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Lesson 8
Financing The Property
Introduction
At the same time that you're doing the work required by
the previous lesson, you need to also be trying to tie down a loan. Ideally, you had
already done most of the preliminary work of choosing potential lenders or a
mortgage broker, putting together the required personal financial information
package, and maybe you've even
been pre-qualified.
In view of the importance of the financing subject, we are developing an e-course called
Financing
Income Property that covers this subject in considerably more detail than
the brief discussion of the subject in this lesson.
Differences from personal residence
If buying a home for your personal
occupancy you have a tremendous number of choices. There are zero cost
loans, 100 percent financing, and various other loan programs that make it
relatively easy for any one with a few bucks, a steady job, and a half-ways
decent credit record to buy a personal resident.
Although there are special programs for
4-plexes and smaller residential properties that are more similar to those
for a personal residence, things are different for commercial and larger
residential properties. Although the exact numbers will depend upon a
number of factors, for a 16-unit apartment building or a 10,000 square feet
office building, you can usually expect to obtain a maximum loan of 70 to 75
percent of the purchase price or appraised value, whichever is less.
Using A Mortgage Broker
Sometimes it is advantageous to utilize a mortgage broker
in looking for the best loan possible considering the type of property and
other factors. The benefits and related information is
discussed in the RHOL Selecting
A Mortgage Broker page.
Types Of Loans
Mortgage vs. Trust DeedE There
are two parties to a mortgage. The mortgagor is the property owner and
the mortgagee is the lender. (Words ending in "or" denote the
party giving, "ee" the one getting.). When the mortgagee loans
money to the mortgagor, the mortgagor signs a promissory note for the amount of
money borrowed, and "gives" a mortgage to secure the debt. The
mortgage is a written instrument that secures the loan by encumbering the title
to the property.
A mortgage or a deed of
trust require a contract between two parties, so the conditions
contained in the mortgage or deed of trust must be agreed
to by both parties in order for the contract to be valid. Those conditions
are likely to include assignments, assumptions, the lender's ability to
declare the loan due on any sale of the property, and assignment of rents in the
event of default on the note.
With these distinctions in mind, we may still
sometimes refer to a loan as a mortgage.
Finding A Loan
Interest rates, terms, fees and closing costs
vary with market conditions and vary among lenders, so it is always wise to shop for the one that will give you the best deal. The difference between the highest and
lowest rate you are quoted could affect your cash flow by significant amounts.
The traditional role of local lending
institutions and mortgage brokers, has been undergoing a major change since the
early 1980s. Now they often act only as agents to create and or service the
loans they write, while their long-term mortgages are packaged and sold as
investment instruments.
Investors Pay More
Rental property mortgages have
historically been higher risk loans, so mortgage insurance underwriters limit
the number of non-owner occupied mortgages they will insure for individual
borrowers to five. Additionally, real estate investors do not have the interest
rates, terms or down payment options that are advertised and available to home
buyers.
The argument for demanding higher rates and
larger down-payments from investors is usually that homeowners are more likely to
sacrifice almost anything to save their home, while investors will walk away
from a troubled property. While that may occasionally be true, the primary
reason for charging higher rates is that investors are willing to pay them.
Lenders are often unwilling to accept the risk of
fixing long term interest rates, that's why they sell the mortgages, but they
may agree to write Adjustable Rate Mortgages (ARMs) on investment property.
Don't be surprised when they demand one or two extra points at closing and a
percent or two more on the mortgage.
Rate Types
A fixed rate mortgage is one in which the
interest remains the same for the term of the loan. It could be a short-term
interest-only loan with the entire principle due at the end of the term, a
balloon note, or an amortizing loan where each payment includes the interest due
and some amount on the principal.
The terms for self-amortizing loans usually
vary between 15 and 30 years. The shorter-term loans will have a higher monthly
payment, but will result in a substantially smaller amount of total interest
paid. The longer-term loan will result in a higher total interest paid, but
allows a smaller monthly payment, making the loan more affordable or providing a
better cash flow for investors. The payment amount is the same for each period,
(in the U.S. usually one month, in Canada every two weeks) so that at the end of the
mortgage term the loan will be paid off.
