Investing In Rental Real Estate - Financing Part III

Financing

You are revved up now as you have been evaluating prospective properties and you are ready to buy, so what comes next?  Financing!  Unless you are an all cash buyer, how you are going to pay for that rental real estate in your sights is with financing.  Before I started into real estate, as I was reading books, I believe this subject was my biggest hang up why I would not get started.  I just didn't know much about this process and it scared me to be honest.  In 2011, I was introduced to a real estate club, Lifestyles Unlimited, that assured me they could walk me through buying a rental from beginning to end.  As you have read in my previous post, I went through it twice already, and potentially a third time in the near future.  Once you go through it once, I'm not saying you will know and encounter everything, but your potential fears around this process will disappear too.

Investing in Rental Real Estate - Intro Part I

Investing In Rental Real Estate - Evaluating Properties Part II

Prep for Pre-Approval

In my previous blog post, Investing In Rental Real Estate - Evaluating Properties Part II, I mentioned in order to work with realtor, you will need to get pre-approval letter.  In order to do that, you need to find a lender that will finance a portion of the property.  In general, when looking to finance rental real estate, you want to work with small banks or specialty banks and/or hard money lenders over the big banks because they tend to do a lot more of these types of deals and are more apt to work with investors.  

This is where you have to have your ducks in a row as far as your finances go.  Listed below are the items you can almost certainly expect for a lender to ask you for.

1. Latest 2 months of checking/savings bank account statements 
2. Latest escrow statement (if you own a house  and use escrow)
3. Latest HOA(Home Owner's Association) invoice for all property owned
4. Latest 2 months investment account statements(401K, brokerage accounts) 
5. Latest month's mortgage statement for all property owned 
6. Latest 1 month's pay stubs from employment 
7. W2 statements for the last 2 years 
8. Tax returns for the last 2 years 
9. 2 forms of government ID (Driver's license, Social Security card, etc.) 
10. If your have the title to your car, that as well
11. Any statements for cash value of life insurance policy
12. Homeowner's insurance for all property owned 

You will in turn, have to fill out some documentation from the lender as follows:

1. Authorization form for lender to pull your credit report, and payment information as this is charged to you. You can get your credit score for free by using the Credit Sesame banner link above this post to sign up.
2. An application form which will ask information about you the borrower(s), like where you live, who you work for, how much income you have and from where it comes, what are are your assets and their values, what are your liabilities and their values, and if you will be paying down-payment, the source where it will come from. 
3. The 4506-T Request for Transcript of Tax Return

Once you have provided all this information, the lender will tell you the max price range up to which you are approved to buy a property.  You can then take that pre-approval letter and send it to whichever realtor you plan to work with.  Just because you are pre-approved by one lender doesn't mean you cannot use another lender to actually close on the property with if the terms for another lender are better than the one which you got the initial pre-approval.

Now, if you go out and find a property within the price range of your pre-approval, you can feel assure that you will be able to close on that property as the lender has already thoroughly vetted your financials.  During this time, all the way through to closing, it is advised to not open new credit cards, make any large new purchases, as this can materially impact you being approved to close because this could change your debt to income ratio causing you to no longer qualify or qualify for a lower amount.

3 Types Of Financing

I mentioned working with specialty banks that is because sometimes the types of houses we investors will be buying might not have carpet, or stove, or refrigerator; thus, deemed unlivable by big banks to be able to lend on.  However, these specialty banks and hard money lenders will give bridge loans which allow for the fix up and re-evaluation of the property post repair for a ARV(After Repair Value).  Often with this type of lending you will do two closings.  The first closing is to acquire the property and fix it up and the 2nd is to refinance into long term loan based upon the ARV of the property; thus called, a double close.  This type of financing is not always required, as conventional financing with 20% down can also be used if the property is in fair condition and it is cheaper to go that route. 

