Real Estate 016: Types of Financing Options for Rental Real Estate

In the latest real estate blog post, I discussed the importance the lender plays in your real estate team, how to find a lender, and the questions to ask when interviewing the right partner. Today I want to take a deeper dive into the different types of financing options available for rental real estate, which are: conventional mortgages, commercial, portfolio loans, and private/hard money loans. Below is a breakdown of the different types of loans:

Conventional Mortgages

Generally speaking, investors who are starting out with less than 10 properties, will most likely be seeking conventional mortgages. The reason is that these loans offer the best interest rate with long amortization (as of this writing, around 5% interest, 30 year amortization). There are other terms such as 15 year amortization, and variable interest rates that increase after a set period (e.g. 5 years), however, fixed 30-year loans are the most common type of conventional loan that allows you to maximize your leverage and cash flow.

Further, these loans are regulated by the Federal Government agencies like Fannie Mae and Freddie Mac, large national banks, local banks, and credit unions typically all offer this program. By having a government backed loan program, financial institutions are able to sell these loans back to Fannie Mae and Freddie Mac if they choose to do so for a profit. Contrarily, they can also decide to service the loan in-house and keep the mortgage on their balance sheet.

The financial institutions providing the loan will underwrite the deal per Fannie Mae and Freddie guidelines as well as their own overlays (additional requirements). The basis of underwriting the loans include the financial health of the borrower (e.g. credit score, income/debt ratio, reserves) as well as the strength of the deal (e.g. debt service coverage ratio). These loans are typically easier to find across banks and you will qualify for as long as you meet certain requirements.  

Commercial loans

If conventional loan underwriting focused on the borrower as an individual, commercial loans focus on the property itself more heavily. Commercial lenders are typically lent to business entities such as an LLC, and may be a requirement prior to close. Further, the interest rates related to commercial loans may be higher than conventional loans as they are for business purposes and considered higher risk. Furthermore, commercial lenders will place a balloon payment around 5, 7, and 10 years and reduce amortization to 15, 20, or 25 years compared to a conventional loan with no balloon payment and 30 year amortization.

As the commercial lender is focusing on the health of the property/deal in question, there are 3 areas that they generally review: 1) net operating income - used to understand the profitability of the deal 2) condition of the property (turnkey, cosmetic rehab, gut rehab) and 3) location of the property (A class, B class, warzone, etc.)

 Further differences between commercial and conventional lenders relate to the appraisal process. The appraisal the commercial lender orders has three types of approaches: Two of them are an income approach and a sales comparison approach. At times the commercial lender orders a cost approach. For the residential lender, his appraisal uses the cost approach and the sales comparison approach, with the latter being most widely used. The income approach used by the commercial lender is important because it focuses on the net income of the real estate property and its ability to “stand on its own.”

 In commercial lending, some lenders require that the borrower has experience in owning commercial property. This factor is considered as the lender views owning rental property with a commercial loan as owning a business, which requires experience to succeed and pay back the debt. The commercial lender may also review the loan to value which is the quotient of the amount of the loan divided by the value of the property. As such, an 80% Loan to value on a hundred thousand dollar property would mean that the borrower is getting an $80,000 loan. A key difference is that commercial lenders may have flexibility in borrowing down payment funds as well as financing up to 90% or 100% LTV if the deal is strong enough.

 Lastly, another key difference between a commercial real estate loan and a residential real estate loan is that commercial lenders have more strict requirements as it relates to the Debt Service Coverage Ratio (DSCR). In short, the Debt Service Coverage Ratio looks at the property’s ability to cover payments and have margin left over. Margin is important so that the borrower will have enough cash flow to pay for unforeseen expenses – plumbing, electrical, roof, vacancy, reduction in rents, etc.

 Portfolio Loans

Portfolio loans are offered to investors by select banks and financial institutions who are willing to lend their own money and service the loan. As they are not backed by Fannie Mae or Freddie Mac, they have more flexibility in underwriting and qualifying the borrower for the loan. Similar to commercial lenders, the portfolio lenders focus more heavily on the deal itself, the ability of the property to produce a profit and repay its debt, and the experience of the borrower. As such, if there is a strong enough deal, these portfolio lenders can lend on less down payment (5-10%) and update terms as they see fit (e.g. lower interest, longer amortization, later balloon payment). A key benefit in using a portfolio lender is the ability to obtain more loans after you have the Fannie Mae limit of 10 conventional loans per person. However, a major drawback may be that banks and financial institutions are stricter than conventional lenders and your loan request may be requested more times than not depending on the strength of the deal.