Because interest is collected in arrears, the
interest due on a mortgage declines with each payment and the amount going to
principal increases.
It is impossible for a lender to predict where
interest rates will be 10, 20 or 30 years from now, so lenders are likely to
quote higher interest rates for a fixed rate long-term mortgage to offset the
risk to the lender.
Adjustable Rate Mortgages (ARMs) have interest
rates that are tied to some kind of financial index, usually U.S. treasury
notes. That results in mortgage interest rates that can vary over a specified
range, and usually mortgage payments that adjust as well. A portion of the
long-term rate risk is transferred to the buyer so the lender is willing to
accept lower initial interest rates on the loan.
There are a number of additional terms
associated with an ARM. The initial interest rate of the mortgage is known as
the "start rate", applicable for a specific period determined by the
terms of the mortgage. The period of time that is fixed can range from one month
to several years. Once this initial period expires, the interest rate can begin
to vary, depending on what happens to the interest rate it is tied to.
In practice, the rate adjustment frequency
varies from monthly to annually. The interest rate will rise, fall or remain the
same depending on other long-term rates. The overall change is usually limited
annually, and over the life of the loan, by a cap. Typically the annual payment
increase cap is around 7.5.
Some adjustable rate mortgages have an annual
interest rate adjustment cap instead of a payment cap. That sets a limit on the
maximum amount of interest rate adjustment. Instead of a payment cap of around
7.5% some ARMs might have a 2% annual interest rate cap. A mortgage with a start
rate of 10% can then only grow to 12% at the beginning of the second year.
ARMs typically have a lifetime interest rate
cap as well, which sets the absolute maximum interest rate allowed for the
mortgage. If the financial index to which the interest rate is tied reaches the
cap, the mortgage basically becomes a fixed-rate mortgage until the financial
index drops enough for the mortgage interest rate to drop below the rate cap.
There is usually a minimum interest rate required by the lender as well.
When the interest rate changes without like
changes in monthly payments, it is possible for the loan amount to actually
increase as the deficit in the payment amount is added to the principal. This is
known as negative amortization.
Competition among lenders has resulted in a
great many real estate financing options. The fixed-rate mortgage is fairly
straightforward and the conservative selection for both borrowers and lenders.
Nothing should change during the 15 to 30 year term, except for the property
taxes and insurance amount that may be collected in the payment.
ARMs can vary in many different ways and
lenders offer a number of different options to deal with changes in the interest
rate index. In addition to an annual rate adjustment, some lenders offer a fixed
rate for a specified period of time, like five to seven years. At the end of
that initial period the rate can vary annually.
Unlike fixed rate mortgages, most ARMs are
assumable. That may be a real benefit to your future buyer if you do not intend
to own the property long term.
Choosing between a fixed and
variable/adjustable rate mortgage can be difficult and depends somewhat on your
investment comfort level. If security and predictability are most important to
you, then the security of a fixed payment long-term loan will be attractive. If
you expect to sell within the next five years or are willing to gamble that
interest rates to go down, the variable/adjustable rate mortgage could be a much
better deal.
Escrow or
Impound Accounts
Property taxes become a lien on real estate
when past due and therefore affect the security given for a mortgage loan.
Causality and flood insurance are also important to a lender because their
security could be damaged or destroyed. Consequently, many lenders require that
a portion of the cost of property taxes and insurance be collected with each
mortgage payment and placed in special account to pay the bills as they become
due. The taxes and insurance portion may, therefore, affect the amount of a
fixed term payment as property values rise and insurance rates fluctuate. That
portion is normally adjusted once each year. See Shopping
for Insurance
Loan Calculations
There are many good
computer programs available to help analyze loan variables. Some of them are
available to RHOL Members from our Download
Page, including: Loan Calculator.
It includes six loan and interest calculation programs for regular loans,
interest due/calendar math, remaining balance, accelerated payment, balloon
payment, and refinancing a current obligation.
