Real Estate 021: Due Dilligence - Buy and Hold Rental Property Deal Breakers

Some of my readers have asked me, "what are some deal breakers when it comes to underwriting a real estate investment?" This is a great question and something we all should think about before starting to invest. The reality is, if we do not set standards, we can easily be blinded by the cash flow and satisfying feeling of the hunt, where we start to purchase mediocre deals that produce mediocre results and delay your path to financial freedom.

Real estate is generally inefficient, meaning every property has a price depending on the condition, timing of the market, location, asset class, etc. that could potentially make it a good deal. Sometimes, that number is a negative, meaning the seller would have to take a loss to let go of the property to stop the bleeding. Some people may argue that large CapEx items such as an entire HVAC system, or foundation issues are deal breakers, however, a savvy investor may understand the problem at hand and be able to significantly reduce the acquisition price and the risk involved in the transaction. Other factors, such as increased crime rate and high vacancy are things that are less tangible and will have to be reviewed case by case.

Lets take a look at my top 5 list of real estate deal breakers:

1. Large houses and lots

This was a painful lesson that I learned and relates to my first rental property purchase. This home sat on a huge lot the size of half a football field which I thought was an advantage at the time. I believed that the large lot would attract tenants who wanted privacy as well as room in the backyard for family gatherings. In my situation this resulted in multiple break-ins during vacancies as the house was well-covered by trees and vandals were able to get in undetected by surrounding neighbors. 

Large houses pose a similar dilemma as in my markets, a 3,000 sq foot home does not necessarily command 2x rents compared to a 1,500 sq foot home. However, a larger home means increased reserves as it costs more to replace a larger roof, paint more walls, and replace flooring. On the contrary, I also avoid homes that only have 1 bedroom 1 bath as they typically become rented by transient tenants who often do not renew their lease. As tenant turnover is one of the single biggest cash flow killers to a landlord, I avoid purchasing tiny homes altogether. I have realized that in the Midwest, a conforming 3 bedroom 2 bath home around 1,200-1,600 sq ft is ideal in attracting the type of tenants that stay long term and take care of my property. 

2. High crime/War Zones

As discussed previously, a real estate investor must first decide where they would like to invest - A class, B class, or C/D class neighborhoods. Although each investor may have their own definition of these classes, I incorporate multiple factors such as school ratings, crime rates, median income, and purchase point of the homes. While A class homes are generally in more expensive neighborhoods, have better schooling, and higher median income, it does not necessarily result in a perfect tenant. I have had B class tenants who leave after one year and leave a mess, but I have also had Section 8 tenants in rougher parts of town that renew and take great care of my property. I personally avoid high crime areas as they result in externally driven situations out of my control - such as gang violence, drug related thefts/break-ins, as well as high vacancy/lower comps.

3. Awkward layouts

This is a common deal breaker when speaking with real estate investors. If you have done hundreds of walkthroughs during your real estate careers, you will notice that some homes in one neighborhood all have the same layout and materials, and one street may have 10 different layouts from 10 different developers. This presents an interesting situation as if you come across a house with an awkward layout (e.g. limited access to the kitchen or bathroom, tiny bedrooms, no access to the garage from the inside), this can result in your property staying vacant as tenants will also realize this as a problem.

4. HOA fees & high taxes

I want to start by saying that there are hundreds of investors who have found success investing in condos, townhomes, and even single family residence with HOA fees. Without getting into details of the pros and cons of having HOA fees, I avoid homes with HOA fees as they are typically variable costs that is difficult to account for while calculating your cash flow. As an investor I see this variable as an increased risk that I do not need to take as there are many other types of investments available.  Further I avoid homes with significantly high taxes / tax assessed value as they may be very difficult to contend depending on the local government. Tax assessors may see the value of your home much higher than what you paid for market value, resulting in a negative impact on your cash flow. Do not assume you will be able to lower your taxes with an appraisal as each market is different and may take more time and money that is worth.

5. Shady sellers

As you continue throughout your real estate journey, you will encounter people who are less transparent than others, and people who try to take you for a ride. This last deal breaker is subtle than the others, and you will have to rely on red flags and your gut in determining whether this deal is worth the risk. Through simple google searches, you will find countless stories on real estate deals gone bad and the shady acts of the sellers. These sellers may attempt to pass off a property with a cloudy title in hopes you take the risk, may fail to disclose repairs that were not done to code, and other issues. This is a key reason why due diligence, not falling in love with a deal, is so important. Investors must trust, but verify the responses made by the sellers through an independent inspection, searching of title, and having multiple eyes on the deal. If you catch the seller trying to give you false information, it may be a huge red flag that there is an issue with the property that they are trying to pass onto you. Like the old age saying goes, where there is smoke, there is fire.

Remember that each deal may have its merit and you can potentially find a diamond in the rough. With a little bit of work and negotiation, the potential issue may result in massive equity and gains. However, other factors such as those mentioned above are not easily fixed, and need to be carefully considered before taking the dive and making the purchase.

