How Construction Draws Work on Fix-and-Flip Loans, and Where Lenders Get Burned
Most rehab loans hold back the renovation budget and release it in stages. The draw process is where a lender's collateral is created, or quietly lost.
Why it matters
- The rehab holdback is often a large share of a fix-and-flip loan, and it is funded after closing, when the lender has the least control.
- Funding ahead of completed work leaves the loan larger than the improved property can support.
- Unpaid contractors can file liens that cloud the lender's title.
Explainer: background on how this part of the market works.
A typical fix-and-flip loan has two parts. One part funds the purchase at closing. The other, often called the rehab holdback or construction reserve, covers the renovation budget and is released in installments, or draws, as work is completed.
The design protects the lender: money goes out only as value is added to the property. In practice, the draw process is where many rehab loans go wrong.
How a draw works
- Budget and scope of work. Before closing, the borrower submits a line-item budget, such as demolition, roofing, electrical, kitchen and finishes. The lender reviews it against the property and the after-repair value.
- Borrower does the work first. In most programs, the borrower or contractor completes a stage of work with their own funds, then asks to be reimbursed.
- Draw request. The borrower submits a request listing the line items completed and the amount requested, often with photos and invoices.
- Inspection. The lender confirms the work through a third-party inspector, a staff inspection or a photo- and video-based remote inspection.
- Title check. Many lenders run a title update before funding to confirm no new liens, such as mechanics' liens from unpaid contractors, have been recorded.
- Funding. The lender releases the approved amount, sometimes minus a draw or inspection fee, to the borrower or directly to the contractor.
Where lenders get burned
Front-loaded budgets. A budget that puts too much money into early line items lets a borrower draw most of the reserve before the hardest work is done. If the project stalls, the remaining holdback may not be enough to finish.
Paying for percent complete, not value. An inspector may report that a kitchen is 80% complete, but the property may not be worth more until it is finished. Funding on progress without tracking the cost to complete can leave too little money for the rest of the job.
Unpaid subcontractors. If the borrower is reimbursed but does not pay the people who did the work, those contractors may have lien rights against the property. Lien waivers and title updates exist to catch this.
Slow draws. Draws that take too long to fund can stall a project and push it past its maturity date. Borrowers notice, and the best ones move to lenders that fund faster.
Controls that work
- Review budgets line by line, and compare them against the scope of work and local costs.
- Track the cost to complete after every draw, not just the amount drawn.
- Require conditional and unconditional lien waivers from the general contractor and major subcontractors.
- Run title updates before significant draws.
- Set a clear turnaround time for inspections and funding, and meet it.
- Watch for change orders that move money between line items without a reason.
Why it matters more now
With rates higher and some takeout loans getting smaller, as we explain in our guide to how DSCR loans are sized, there is less room for a project to run over budget or behind schedule. A disciplined draw process is one of the few parts of the loan a lender fully controls after closing.
Sources
- This explainer describes common industry practice. Specific draw procedures, fees and inspection requirements vary by lender and by state lien law.
