Financing your Empire
If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.
J. Paul Getty
(Note: This section is quite a bit longer than the previous ones published. I decided that it would be easier to grasp if it was all in one piece, rather than broken up. I hope you’ll agree)
We have seen how leverage works to increase the rate at which your equity grows. By putting a loan on the property, there is a multiplying effect on appreciation. If you have been paying attention to the media at all, you have been reading how it is nearly impossible to get a mortgage these days—especially one for an investment property.
Newspaper editors sometimes say, “If it bleeds, it leads.” Bad news seems to sell better than good, so stories about the difficulties of getting a mortgage abound. The truth is that, while the mortgage application process is far more rigorous than it was just a few years ago, money for real estate is plentiful—and very, very cheap.
The biggest change in the mortgage process is that the requirements for documentation have increased dramatically. There are no more “stated income” loans where the lender takes your word for what you say you earn, with no income documentation required. You will have to provide tax returns for at least two years, along with current pay stubs and bank statements. If you presently own rental property, you will have to provide leases for your tenants, as well as documentation confirming what your hazard insurance premiums and property taxes are. If there are unidentified deposits on your bank statements, you will have to provide a “paper trail” showing where the money came from.
A good friend and client of mine, an active real estate investor, asked me to refinance one of his rental properties. He delivered all the paperwork I asked him for. There were two large deposits listed: one for $300,000 and one for $700,000.
“What are these?” I asked. “You know we have to paper trail large deposits.”
“Oh, right,” he said. “Those were two cashier’s checks I had.”
“You keep a million dollars on you?” I asked, incredulous.
“Oh, no,” he said. “I had them in my glove compartment!” In fairness, I should mention that my friend buys a lot of property at foreclosure auctions, and those sales are always cash, so he was just being prepared. But it was no small matter to explain to the underwriter where those funds had come from.
When a lender looks at the loan application, it is making some critical calculations. The first is the Loan To Value ratio (LTV). This is the loan amount expressed as a percentage of the purchase price. In our $400,000 example earlier, we had a $300,000 loan, so the LTV was 75%.
It is possible to get a loan for investment real estate for a higher LTV, but the cost goes up dramatically. If you wanted to make a down payment of $80,000 rather than $100,000, your cost for that larger loan would be $4,000 higher. Lenders are discouraging investors from buying properties with excessive leverage.
The second calculation the lender makes is Debt To Income ratio (DTI). The lender adds up the buyer’s current house payment, including taxes and insurance. It adds any monthly payments for long-term debt (longer than 10 months). If the buyer owns rental property already, the lender will calculate the positive or negative cash flow from the rental(s). If the calculated number is negative, it will be treated as though it were a debt. If it is positive, it will be treated as income.
If you are buying a rental property, the lender will take 75% of the projected (market) rent and subtract the mortgage payment, including taxes and insurance. The resulting number will be treated as either a debt or as income, depending on whether it is positive or negative.
The total debt is then expressed as a percentage of the buyer’s gross monthly income. If you earn $8,000 per month and your total debt comes to $3,500 per month, your DTI would be 43.75%. The DTI cannot exceed 50%, and in many cases a lender will put their own maximum on that number.
When the lender’s underwriter looks at the rental property you already own, she will go to your Schedule E form from the last two years. As you remember, this form contains income and expenses. Two items are especially important in the underwriting process: first, the depreciation. Because this is a “paper loss,” we can add it back to the net income for qualifying purposes. Second, the underwriter will add the principal portion of the mortgage payment back into the expenses. If the mortgage payment on a rental you own is $1,309 and you claim $11,000 in interest on your tax return, you will have paid around $390 per month toward the principal. The underwriter will add that amount to the expenses showing on the tax return.
This is a somewhat recent approach to underwriting loans where the borrower owns rental property. Just as this change was beginning to take place, a client came to me to apply for a mortgage on a rental he was buying. He already owned five houses and was looking to expand his holdings. He had very good income, money in the bank and flawless credit. Looking at his tax returns, he had a very low DTI.
The lender turned him down. As it turned out, he had financed all his five other properties with 15 year loans. Although the rates were very low, his payments toward principal were very high—so the lender calculated his DTI at over 60%.
There is another aspect of financing rental properties that you should be aware of. Most loans today are ultimately owned by Fannie Mae or Freddie Mac. Even though you may get your loan from small-but-might y PFS Funding, that loan will ultimately be owned or guaranteed by either of the two agencies. The term, “conforming loan” means that the loan conforms to the requirements of either of the two agencies.
One of those requirements has to do with the number of properties you can own with financing on them. If you own your personal residence, a vacation home and eight rental properties—regardless of the type of financing on them—you will already be at the maximum number of financed properties allowable under Fannie or Freddie. Furthermore, once you own more than four financed properties, the cost of financing others with Fannie Mae or Freddie Mac financing increases. While this is not a show stopper, it is definitely something you should keep in mind when you are building a portfolio of income producing real estate.