Sources Of Loans
If
new conventional financing is required on a purchase of
income producing property, expect to put a substantial amount down. Banks
and Savings and Loans usually require at least 30% down and you may also
have to pay substantial amounts in closing
costs.
However, if you don't have the necessary
cash in the bank, there is always room for
creativity in the overall financing package. For example: the seller can
pay the purchaser for things like deferred maintenance, major repairs and
decorating ... at closing. There can also be an agreement for the seller
to provide secondary financing. But if a new loan is necessary, there are
numerous sources to consider, including:
Seller
Financing
Having the seller carry back the financing
has several potential advantages for the buyer, including that the seller is
usually less concerned about buyer qualifications than are other lenders.
Certain costs can also be avoided, including appraisal and loan fees.
There are, however, certain potential
disadvantages to seller financing, including less protection for the
unsophisticated buyer. For example, the seller will not likely want an
appraisal, pest control inspection, or environmental testing/report that are
usually required by other lenders. Of course, the knowledgeable buyer can
always include these things anyway.
Private Lenders
Private lenders can be a good source of funding for rental
housing. They can be anyone you know, or even people you seek out just for
that purpose. Real estate investors can usually offer a better rate of
return -- and better security -- than an individual can obtain from more
traditional investments. Real estate investing, like life in general, is
facilitated and enhanced by who you know. If your circle of friends is
typical of average Americans who are involved in their community, you will
know someone, who knows someone, who will be looking for just the kind of
investment opportunity that you can offer in rental housing.
Mortgage Investors
Mortgage Investors are often individuals or investor groups who buy
existing mortgages, trust deeds or land contracts from private parties,
usually sellers. The discount they require generally depends on the
principal amount, interest, term, purchaser's equity, and the seasoning of
the financing instrument. Professional real estate brokers and investors
maintain relationships with one or more mortgage investors to help them put
a deal together in the event a seller is reluctant to carry back financing.
The real estate purchase can be structured so that a seller can offer
financing and still get their cash out at closing.
Savings & Loan Associations
S & Ls were the primary source of funds for
single family residential property purchase for most of this century. Some
advantages they offered were: longer terms; higher loan to value ratios;
competitive interest and easier credit requirements. 80% of their loans were
typically in real estate. New regulations, and curtailment of many of their
more creative practices by the Federal Reserve, has caused some of these
institutions to retrench.
Many S & Ls were burned badly during the
period of high interest and inflation in the late 70s -- early 80s. Their
traditional depositors abandoned them to chase high interest CDs and Money
Market Funds, while the S & Ls were stuck with long term, low interest,
underlying assumable mortgages. The properties they had mortgaged were also
being sold and resold at high prices and high wrap-around interest rates,
often to un-credit worthy customers who later abandoned the marginal
properties, many of them rentals in bad areas. As a result, many S & Ls
now focus primarily on owner occupied housing. If they make income property
loans they are likely to charge higher interest rates and require at least
30-70 loan to value ratios.
Commercial Banks
Banks are a good source of investment capital, however, they
typically prefer short term loans of up to five years and use very
conservative appraisals.  And, they have a well deserved reputation for not
even liking real estate. However, in 1977 Congress passed the Community
Reinvestment Act which requires that banks make loans for housing in low
to moderate income neighborhoods. Typically banks tie their CRA loans to
large multi-family income projects, but it behooves any rental housing
investor to contact their local bank loan officer and bring up the Act.
Some investors use lines of credit and
signature loans from banks to pay cash for rental property, then fix it up
and seek long term financing based on a new larger appraised value
elsewhere. That approach sometimes allows investors to ultimately achieve 100%
financing, or even more.
Federal Housing Administration (FHA)
FHA is part of the
Department of Housing and Urban Development (HUD) and offers several kinds of
help to rental housing investors, including one program that provides
mortgage insurance to facilitate the refinancing or purchase of rental
housing that does not require substantial rehabilitation. See our page on HUD
FHA Refinance Assistance.
Insurance Companies
Insurance Companies invest much of their
assets in real estate loan, but typically deal in larger
transactions of $5 million or more.
Pension Funds
Pension Funds invest much like insurance
companies and prefer to finance large transactions.
