Real Estate 029: Financing Rentals with 15 vs 30 year mortgages?

There are a lot of nuances when it comes to real estate investing, and one important decision is financing. Once you have decided that you are going to use good debt to leverage other people's money and scale your portfolio, you must also decide the terms. Investors typically finance their properties through conventional loans (secondary mortgages with Fannie Mae, Freddie Mac guidelines), as such, they decide between 20% or more in downpayment, or 15 or 30 year mortgage terms.

In simplistic terms, 15 year mortgages will generally have better interest rates as they are being amortized over a shorter period of time and seen as less risk to the bank. To the borrower, it may seem beneficial because you have a smaller interest rate, and less interest paid during the 15 years vs the 30 years. However, once you step back and look at the bigger picture, you may want to take into consideration other intangible factors such as flexibility, potential for interest rates to increase, and the ability to use good debt when your returns are expected to far exceed the debt service (Note: if your property is not covering the debt and leaving you with a healthy amount of cash flow each month, you are taking on a big risk as the property may not be self-sustaining from day 1).

Lets take a look at some of the savings on a rental property with a 15 year vs 30 year mortgage:

Purchase price: $100,000

Down payment: 20%

Scenario A: 15 year mortgage with 5.5% interest

This will leave you with a monthly payment of principal and interest of $653. Over the course of 15 years, the total amount disbursed will be as follows:

Total payment: $117,725.95

Principal: $80,000.00

Interest: $37,725.95

Scenario B:  30 year mortgage with 6% interest

This will leave you with a monthly payment of principal and interest of $479. Over the course of 30 years, the total amount disbursed will be as follows:

Total payment: $173,083.40

Principal: $80,000.00

Interest: $93,083.40

This results in additional interest of $55,357.45 ($93,083.40 - $37,725.95).

Looking at $55,000 of interest savings may make you think this decision between scenario A and B is a no brainer, however if we take a closer look there are various factors to consider:

  • Additional interest can be converted into tax savings across rental portfolio

  • Opportunity cost of fast loan paydown vs re-investing the difference

For example, the monthly PI of scenario A is $653 - scenario B of $479 results in a monthly PI delta of $179 that could be used to reinvest for a higher return or used as additional payments as conventional loans typically do not have pre-payment penalties. Lets take a look at how interest payments would change if we used the $179 to make additional payments toward the 30 year loan:

Total payment: $123,515.78

Principal: $80,000.00

Interest: $43,518.13

Now the difference in interest is only $5,792.18 ($43,518.13 - $37,725.95) all the while maintaining flexibility to change directions if you wanted to, instead of locking yourself into a decision for 15 years. In addition, the $179 in savings in scenario B may come in handy when other rentals in your portfolio are not performing or may be negative $200. The extra cash flow from a 30 year mortgage may be used to offset these fluctuations.

Lets take another example and say that you use your monthly $179 PI difference from a 15 year vs 30 year and combine it with savings to purchase a turnkey rental property with a cash on cash return of 12% (These are actual deals I am seeing in the midwest for a C class neighborhood).

With a $179 starting balance and contributing $179 monthly at 12% returns, you will end up with $632,034 after 30 years when you will have paid off your home in scenario B. Without even calculating, the difference is clear. Although this is just an example, investors must understand these variables and opportunity costs when they decide to forego one for another.  There is not real benefit to paying off your mortgage from a numbers perspective. 

I do believe that risk needs to be managed and am not looking to maximize the debt across all of my rental properties, however, depending on what season you are at life: 20-30s "grow", 40-50s "maintain", 60s+ "enjoy", you may find yourself wanting to lower risk and have peace of mind. 

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!

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Real Estate 028: Motivated Seller Questionnaire

A great way to build equity and rental portfolio in a competitive market is to find a motivated seller. A motivated seller is someone who doesn't want to sell, but needs to sell due to their personal circumstances (e.g. death, divorce, inheritance, debt, etc.). Chad Carson wrote on the BiggerPockets blog on the importance of hustle by sharing the following metaphor: “Every morning in Africa, a gazelle wakes up. It knows it must run faster than the fastest lion, or it will be killed. Every morning, a lion wakes up. It knows it must outrun the slowest gazelle, or it will starve to death. It doesn’t matter whether you’re a lion or gazelle. When the sun comes up, you’d better be running.“

Similarly to the lion or gazelle that is running, a savvy investor must be on the lookout for great deals through their marketing efforts in identifying motivated sellers. Once you have found a motivated seller through a lead generation software (e.g. bandit signs, flyers, postcards) or referrals from brokers or property managers, having a motivated seller questionnaire or intake script is useful for screening those leads. 