Private/Hard Money Lenders

Private lenders and Hard Money Lenders are often used interchangeably in the real estate forums and meet ups, however, I believe the key distinction is that private lenders are typically your mom and pop shop lenders whom you have a pre-existing relationship. These people can be your parents, other family members, friends, and co-workers. Hard Money Lenders, on the other hand, are sophisticated investors who purposefully pool their money, or directly lend their own money to other investors for interest and/or fee.

As it relates to the purposes and terms of these loans, they can be the same, but it differs from lender to lender based on the risk of the deal, and return these lenders would like to make on their money. For example, there are fix and flip hard money lenders who lend a minimum of 50K up to 500K for 12 months or less at 10-14% interest (based on LTV), and a $2,500 fee. Private lenders can also decide to have the same aforementioned fees, but can also decide to loan you the money at 6% interest and no fee. The beauty of private lenders is that it varies from person to person, deal to deal, so depending on your relationship, strength of the deal, and wants of the lender, you can obtain financing that is even better than conventional, commercial, portfolio, and hard money loans.

In addition to flexible terms, a huge benefits is that you can also find lenders with less paperwork requirements as their underwriting is unique. Some lenders may request documents such as W-2, tax returns, rehab budget, appraisal, inspection report, and your experience with real estate, while other lenders may give you the money simply based on reviewing the deal’s proforma. Lastly, conventional, commercial, and portfolio lenders may try to avoid properties than need extensive rehab, but a savvy investor may see potential in doing the work themselves. This creates a great opportunity for an investor to partner with a private or hard money lender to purchase the deal, fix it up, and create forced equity (appreciation) and refinance with a long-term conventional or portfolio lender.

In summary, most real estate investors will want to maximize the use of their 10 Fannie Mae conventional loans, and then seek other types of financing such as private loans, commercial, and portfolio loans. Each type of loan serves a purpose and knowing different tools will help you take down more deals, creatively, efficiently, and for maximum profit.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 015: Finding a Lender to Finance your Rental Properties

Now that you have learned about the benefits of real estate, how to identify a market, analyze a deal, and applying different strategies, it's time to understanding the financing. As David Greene mentions in his book “Long-Distance Real Estate Investing”, there are a “core four” you need in your real estate team that is comprised of the deal finder, the property manager, the contractor, and the lender. Today we will be discussing the lender and their role in financing your deals.

Before you start looking for properties, it's important that you receive pre-approval from a potential lender to understand your buying power. This will also give you a leg up on the competition because it shows the seller you are a serious buyer who is capable of closing. In a hot market, a pre-approval is a minimum requirement to get your foot in the door and have your offer be reviewed.

When you are looking to build a relationship with a lender, you may come across direct lenders as well as mortgage brokers. In short, direct lenders are actual lenders such as banks and credit unions that will have in-house underwriting and review your documents themselves. On the other hand, mortgage brokers will connect you to different programs that they have build a network around and be an intermediary between you and the final lender from start to finish.

There are pros and cons to using direct vs a broker as a direct bank may have more flexibility in terms of removing some of their own underlays as well as the convenience of dealing with on shop when doing multiple loans across your portfolio. On the other hand, brokers are able to shop around rates with different banks and also become your advocate in terms of trying to get you the best deal possible. In addition, you may come across complex deals that the direct lender you have worked with in the past is unwilling to lend on. This is when the mortgage broker can speak with multiple banks in hopes to find a lender who will loan you the money.

Finding a lender will vary depending on where you want to invest as well as your asset class. For the purposes of this discussion, we will assume that we are seeking residential mortgages for 1-4 unit rental properties in the state of Missouri. As your lender needs to be licensed in the state in which your property is located, it may benefit you to find a national lender who has the license and knowledge to lend in most if not all 50 states. To find a lender, you can ask your investor network, Biggerpockets forums, and local real estate property managers and agents, you may notice names being repeated as lenders who have a high reputation for being investor friendly and closing deals are sought after.

Once you have identified the lender you would like to work with, it's important that you ask them good questions to ensure that you understand one of the core members of your core four. Remember that you do not have to “impress” them as they too are trying to earn your business. Some lenders do not like to work with investors, a quick interview is also a good way to measure how responsive the lender may be and also see if they are investor friendly.