Funding The Down Payment
In addition to finding a loan, you must, of course,
come up with the cash for the down payment plus closing costs. There are
many ways to do so, including the ones discussed below. You should,
however, keep in mind that most lenders will require proof of funds to be used
in closing the purchase and that some of these ways will not be allowed by many
lenders. Be sure to verify, before even writing the offer, that your
expected source of funds will be acceptable to the type of lender that you are
planning to use.
Home-Equity Loans
Borrowing against the value of
a home is the loan of choice for most small investors. Home Equity Loans are
easy to get and have relatively low interest rates.
Most local banks will loan at least 75% of an
owner-occupied home's tax assessed value, without closing costs including
expensive and time-consuming appraisals and surveys. Many aggressive lenders
will loan a much larger percentage of a home's value, some even more than
the appraised value, but are likely to
charge closing costs and points.
Another possible bonus from a home loan is
that you do not need to use the loan proceeds for a business purpose in
order to deduct the interest. Loans secured by the value of a home are the
only kind of deductible interest expense left to most consumers. You can
deduct the interest on up to $100,000 of an equity loan on your principal
residence and use the money for anything you wish.
Refinance an existing mortgage
Refinancing your existing mortgage is
another way to borrow new money against the value of your home. A refinance
may be the best choice if you need to borrow against your equity, and your
current mortgage rate is more than one and a half percent higher than the
mortgage rate you can get today.
Always remember that you are putting your
house up as collateral with any kind of mortgage loan. That means if you
can't repay the loan, you are likely to lose your home.
Business loans
In order for the interest to be
deductible using non-home-related loans, you will need to sign a Business
Purpose Affidavit at the time of the loan.
Borrowing Against Stocks and Bonds
Loans against securities you own are
probably the cheapest source of money after a home-equity loan. With a
so-called "margin loan" from a brokerage firm, you can usually
borrow up to 50% of the value of stocks. Bonds are even better. Some brokers
will let you borrow more than 90% of the value of US Treasury securities.
Interest rates on margin loans are always very competitive. The main risk
with a margin loan is what happens if your securities drop in value.
If the stocks drop far enough (the
amount varies by brokerage firm), you may get a "margin call" and
be required to deposit more money into your account. If you don't have the
cash, you could be forced to sell your stocks to pay off the loan, usually
when the stocks are at a low.
Interest on margin loans can be deducted only
against investment income, not against ordinary earned income. If you have
$100 in dividend income, for example, you can deduct up to $100 in margin
loan interest.
Unsecured Personal Loans
The best kind of personal loan you can
get is one based on your earning capacity or net worth, but is not secured
by the specific assets you own. These loans are typically set up as personal
credit lines. The maximum credit amount you can borrow unsecured from any
one bank is likely to be about 10% of net worth. The interest rate is
usually tied to prime. The so-called "prime rate" is the rate of
interest offered to the bank's most creditworthy customer. Most personal
credit lines will carry an interest rate from a half to two points over
prime. It is a good idea to set up personal credit lines at more than one
bank, whenever possible.
Secured Personal Loans
Most personal loans are secured by
possessions. The most common personal loans are for cars, boats, or similar
assets with a published value. You may be able to use just about any other
tangible asset as collateral for a loan, as long as your lender can easily
determine the actual value of the collateral.
A certificate of deposit or savings account
secures another variation of a personal loan. For example, if you have a
3.5% certificate of deposit, you would be allowed to borrow the same amount
of money for one or two percent over the rate you are receiving. Although
you're paying more for the loan than you're getting from the CD, this type
of loan can make sense if you need money quickly and want to avoid the
penalties for early withdrawal that many certificates of deposit carry. You
can then pay off the loan when the CD matures.
Loans From Retirement Plans
You may be able to borrow against a
defined-contribution retirement plan, such as a 401(k) or company
profit-sharing plan. There are restrictions on these loans. You can borrow only up
to half of your vested balance or $50,000, whichever is less. You have to
repay the loan within five years (loans used to buy a home can have a longer
payback period), and interest is not usually deductible. You also have to
repay the loan in full if you leave your job. Employers may impose other
limits on these loans or forbid them entirely.