There are some ways around this limitation. One is to consolidate your equities into multi-unit properties, rather than many single family units. Let’s look at how this might work.
You should be aware of some common terms:
- Operating Expenses: This includes all those normal costs of owning the property including (but not limited to) property taxes, insurance, repairs, maintenance, advertising, legal fees, etc. It does NOT include the mortgage payment or depreciation.
- Net Operating Income (NOI): This is the rent collected, less the Operating Expenses
- Capitalization Rate (Cap Rate): This is the NOI expressed as a percentage of the purchase price of the property. A rental property worth $200,000 that generates $12,000/year in NOI would have a Cap Rate of 6.0% (12,000 200,000). We can use the Cap Rate in another way: if we have decided that we expect a minimum Cap Rate of 7.5% and we know that a building has a NOI of $18,000, the building would be worth $240,000 to us for that Cap Rate (18,000 .075). The seller may not be willing to part with the building at that price, but at least knowing the numbers you require as an investor will help you narrow down your criteria.
- Cash-on-Cash Return: This is the amount of cash flow produced by the property before income tax consequences, expressed as a percentage of the cash investment. A property that generates annual pre-tax cash flow of $5,000 will have a Cash-on-Cash return of 5% if the cash investment was $100,000 (5,000 100,000).
- Mortgage Constant (MC): This is the annual debt service divided by the balance. A 30 year $300,000 mortgage at 4.5% will have a monthly payment of $1,520. The MC is 6.08. MC is useful in evaluating the potential cash flow of an investment.
A property’s Cap Rate is a measure of how efficiently it produces income. A $300,000 property with a 5% cap will generate $15,000 per year in NOI. A $300,000 property with an 8% cap generates $24,000. As a general rule, properties with lower Cap Rates tend to be “nicer” than those with higher rates. Theoretically, a rental home in an upscale neighborhood can attract higher quality tenants, and present fewer management headaches. This theory may or may not prove true in The Real World. As an investor, you may decide that you are willing to sacrifice some rate of return in exchange for owning a “pride of ownership” building.
In general, single family rentals are less efficient producers of income (lower cap rates) than small multi-unit properties. Let’s compare two $400,000 properties: a single family home in a very nice neighborhood, and a triplex in a working-class area. Both properties are in good condition.
The single family rental rents for $2,100 per month. The NOI is $18,900, so the cap rate is 4.73% (18,900 400,000).
The triplex, also worth $400,000, has three units rented for $1,100 per month. Although the potential rent is $3,300 per month, we should make an allowance for the occasional vacancy (5%). The rent we can expect to collect is $37,620 (1,100 3 12 – 5%). Our operating expenses will be slightly higher. Let’s say we have NOI of $30,470 (Gross Income of $37,620 less Operating Expenses of $7,150). If the price of the building is $400,000, the cap rate will be 7.62% (30,470 400,000).
Let’s compare cash flow for the two buildings.
The reason for the dramatic difference in cash flow is the cap rate; each dollar paid for the triplex generates more net income than for the single family house.
There is no free lunch, however. The triplex, with its $1,100 per month rent, will have a different kind of tenant than the $2,100 per month single family. Along with that lower rent will come higher maintenance demand and a vacancy factor (I have allowed for both here). Only you can decide whether the trade-off is a good one.
For many investors, cash flow is a more important objective than equity appreciation. If you are one of those investors, you might reasonably ask whether making a larger down payment—or even buying with no mortgage at all—might make sense. After all, the mortgage payment is the single largest expense in the examples presented here.
If you were to buy the single family rental for cash ($400,000), your annual cash flow would be $18,900 because there would be no mortgage. Your Cash-on-Cash return would be 4.73% (18,900 400,000). This is a far higher return than the .66% Cash-on-Cash return with a $300,000 mortgage on the property. If you are willing to forego the benefits of leveraged appreciation, this could be a good choice for you.
The reason for this large difference in Cash-on-Cash return has to do with the Mortgage Constant. Any time the Mortgage Constant is higher than the Cap Rate, having a mortgage will reduce your Cash-on-Cash return.
But the converse is also true: when the Cap Rate is higher than the Mortgage Constant, the rate of Cash-on-Cash will be higher with a mortgage. We are actually leveraging cash flow along with growth.
In the triplex example above, with its Cap Rate of 7.66%, we would have a Cash-on-Cash return of 7.66% if we had no loan on the property. Financing the property with a $300,000 mortgage and a monthly payment of $1,520 (6.08 MC), we’ll have annual cash flow of $11,780, for a Cash-on-Cash return of 11.78 (11,780 100,000).
