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Lesson 5 - 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.
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.
Security Instruments
Although loans are often commonly called mortgages, a loan is a loan and a
mortgage is a mortgage and though "the twain shall meet," they are not the same
thing. A loan is the money that a borrower receives from a lender. A Mortgage
is the security interest in the property being financed that the mortgagor
(borrower) gives to the mortgagee (lender). The mortgage document is usually
recorded in the public record and becomes a lien on the property. And then
there is the Trust Deed, more correctly called a Deed of Trust. Although the
Deed of Trust is also a security instrument in the property being financed, it
is different from the mortgage instrument. First, the security interest is
given to a Trustee, who forecloses on behalf of the Beneficiary (lender) if the
Trustor (borrower) defaults. Second, foreclose of a Deed of Trust does not
usually require a court action, although doing so is an option. Instead the
Trustee sells the property at public auction if the borrower/trustor has not
cured the default by the end of a prescribed period of time. As with the
mortgage, the Deed of Trust document is recorded in the public record and
becomes a lien on the property.
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.
Finally, there is the Contract of Sale, also
called the Land Contract. This instrument is different from the Deed of
Trust and Mortgage in that the seller continues to be the equity owner until
fulfillment of contract terms. That is, although transfer of ownership can
be set up to transfer at any time, usually the buyer does not own the property
until it is fully paid for.
With these distinctions in mind, we may still sometimes refer to a loan as
a mortgage.
Loan Costs
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 most of
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.
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.
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.
Loan Calculations
There are many good computer programs and Web sites
available to help analyze loan variables.
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. New regulations, and curtailment of
many of their more creative practices by the Federal Reserve, has caused some of
these institutions to retrench. 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.
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. There are also potential tax advantages.
Refinance an Existing Mortgage
Refinancing your existing mortgage is another way to borrow new
money against the value of 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. There are both investment risk and tax
considerations for this type of borrowing.
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.
Secured Personal Loans
Most personal loans are secured by
possessions. The most common personal loans are for cars, boats, bank accounts,
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.
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 as to maximum amount and term of the loan and other tax
considerations.
Borrow 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.
Credit-Card Loans
Taking a cash advance against a credit card is one of the quickest
and easiest ways to borrow money. However, credit card advances should
only be used as "bridge loans" until other financing can be arranged.
Interest rates on credit-card loans are usually quite high. 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.
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.
Syndication Vehicles
There are various legal formats for such a group, including:
- General partnership (GP)
- Limited partnership (LP)
- Corporation (C or S)
- Limited Liability Company (LLC)
- Real Estate Investment Trust (REIT)
Each of these forms of ownership have advantages and
disadvantages as to tax treatment and/or operation.
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.
Financing 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 as
well as tax considerations must be taken into account when calculating your cash
flow.
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?
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. 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 all inspections
as contingencies and taken the costs into account? Are the costs of the
appraisal (certain) and Phase I Report (possible) in your budget?
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