When you pay interest on a 401(k) loan, that
money goes back into your account. So you are, in effect, paying the
interest to yourself. However, you are giving up the interest that the money
would have otherwise earned, tax-deferred, had it remained in your account.
These loans should be approached with
caution. If you don't follow all the restrictions, the Internal Revenue
Service can hit you with a bill for income taxes on the money you borrow, as
well as a 10% penalty.
Borrowing Against Life Insurance
If you have a whole-life or other
cash-value insurance policy, you can borrow against the value of that
policy, often at interest rates near the prevailing mortgage rate.
Getting a loan against your insurance policy is probably easier and cheaper
than any other source. It should be - it's your money.
However, your insurance death benefit
is reduced by the amount you borrow. If you die while the loan is
outstanding, your estate will receive less than the policy's face amount by
the amount of the loan outstanding. However, keep in mind that your estate would have to pay off any other loan that you
took out in place of a life insurance loan anyway and almost any other loan
will have a higher interest rate.
Credit-Card Loans
Taking a cash advance against a credit
card is one of the quickest and easiest ways to borrow money. Just put your
card into an automatic teller machine or write a check and the money is in
your hands. However, credit card advances should only be used as
"bridge loans" until other financing can be arranged. Easy money
is almost always the most costly. Interest rates on credit-card loans are
often the maximum allowed by law and routinely approach 20%. Additionally,
most cards charge a cash-advance fee of 1% to 3% of the amount you borrow,
so before using this resource, be sure to check your cards and use the one
having the lowest cash-advance fee.
Because of the high cost, the only time
credit-card advances make good sense is when you can save a great deal with
an immediate purchase, and the loan will be very temporary.
Summary
There are a lot of possible sources of funds
to use in supplementing your available cash. However, all the sources
charge interest and this expense must be taken into account when calculating
your cash flow.
Investors
Whether for the down payment or even for the total price of an
all-cash purchase, if none of the above sources are
available to you, or you prefer not to use them, and you are willing to share the benefits of income
property ownership with one or more others who have the necessary cash, you
might consider forming an investment group, also called a syndication.
There are various legal formats for such a group, including:
Each of these forms of
ownership have advantages and disadvantages as to tax treatment and/or
operation.
General Partnership
A
partnership is a relationship between two or
more persons who join together to carry on a trade, business, or investment. Each person contributes
money, property, labor or skills, and each
expects to share in the profits and losses
of the business. Any number of persons
may join in a partnership. For the purpose
of income taxes, a partnership includes a
limited partnership. syndicate, group, pool, joint venture or other
unincorporated organization that carries on
a business and that is not classified as a
trust, estate or corporation.
Limited Partnership
A limited partnership has two classes of
partners - general partners and limited partners, at least one of
each. The general partners have the same liabilities as for partners
in a general partnership. The limited partners, however, are only
liable to extent of their capital investment (plus any agreed assessments)
assuming that they do not participate in business of the partnership that
makes them look like general partners. Sharing of profits and losses
and tax benefits amount the partners is as defined in the partnership
agreement.
Corporation
A corporation
is created under state law and is treated by law as a legal entity. It has a life separate
from its owners and has rights and duties of its own. The structure
and powers of a corporation are defined in its Articles of Incorporation and
its By-Laws. The owners
of a corporation are the stockholders. Stockholders elect a Board of
Directors, which in turn hires Officers who are responsible for day-to-day
operations of the corporation. Board members and Officers may or may not be stockholders. Forming a
corporation involves a transfer of money or property, or
both, by the prospective shareholders in exchange for capital stock
in the corporation. For the purpose of
federal income tax, corporations include associations,
joint stock companies, trusts, and partnerships that
actually operate as associations or corporations.
There are two basic types of corporations, the
'C' corporation and the 'S' corporation. They are the same for most purposes except for income tax treatment.
An 'S' corporation is a small business
corporation that elects to have its income
taxed in a manner similar to that of a partnership. In
general, an 'S' corporation does not pay tax on its income. Instead,
the income and expenses of the corporation are divided among
its shareholders (limited to 75), who then report them on their
own income tax returns.
