need three to five times monthly volume in cash on hand if you want to play this game.

Surprisingly, making in-house financing a realistic option may not require as much sales volume as some might think. “There's no real minimum,” Simone says. “For me, it's really an exit strategy: When I'm done [with the business], I know I'll have no less than 72 months of income stream that can be sold or retained.”

One other benefit of legally separating the construction and finance activities is that the remodeling company is less tempted to lose its focus. In fact, Ricciott says that the company's primary motivation for doing its own financing has always been to improve customer service. “We're a design/build remodeling company. Our intent is to be a one-stop shop, providing everything from design to construction. That includes offering financing where appropriate.”