When you are obtaining a Fannie Mae (conventional) mortgage, banks have to adhere to certain rules and regulations set by the government agency, however banks can have their own “overlays” and rules (e.g. maximum 4 properties per person vs 10), so it's important to be able to identify the differences between Fannie Mae’s requirements and the bank’s additional overlays. It may be disadvantageous for an investor to work with a bank with multiple overlays which restrict the investor from scaling their portfolio. Below are some basic questions you may want to ask your potential lender:

1. How many loans do they close per month (understand the bank’s volume and experience. A bank doing 35 loans a month may know how to navigate complex situations vs a bank doing 3 loans a month as they will have seen more unique cases).

2. What type of loan programs are available? (e.g. Owner Occupied, Non-Owner Occupied, VA, FHA, Conventional, Portfolio, Delayed-Refinance)

3. What states are you licensed to operate in?

4. What are your minimum and maximum loan amounts

5. What paperwork is required, Debt to Income (DTI), Debt Coverage Ratio requirements?

6. What are current interest rates for a FICO score of XXX?

7. What fees are involved (administration, closing costs, etc.)

8. What is your average time to close?

9. What is the maximum number of loans per person?

10. What are the reserve requirements per loan, do you help investors with planning for multiple loans?

The answer to these questions will vary from lender to lender and I would recommend you interview at least 5 lenders to understand the differences and similarities across the market. Once you have selected a lender you would like to work with, you will need to submit the paperwork required to get pre-approved. This will result in a hard inquiry and briefly lower your credit score, so make sure you are ready to purchase a home in the near future. Once you are pre-approved, you are ready to make an offer on a property.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 014: To buy or rent, that is the question

For people who are looking to move, there is always the question that one asks themselves, “is it better to buy or rent?”. At the time of this writing, the US real estate market has seen close to 8-9 years of solid year over year appreciation. While no one has a crystal ball, history tells us that the real estate market goes up and down through different cycles that last as short as 6-7 years to as long as 10-12 years. Whether you are single, newlywed, or have a growing family, the decision to buy or rent can have multiple trickle effects to your financial situation and future trajectory. It is a very important decision. Many people see their friends buying their homes, market going up, and wonder if they need to buy now as well. Let's take a look at some of the pros and cons of buying a house vs renting as well as other factors to consider before making this decision.

Before you even jump into the idea of looking for a house to purchase or contacting a realtor for showings, you need to have your finances in order. This can include reviewing your credit score through your annual free checkup via the three major credit bureaus (Transunion, Equifax, Experian) or you can sign up for free services such as CreditKarma.com (I personally use this and love the ability to check my score through a “soft inquiry” that doesn’t negatively impact your score. ALthough the credit score you see on Credit Karma may end up being lower than what your mortgage lender actually sees when they pull your FICO score, in my experience, it has been very close (+/- 5 to 10 points).

Although its widely accepted that owning your own home is part of the “American Dream”, there are alot of things that come along with owning your home. You have to ask yourself if you are ready to handle the extra costs and maintenance that comes with owning a home. Furthermore, look at other areas of your finances to determine if you can withstand any sudden life changes (e.g. new baby, loss of job, job relocation):

1. Do you have an emergency savings account with roughly six months of expenses?

2. Do you have any large student loans or credit card debt that may have variable interest?

3. Do you have down payment + closing costs saved for your new home?

4. Will your new mortgage be under 30% of your debt to income ratio? (DTI) - Lenders look at this as a metric to determine if the borrower’s capacity to repay the loan.

5. Does your job require you to move frequently? (e.g. state to state or military)
   

If you have answered “yes” to any of the above, there is a good chance you may need to wait a little longer before you decide to purchase and think hard about this move.

Assuming you have decided that renting is out of the question and you are ready to buy, let's consider some of the pros and cons of buying a house.

Advantages

1. Building Equity

By purchasing a house with “other people’s money” (e.g. bank or private lender), you are able to lock in a payment (typically fannie mae 30 year fixed rate mortgages) where you build equity as long as you are current on your loan. As the loan is being amortized over 30 years, the first 12-18 years will mostly be interest payments, however, you still will increase share of ownership compared to a lease situation. Furthermore, as your payments are fixed (unless you have variable interest mortgage), you are not impacted if your landlord wants to raise rents 5-10% each year over the next 10 years, or are you impacted if the landlord decides to sell and not renew your lease, in which case you are forced to move.