When doing a double close, often, you will not be able to be your own general contractor as you need to fix up the property.  You will need to enlist the help of a professional and a scope of work will need to be defined and itemized by cost.  Based upon this scope of work, the appraiser will access what the ARV on the property will be and this work will be inspected to ensure it is done before disbursement of cash are done or the second close is completed.  So, be as quick as possible to get the work completed so that you can refinance into a long term loan and get a tenant in there and start earning some cash flow.
 
The third type of financing, which will require you to throw out pretty much everything above, is private money lending, where you won't necessarily have to qualify as a borrower much like you would with a bank as the lender will be mainly focused on your ability to deliver based on agreed upon terms of deal and the property which will be their collateral.  I am slightly familiar with private money lending; although I have yet to actually use when purchasing the properties I have.  I have sought out private money lenders via those with self directed IRAs or just those that have money looking to earn a higher than average rate of return.  If you are seeking private money, you can often find at companies that run self directed IRA as they often try to bring investors together with potential lenders to allow for the transact of deals, or if you have rich friends or family, perhaps they can be a source.

Terms Of The Deal

The property and the terms will dictate what type of financing you will use.  In selecting property, one thing which I forgot to mention in the evaluating property's blog is that as investors we are looking for properties that are below market value where possible.  These can be foreclosures or simply houses that the current owner doesn't want to put money into it for repairs and the like.  We often will make an offer that looks to secure a fair amount of free equity once the place is brought to the standards of other properties in the neighborhood.

When doing evaluation, often I would search for houses that would have appraised ARV worth $100,000 that I could buy for $65,000.  In terms of closing with private or specialty lender they will often lend up to 75% of the ARV($75,000 in this example ($100,000 x (1 - .25)), that would leave $25,000 in equity; thus, no PMI(Private Mortgage Insurance) would be required, and $10,000 difference, that could be used towards repairs and/or closing cost.  My total out of pocket on my 2 deals was about 15K each as mine were purchased in the $70K range, but repairs were often reasonable between $6,000 - $9,000.  With a conventional loan, you would just put 20% down and close and take care of any repairs out of pocket.  If the value is actually higher, down the road, you could do cash out refinance to pull out some of your cash/equity.

In Houston today, I am not finding the gravy train on MLS(Multiple Listing Service) that once existed on properties that were foreclosed as result of the 2009 financial meltdown which resulted in no criminal jail time for the bad actors in this mess, except for fines.  During that time, there was general depression on housing prices even if your house wasn't a foreclosure.  Properties today, even foreclosures, basically will leave you in position where you are just putting down the 20% on property that is basically retail, and then ensuring you get positive cash flow, a good cash on cash return of your money while looking at market appreciation and loan pay-down for opportunities to do cash out refi for buying more property.
 

Conclusion

So, general rule of thumb,

• If lots of equity over 25% in the house based upon ARV, and the repairs b/t $5K - $30K, look to do either double close or private money
• If not much equity, and generally below market value(which evaluating comps your realtor can provide will show) but minor repairs look for conventional financing

These are some of the basic financing options you have when purchasing rental real estate.  However you chose to go about it, ensure the end result is positive cash flow.  In all cases, you should be evaluating if the numbers make sense from purchase price, to interest cost, to expenses, and eventual cash flow.  If these are all good, then pull the trigger and purchase that property.  

Poll Result

I had a poll on my blog last week asking, "Which Property Is Best Prospect, based upon Investing In Rental Real Estate - Evaluating Properties Part II blog of the 3 choices."  One person answered the poll, and that person was correct in the choice I too would have chose based upon the prospects, so kudos to you.

Correct Answer

The 3 Choices to Chose Between

As you can see, someone else scooped up that house as it's under contract.  The price per square foot was way better by comparison; thus, you would be getting more for your money and generally can charge higher rents.  All would have had the same down-payment and are around the same age, but the gray house was the best.

This is intended to be a non-consecutive series of 7 other post on this topic.
 
Next on deck are:

• Tenant Screening/Move In Process - Part IV 
• Property Management - Part V 
• Cash Out Refinance Potential - Part VI 
• Move Out Process/Make Ready - Part VII 
• Single Family to Multi-Family Progression - Part VII

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