A 'C' corporation is a regular
corporation. Profits and gains are taxed at the
corporate level and dividends paid to shareholders are taxed to the
shareholders, thus, double taxation. Employees, whether shareholders,
directors, or officers, pay income taxes on compensation the same as if
employed anywhere else. A 'C' corporation is not normally considered a
vehicle for real estate investment.
Limited Liability Company
All states
have enacted limited liability company (LLC) statutes. An LLC is
a separate legal entity formed by filing articles of organization with
the secretary of state. LLCs (and similar entities called Limited
Liability Partnerships - LLPs) combine certain features of partnerships
with certain features of corporations, most notably, limited
liability. The individual members are not
personally liable for the LLC's or LLP's
debts, except to the extent of their investment and
capital commitment in the company. It is
important to note that an LLC/LLP is
not a federal tax entity and is generally treated
as a partnership by IRS. A single-member
LLC can be treated as a "disregarded
entity" for tax purposes, even though still
respected as separate for legal purposes. Thus, if owned by an individual,
such an entity can be reported as a Schedule C sole proprietorship
on the owner's personal tax return.
The LLC is probably the most often
recommended entity for holding title to income property because it provides (1)
favorable tax status (2) limited liability, and (3) relative ease of operation.
Real Estate Investment Trust
Simply stated, a REIT is a
company dedicated to owning and, in most cases, operating income-producing
real estate, such as apartments, shopping centers, offices and warehouses.
Some REITs also are engaged in financing real estate. Most importantly, to
be a REIT a company is legally required to pay virtually all of its taxable
income (90 percent) to its shareholders every year.
In short, a REIT may deduct the dividends
paid to the shareholders from its corporate tax bill so long as
- the company's assets are primarily composed of real estate held for the
long term,
- the company's income is mainly derived from real estate, and
- the company pays out at least 90 percent of its taxable income to
shareholders.
The main benefit of being a REIT: one level of
taxation. The main limitation of being a REIT: a restriction on earnings
retained by the company.
Securities Laws
You need to be aware that there are
both federal and state laws that define interests in an investment as securities
and regulate their sale, including requirements for registration. While
there are exemptions to registration at the federal level and in most states, it
is important that the investor wishing to utilize these exemptions fully
understand them. It is usually advisable that a competent attorney assist
in setting up at least the first syndication.
What Lenders Need & Look For
When completing your loan application, it is important that you know what the
lender will need and what he is looking for when analyzing your property.
Do you have the necessary personal financial
package ready to go? Do you have readable copies of all lease
documentation available?
Is the lender aware of the manner in which you
plan to hold title? Most lenders will usually allow vesting in a limited
liability entity such as LLC or Corporation, with personal liability being
provided via a personal guaranty, but it is best to disclose your plans up-front
just in case there are any special issues with a particular lender.
Have you given the property the same consideration that a lender will?
Have you included a realistic
vacancy factor? Lenders will usually assume 5% or the local market rate,
whichever is higher.
Have you included a reserve for future capital expenditures
such as a new roof, painting, etc? For example, if a new roof will cost $10,000
and the existing roof has an estimated life expectancy of 10 years, then the
reserve must include $1,000 per year for the roof. Similar analysis applies to
other future expenditures that are not in normal annual expenses. Lenders will
usually include reserves as an expense in their analysis. They may instead
utilize a Debt Coverage Ratio that allows for reserves. Is there any deferred
maintenance for which the lender will require correction prior to closing and,
if so, will the seller pay for it or can you?
What about issues such as lead-based paint (pre-1978
residential), asbestos, lead, radon, and/or other
environmental issues that will be of concern to a lender? Are you
in an area of the country where wood infestation is a concern? Have you
included a inspections as contingencies and taken the costs into account?
Are the costs of the appraisal (certain) and Phase I Report (possible) in your
budget? There are other factors that can affect
financing, including such issues as (1) the age of the property and/or (2) the
types of units - all studios will be harder to finance than all 2-bedrooms.
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