2. Tax Benefits

The US tax code allows us to deduct interest associated with your home’s mortgage as well as property taxes. Note: There may be other tax favorable treatments, but please consult your CPA to determine what fits your unique situation. Further, starting 2019 tax year, the standard deduction has increased to $12,000, meaning your the break even point on standard deductions vs itemized (tax benefits mentioned above) has gone higher. You need to evaluate the price point of the home, as well as possible tax advantage amounts before assuming one is more beneficial than the other

3. Appreciation

Generally speaking, US real estate has appreciated over a long period of time. However, there also have been multiple down turns that have had negative consequences to homeowners who wanted to sell. I personally consider appreciation to be icing on the cake, as speculation can be a very dangerous gamble from an investment standpoint.

4. Pride of ownership

As a homeowner, you have the freedom to do make updates to your home as you please (within laws/regulations, HOA guidelines, etc.). This means that there is no landlord to stop you from using nails to hang picture frames, paint the baby room purple, or have a vegetable garden in the back lawn. Furthermore, some view a home as a long-term situation compared to leasing, as such you may psychologically feel more attached to your house, neighborhood, and feel grounded.

5. Using Leverage (Bonus - Investor’s Perspective)

This last advantage has been mentioned less by potential buyers evaluating decisions as most new homebuyers do not think like an investor. However, as an investor myself, I like to purchase my primary residence as I know there are a couple different ways to make money.

In my neighborhood, I was renting a 2 bedroom apartment for close to $1,800 a month. However, after 1 year, I decided to purchase a 3 bedroom townhome which resulted in monthly expenses of $2,700 a month. When normalizing the tax benefits I would receive on this property, I was able to credit about $300 a month to the “buy” side ($2,700 - $300), making it a $1,800 vs $2,400 decision, with the difference being $600. I ended up renting out one of the bedrooms for $750 a month which actually made my decision to buy $150 cheaper per month. Furthermore, the price of the home increased $70,000 over two years when I received an appraisal for a HELOC (home equity line of credit). Using this HELOC, I purchased two additional rental properties that cash flowed $700 a month after all expenses - $200 HELOC payments = $500 additional cash flow, which further brought my “buy” side down to -$650/month. Looking back, this was a no brainer for me, and I would gladly make these decisions again as I am creating equity in my primary home and two rental properties, have tons of tax benefits, reduced my cost of living, and did this all using other people’s money. Note: Not all home purchases can result in my experience, in fact, if you buy too much of a house in coastal markets of LA, NY, SF, etc. then you will probably lose money most of the time vs leasing. However, if you buy slightly undervalued properties at the right time (historical low interest rates 2012-2015), then you have a good chance of success.

Disadvantages

1. Lack of Flexibility

Due to the costs associated with buying, maintaining, and selling a home, there are fixed costs that require you to wait, or season, before you will break even. For example, if you have purchased a home and 6 months down the road you need to sell, unless the home has appreciated 10% or more, closing costs (transactional + commissions, etc.) alone may put you in the red. If you are not sure that you will be staying in a certain location or job for 2 or more years, it may be best to rent until further notice.

2. Dealing with maintenance

As a renter, when there is a leaky pipe, or broken toilet, you call your landlord. Unless there was excessive damages caused by you, the landlord is responsible for wear and tear, as well as general upkeep of the home with due notice. Once you become a homeowner, that switch is flipped and you are responsible both financially and mentally dealing with the stress of the repair.

3. Opportunity Cost

The difference in total cost of owning a home - leasing = financial opportunity cost. You may be better off using the difference to invest in the stock market, real estate, or other self improvement to get you that promotion or new job with better pay and benefits. Also, there are intangibles such as being able to easily relocate to other market, from LA → SF to work for a startup tech company or move from NY → Thailand to drastically lower your cost of living, be with family, or live a lifestyle by design. A mortgage will most likely be the biggest expense in your personal finances, so make sure that it doesn't become your golden handcuffs.

In conclusion, be sure you have adequately planned for any unforeseen expenses that come with home ownership - foreclosure can be a painful and detrimental to your financial health for many years. Furthermore, if you have big life changes ahead of you (e.g. marriage, new job, new child), remember to factor in how each of those events may change you stance in wanting to root yourself in a new home.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!