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!

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!