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.

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.

Loan Calculations
      There are many good computer programs available to help analyze loan variables. 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.

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.