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 020: Purchasing Rentals All Cash vs Financing

One of the greatest advantages of investing in real estate is the ability use leverage, in other words, other people's money (e.g. bank, private investors, credit unions, etc.) to build your portfolio. When asking yourself the question of paying all cash vs financing a rental property, you have to consider the return on investment (ROI) and the risk involved in deploying your hard earned cash. Lets take a deeper look into the pros and cons into the two different strategies below:

Assuming that you have a lead on a $100,000 property, paying all cash for this deal may initially cost less as there are no financing fees (points), interest charges, appraisals, and additional closing costs. However, by deploying all $100,000 into one deal, you are essentially placing all of your eggs in one basket (e.g. one market, one home, one tenant, one rehab). When performing a "stress test" or "what could go wrong" analysis, you may be opening yourself up to potentially massive losses in this one deal. On the other hand, if you leverage your cash and purchase 4 financed properties ($20,000 downpayment + $5,000 closing costs), you will be spreading your risk across 4 different properties. Assuming both financed and all cash deals are expected to produce a 20% return, the financed option provides $60,000 more profit that the all cash method.

This analysis isn’t as black as white as stated above, as we all know quality beats quantity when it comes to investments. By purchasing 4 properties instead of 1, you may also be purchasing a handful of properties that are below your standards or have increased risks due to the volume of activity (e.g. multiple rehabs, tenants, property managers, and markets). Having one project may allow you to give more careful attention to the project and leave less room for error. Of course, this is also dependent on the strength of your team and the speed and timing of the market when you decide to scale. After analyzing the cash flow, deducting the debt service and other fees/costs involved in purchasing the home, you will note that your cash on cash return will be higher than the cap rate, as you are utilizing other people's money to purchase a bigger piece of the pie. 

There are also other hybrid ways to reduce risk when determining how to finance your rental properties:

1. Using short term loans to use the Delayed Financing Exception (DFE). The DFE is a Fannie Mae product where investors are allowed to purchase a home all cash and cash-out refinance their home within 180 days of first taking title on the property. The cash out portion is limited to the lower of the purchase price and closing costs of the new loan or 75% of the after repair value (ARV). This strategy may allow an investor to purchase a home off market at a deep discount all cash, and with a little bit of cosmetic upgrades command a higher appraisal value and cash out refinance before the tradition 6 months seasoning requirement for a BRRRR (Buy, Rehab, Rent, Refinance, Repeat) strategy. In this strategy, you increase your ROI by using leverage, but also decrease risk as you have less money in the deal through forced appreciation. 

For example: An investor purchases a rental property all cash for $50,000 that needs about $3-5,000 in paint, carpet, and finishings. The home is expected to appraise for $65-70,000 and cash flow $300/month after obtaining a mortgage. The investor is able to purchase this home at nearly 70% of ARV as it is an off-market deal from a motivated seller that does not want to invest the time or money to make upgrades and sell for a higher profit. After the cash closing, the investor is all in at $57,000 (purchase, light rehab, closing costs), and requests a DFE cash out refi 1 month after closing. The property appraises at $70,000 which means the investor is able to take a loan of $52,500 (lower of purchase price and closing cost of new loan vs 75% of ARV). As the investor recoups $52,500 of her initial $57,000 investment, she now only has $4,500 into a property that cash flows $300/month and her return on investment is 45%. 

Note: These numbers are taken from an actual deal of mine where I purchased an off-market deal through my property manager's contact from a retiring out of state investor. These types of deals are not easy to find, but if you do, will produce high yield, so network with people in your REI meetup groups, facebook, real estate forums, and let your brokers/property managers know you have cash to purchase. If they have a good experience working with you, they will be more likely to send you warm leads. Please remember that there are nuances with the DFE and specific requirements, so consult with your lender before deciding to pursue this strategy.

1. Snowball debt strategy. This is a method that is covered by Chad Carson in his book "Retire Early with Real Estate." By creating passive income through rental properties you are able to take the cash flow and start tackling the smallest amount of debt or debt with highest interest. This is the same strategy financial experts such as Dave Ramsey preaches when teaching his students how to eliminate consumer debt. 

For example: An investor has a $52,500 loan on a rental property (example above), that provides $300/month in cash flow after all expenses and debt service. Instead of using the cash flow for other expenses, the investor decides to re-invest that money into the same property to reduce the principal amount of debt and save on the overall interest. (Note: some investors may want to only do this when deciding to de-leverage their portfolio or when they cannot find a good investment during a downturn in the market. If you have a 30 year fixed interest at 5%, by chipping away at the loan, you will be slowly giving yourself back a chance to keep the 5% interest that would have gone to the financial institution). Now if you continue to do this over time, as well as start bringing the excess cash flow from your W-2, business, and/or other rental properties, the velocity of this money will be much quickly and you will have multiple paid off properties that are less impacted by market risk.

In summary, when personally looking at using cash or leverage to buy properties, financing investment properties appear to be less risky than paying all cash. Financing puts more risk on the lender (assuming 80% LTV) than the investor, since the lending institution picks up the higher loan to value portion of the deal. By using leverage, you would gain essential investor experience in working with a financial lender, and have them as a second pair of eyes on underwriting the strength of your deal. While working with a lender may require more paperwork and time commitment, there are significant rewards as you continue to gain experience and pick up additional rentals.

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 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!