Understanding Draws: A Must-Know Concept for Real Estate Investors

As you venture into the fascinating world of real estate investing, you'll quickly discover that understanding the financing aspects of the business is just as important as identifying the perfect property. Among these, the concept of "draws" stands out as a crucial element, particularly for those eager to dive into fix-and-flip projects. This mechanism, fundamental to rehabilitation loans, could be the key to successfully funding and managing your renovation costs. In this article, we'll unpack the concept of draws, breaking down its process, advantages, and how it serves as a financial lifeline throughout your fix and flip journey.

Imagine you're a real estate Indiana Jones. You've navigated the winding corridors of listings, avoided the traps of overpriced houses, and you've finally found it – the elusive 'fixer-upper' that promises a fortune when flipped. But there's a catch. It's a diamond in the rough, and you're going to need funds to polish it into a sparkling gem of the market. But where will the money come from? How will you ensure it doesn't dry up halfway through the refurbishment? That's where our unsung hero, the mysterious concept known as a 'Draw', swings in, just in time to save the day!

A draw, in the thrilling adventure of real estate investing, is like the periodic refilling of your treasure chest. It’s not just one lump sum of gold coins; it's a series of payments that come to your rescue at different stages of your fix-and-flip journey.

Here's the plot: you’ve secured a rehabilitation loan from a willing financial adventurer, your lender. Together, you chart a map – a 'draw schedule'. This plan breaks down your quest into stages, marking each with a specific task and cost, such as demolition, structural repairs, or interior renovations.

Each time you complete a stage of work and tick it off your map, you signal for your lender, who sends an inspector, your trusty sidekick, to confirm your progress. Once the work's approved, the lender unlocks the next chest of funds, equipping you for the next stage of your journey.

Think of this draw system as your financial lifeline, a trusty whip to help you swing across the renovation chasms, ensuring you're never stranded without funds midway. But beware, as with any adventure, understanding the rules of the game is key, and planning wisely can be the difference between a successful flip and a financial flop.

Here's a step-by-step explanation of how a draw works in a fix-and-flip scenario:

1. Loan Approval: The investor applies for and secures a rehabilitation loan from a bank or other lending institution. This loan is specifically for the purpose of repairing or improving the property.
2. Project Planning: The investor and their contractor create a detailed repair plan, itemizing the work to be done and estimating the costs involved. This plan is shared with the lender.
3. Draw Schedule Creation: Based on the repair plan, the lender and the investor agree on a "draw schedule". This schedule breaks down the project into stages, with a set amount of money to be disbursed at the completion of each stage. For example, there might be a draw for demolition, another for framing, another for roofing, and so on.
4. Work Commencement: The investor begins work on the property. This often involves hiring contractors to perform the necessary renovations.
5. Draw Requests: After a stage of work is completed, the investor submits a draw request to the lender. This request is essentially asking for the next installment of the loan to pay for the work that's been done.
6. Inspection: Upon receiving a draw request, the lender often sends an inspector to verify that the work has been completed as planned. The inspector's job is to protect the lender's interests by ensuring that the loan money is being used appropriately and progress is being made on the project.
7. Funds Disbursement: If the inspection is satisfactory, the lender releases the funds as per the draw request. These funds are used to pay the contractors for the work they've completed.
8. Project Completion: This process of completing work, requesting draws, inspecting, and disbursing funds continues until the project is complete. At that point, the property is typically sold, or "flipped," and the loan is repaid with the proceeds.

One important note is that the specifics of the draw process can vary between lenders. Some lenders may release funds for materials upfront, while others only disburse funds for completed work. The interest rates, fees, and other loan terms can also vary widely, so it's important for investors to shop around and understand the terms before accepting a loan.

Moreover, it's crucial to keep the renovation timeline as short as possible. Delays can increase holding costs, which can cut into the final profit. Proper planning, timely work, and accurate draw requests can help keep the project on track.

The amount of money you need to put into a project before a draw can be initiated largely depends on your specific agreement with your lender. The terms of the loan and the draw schedule would usually specify this. However, a common practice in fix-and-flip financing is that the lender would provide a loan for a certain percentage of the purchase price (usually around 80-90%) and a certain percentage of the renovation costs.

In this case, you'd need to put in the difference between the purchase price and the loan amount, plus any additional funds needed to start the renovations. For instance, if you bought a house for $100,000 and received a loan for 90% of that, you'd need to put in $10,000 of your own money to purchase the property.

When it comes to renovation costs, it often depends on the specific work being done and the terms of your loan. Some lenders may disburse the first draw after certain work has been completed, meaning you'd need to cover those initial costs out-of-pocket until the draw is released.

Let's consider a renovation budget of $50,000, with the first draw for demolition and cleanup being $10,000. If your lender disburses the first draw only after the work is completed and verified, you'd need to pay for the demolition and cleanup upfront and then request the draw.

Let's use a fictional example. Same number as up above, let's say that you've purchased a house for $100,000, and you estimate that it will need $50,000 worth of repairs. You secure a rehabilitation loan for $50,000 to cover these costs.

The loan will not be given to you in a lump sum, instead, it will be divided into draws based on a pre-arranged schedule. Here's how a simple 5-draw schedule might look:

1. Draw 1 - Demolition and Cleanup: $10,000
2. After you've paid and completed the initial cleanup and demolition work, your lender sends an inspector to confirm that the work has been done. Once confirmed, the lender releases the first $10,000 of your loan to pay for this work.
3. Draw 2 - Structural and Exterior Work: $15,000
4. Next, you move on to any structural work, including exterior renovations like roofing or siding. Once this is completed and confirmed, you receive the second draw of $15,000.
5. Draw 3 - Interior Framework and Systems: $10,000
6. This draw covers framing out new rooms or walls, as well as any plumbing, electrical, or HVAC work. After the work is done and verified, the third draw of $10,000 is disbursed.
7. Draw 4 - Drywall, Paint, and Fixtures: $10,000
8. Once you've finished installing and painting drywall, as well as installing basic fixtures (like lighting, faucets, etc.), the lender releases the fourth draw of $10,000.
9. Draw 5 - Final Touches and Landscaping: $5,000
10. The last draw covers the finishing touches like flooring, cabinetry, appliances, as well as any landscaping. After the final work is completed and confirmed, you receive the final draw of $5,000.

This is a simplified example, but it gives a basic idea of how the draw process works. The actual draw schedule can be more detailed and specific, depending on the lender's policies and the scope of the renovation project. As a fix and flip investor, it's crucial to have a clear understanding of your loan terms and the specifics of your draw schedule. This will help you plan your budget effectively and avoid any cash flow issues during the renovation process. It's also a good practice to have a contingency budget for unexpected expenses.

As we pull back the curtain on the process of draws, we see their integral role in the realm of fix and flip real estate investing. This systematic approach to fund disbursement acts as a financial safety net, ensuring that your renovation journey is well-equipped at each step. Remember, understanding and navigating the intricacies of draws is like having a compass in the unpredictable seas of real estate investing. As with any adventure, the more tools and knowledge you have, the more likely you are to find success. While the draw system does provide substantial financial support during the renovation process, it's crucial for potential investors to understand the initial financial requirements (10%-20% downpayment which includes the purchase price and renovation costs plus the funds to get from draw to draw). A well-structured financial plan, including a clear understanding of the funds needed for the down payment and to bridge the gap between draws, is a key ingredient in the recipe for successful real estate investing. So, here's to charting your course wisely, navigating your rehabilitation projects strategically, and making the concept of draws an ally in your real estate investing adventures. Happy flipping!