A big mistake made by newbie real estate investors is not being able to filter out the warm/hot leads from the cold leads and end up wasting valuable time with a person that will end up keeping their property.

Below is a list of information you want to document during the initial screening process:

Contact Information

  1. Full Name

  2. Phone number

  3. Address

  4. Spouse/Partner Name (if any)

  5. Email Address(es)

  6. Property Address for Sale

  7. How did you find us? (Used to understand marketing efforts)

These are the basic information you need to ensure that you can get in contact with the seller in case they hang up accidentally and to follow up periodically. Next you want to screen them for motivation for selling their property:

Motivation:

  1. Is property currently on the market?

  2. If yes, how long has it been listed?

  3. Why are you selling?

  4. Have you listed your home with a real estate agent?

  5. What is your plan if your house doesn't sell?

  6. Do you have any written offers yet?

  7. Who lives in the property right now?

  8. Are your mortgage/tax payments current? 

  9. Potential problem with co-owners? (Divorce, business, etc)

  10. Any known severe property damage?

  11. Other need for fast and immediate lump sums of money? How much?

These questions cut to the meat of why a motivated seller may decide to work directly with an investor rather than a conventional method of selling through the MLS with an agent. 

Property Details:

  1. Property style: (Single Family, 4plex, ranch style)

  2. Square footage

  3. Age of property

  4. Neighborhood Quality scale

  5. CapEx useful life (Roof, Foundation, HVAC, electrical, plumbing)

  6. Any other improvements needed?

These questions ask about the physical condition of the property and to a certain extent, the neighborhood. In most cases, the investor should already be knowledgeable about the surrounding areas and rough ARV to be able to quickly determine if the seller is in the ball park of an asking price. Motivated seller screening involves knowing how to ask open-ended and probing questions about the property, to get more accurate and time-saving answers. For example, instead of saying, "How is the roof? Good? Bad? Ugly?", you should ask instead, "When was the roof last replaced?"

Some landlords and property owners will call you assuming they can scam you into overpaying for their property. These people may become motivated sellers later on, but at the moment, they are not worth spending too much time with after the initial screening calls. 

Financial Data:

  1. Asking Price

  2. Mortgage loan balance and interest rate (Lender information)

  3. Any 2nd mortgage on property? (HELOCs, Loans)

  4. Mortgage loan terms and conditions

  5. Are there any other liens or debts on your properties?

  6. How much rent per month? Request rent rolls (if rental property)

  7. Any non-rental income from property? (laundry, pets)

  8. Any HOA (Homeowner's Association) fees? How much are HOA payments

  9. How much is monthly PITI (Principal, Interest, Taxes, Insurance) payment?

  10. Utilities costs (Gas, Electric, Water) for the past 6 months (Statements)

In conclusion, using a motivated seller questionnaire can help guide your interview process, and gives you a framework to make the screening as conversational as possible.  This information will help you determine the best way to structure this deal (wholesale, lease option, seller finance, or cash purchase) for a flip or rehab and long term hold. Using the information on this page, investors should be able to work out win-win solutions for your sellers and yourself.

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!

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Real Estate 027: All About Home Inspections (Rental Property Edition)

A critical step in the home purchasing process is due diligence. Assuming that you have done your market research, found a deal, and negotiated it under contract, its time to conduct a home inspection to ensure that there are no surprises that significantly change your cash flow numbers. As Ronald Reagan infamously said, "Trust, but verify." Home inspections are a great way for a buyer to hire an objective third party professional to be your eyes and ears, especially if you are unable to physically visit the subject property.