The comparison between these two properties is not entirely fair. Just looking at the difference in rents between the two properties, we can assume that they will be located in very different neighborhoods. Multi-unit buildings have certain economies of scale: for one thing, they are likely to have less land for each unit. They will also tend to have a lower cost of construction—there is only one roof and only one set of exterior walls for three units, for example.
Historically, small multi-unit properties (2, 3 or 4 units) have tended to appreciate at roughly the same rate as single family homes in the same area—so their ability to support more leverage while still generating regular cash flow means that their overall rate of return will be higher.
So what could possibly go wrong?
First, you should keep in mind that investing in rental property is two things: it is an investment, where you put your capital at risk; it is also a business, where you provide a service (housing) to customers (tenants). That business requires a certain amount of skill. As a landlord, you have to know how to survey the market rents to charge the right price. You have to be a keen judge of character in selecting good tenants. At times you may have to be a proficient handyman. Your ability to do all these things will affect your rate of return.
If you lose a tenant, you will be faced with the task of cleaning the property, making needed repairs and attracting a new tenant. While your property is vacant, you will still be on the hook for the mortgage payment.
If you did not do a good job of selecting a tenant, you could have collection problems. There could be increased wear and tear on the property because of less desirable tenants. That would lead to higher expenses for repairs and maintenance.
One of the benefits of multi-unit properties is that when one unit is vacant, you still have income from the others. This fact would make the inevitable vacancy less traumatic to your checkbook.
Properties made up of four units or fewer are most commonly financed through loans conforming to Fannie Mae and Freddie Mac guidelines. Qualifying for these loans is no different from qualifying for the loan on your own home. The lender looks primarily to you, the borrower, as the determining factor.
What if you have decided to go “all-in” and buy more than four units? You have held your rentals for years now, and have built up a significant amount of equity. What about buying a large apartment building—say, 60 units, for $5 million? How would that work?
Financing large buildings is different from financing single family homes or triplexes. The banks making these loans typically hold on to them, keeping them in their portfolio, rather than selling the loans to an investor.
Commercial lending looks primarily to the property itself (although the strength of the borrower is important, as well). The underwriter asks, “Does this property with this loan on it make economic sense?” That means, “Will this property provide cash flow after paying all the expenses and paying the mortgage?”
The primary determination of how large a loan the lender will make on an apartment building is “Debt Service Coverage.” This refers to the amount of cash flow that will be available after all the expenses and the mortgage have been paid. Debt Service Coverage (DSC) of 1.25 means that the net operating income of the property will be sufficient to make the mortgage payment with 25% left over. The NOI is 125% of the mortgage payment.
We have an apartment building with a NOI of $160,000. The property is for sale for $2,000,000 (Cap rate = 8.0). We can get a mortgage for 4.25%, amortized over 30 years. The maximum mortgage payment the lender will allow is $10,667 per month (160,000 12=13,333/mo 13,333 1.25=10,667).
Working backwards with a magical financial calculator (the HP-12C is the best there is), I can solve for the loan amount: $2,168,000.
Wait a minute. Does that mean the lender will pay me to take their money? Nice try. Even though this property will support that larger loan, lenders will limit the loan to value ratio—typically no higher than 75%. So in this case, the lender would agree to make a loan of $1,500,000 on this property.
If I have a number of rental properties whose value has gone up (leveraged equity growth), I can accomplish a tax deferred exchange to acquire this apartment building—and pay no tax on the gains I am enjoying. Here is how it would look:
Keep in mind that, because of depreciation write-offs, some or all of that cash flow you pocket each month will be tax-sheltered. Also, because the value of an apartment building is directly tied to its net income, you can expect to see appreciation as a direct result of the net income increasing over time.
When you evaluate an apartment building for sale, you should not rely too heavily on the statement provided by the listing agent or the seller. The nice four-color brochures they give you may overestimate the rents and understate the expenses. It is very important that you analyze the tax returns for the building and make your own reasonable projections for income and expenses.
Some of the areas where expenses may be understated are property taxes and reserves for replacements and repairs. Property taxes are based on the purchase price of the property, so if you pay $2 million for it, you can expect the annual taxes to be around $25,000. This number is based on a rule-of-thumb figure of 1.25% of the purchase price, but you can get a more accurate figure by looking up the actual tax rate. You can do this by finding the Tax Assessor’s website for your county, then looking up the tax bill for the building. The bill will show the tax rate, which you can then apply to the anticipated purchase price.
Another commonly omitted item is reserves for maintenance and replacement. As you reconstruct the operating statement for the apartment building, you should include line items for money set aside to replace carpets, appliances, roof, etc. Even though these are not predictable monthly expenses, they will have to be paid at some point. Once you have reconstructed an operating statement for the property, you will be in a position to decide on whether this property will meet your financial criteria, and whether the asking price is even within a negotiating ballpark. Just as with other types of real estate, the real price of the property is what buyer and seller can come to terms on.
Next: What are your next steps?