The first step in home inspections is to find the right inspector. For investors, this means finding a team that is investor friendly and understand where you are coming from. There may be "add-ons" to the inspection package that an investor may not need as they are not occupying the property. Further, you may come across a conflict of interest when inspectors also perform repair/rehab services as they may be incentivized to recommend repairs and attempt to perform the work themselves. Hiring an inspector who's sole job is to find issues without being the remediator will allow you to have an objective helper.

Below are a couple ways that I have found my property inspectors when investing in a new market:

  • Property Manager

  • Real Estate Broker/Agent

  • Google (Yelp/Facebook Groups/Bigger Pockets)

  • Fellow investors

  • Local Real Estate Investment Association (REIA)

Once you have created a short list of inspectors, make sure you have a phone call w/ them to set expectations, check if they are properly licensed and bonded,  request sample inspection reports, and understand costs involved (e.g. Single Family Residence, Duplex, Quads, Radon, Termite, and Sewer Scoping). Although inspectors will have disclaimers stating that they are generalists and not experts when it comes to specific issues such as the foundation, electrical, and plumbing, etc. their experience inspecting homes will allow them to help identify patterns and trends when it comes to issues they have seen in the past. For example, an inspector who has seen a hundred homes in a certain zip code will understand the nuances of that neighborhood and will be able to advise the buyer in a more specific manner. In my experience, I have been able to find an investor friendly inspector who knows I will be a repeat customer, offer special pricing, take additional reference photos (not in the report) as well as walkthrough the inspection report with concerning areas. 

Once the home inspection has been scheduled, be sure to coordinate with your Broker or Property Manger to make sure utilities are turned on so that the inspector can test lighting, appliances, and other CapEx items. Upon successful completion of the inspection, its time to assess remedial costs. Generally, your property manager, handyman, or General Contractor should be able to put together a "high level" bid for you to take to the seller and negotiate a credit at closing, reduction in sales price, or seller repairs. Of the three aforementioned scenarios, I prefer a credit at closing as I would like my own team to perform the work and control the output. Sellers may opt to use cheaper materials or put "lipstick on a pig" that may result in reperformance of the work down the road. Further, I do not have my rehab crew put together a detailed scope of work at this stage, as I do not know if the seller and I will be able to reach an agreement. Reason being, if market conditions do not allow for us to reach a deal, I do not want my team to have spent to much time on this project.

Some of the red flag issues that may cause serious concern relate to:

  • Significant termite damage

  • Mold

  • Radon

  • CapEx (Roof, Wiring/Electrical, Plumbing, HVAC, Structural)

  • Asbestos

  • Lead Paint (Generally found in homes older than 1978, highly toxic and a health hazard)

  • Flood Zone

Please note that if you are financing your property, your lender may request many if not all of these above items to be remediated before closing. Further, your lender will typically require an "A" grade insurance plan to cover liability of the property, and your insurance company may deem these issues to be uninsurable. These are real problems that you need to consider before moving forward in the purchasing process. Be sure to differentiate the "must repair" items with the "nice to have/value add" repair list. The seller will generally list the house taking deferred maintenance into consideration (e.g. old carpet, cabinets, touch up paint, fixtures, windows, etc.). 

Refer to my previous blogs on negotiating real estate (e.g. Never Split the Difference book review, and buying real estate through seller financing) for tips and tricks on how to speak with the seller. Bottom line, remember you are not trying to squeeze ever dollar out of the seller, but you are simply trying to hit your pre-defined cash flow numbers and renegotiating the deal based on newly discovered facts. Remember to use your Real Estate Broker as a sounding board when negotiating as an experienced Broker will have a good idea on the After Repair Value (ARV) and local market cap rates that typically drive the selling price. In addition, be strategic when negotiating issues with the buyer and make sure you highlight the high dollar value items and not make a long list of minor repairs. Show the seller you are a reasonable buyer who has identified these issues, but am willing to give up the smaller things (e.g. cosmetic repairs below $100) in order to close the deal. 

In addition to the inspection report, its always good practice to perform an inquiry with the seller or their representative agent to understand their motivation for selling, which may sometimes uncover issues the owner is currently facing or have faced in the past (e.g. high vacancies, vandalism, wet basement, or roof damage due to high winds/hail). Further, you will be able to get a sense of whether or not the seller is trying to hide or conceal issues from you as you begin to ask probing questions.

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!

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