Leverage

Leverage

Leverage can be a scary word, especially post-recession.  For many people, the idea of borrowing a lot of money is terrifying to the point of paralysis.  I understand this perspective and I believe it is perfectly acceptable to ease into the process of using other people’s money to accomplish your goals.

The first investment property I purchased, I put 10% down (not uncommon in 2004) and I used all of my own money to finance the remodel or my duplex.  I had recently sold my primary residence, so I had the funds available.  Because I used up all my money on the first property, I had to get creative when the second opportunity to purchase a single family house came along.  I had a really clear plan to minimize the down payment, utilize an investor’s funds for the remodel, flip the house and pay the investor back. As you will see throughout this presentation, the common theme is that things rarely go according to plan. You can read more about how that deal actually unfolded at “Getting Started is Rarely Pretty.” But from a financing standpoint, I was able to refinance the house once the project was completed and cash out my investor.  I still own the house, ten years later, as a cash flowing rental.

A key point here is that if you structure a deal properly, you will have a whole lot more options when it comes to financing and re-financing.  The saying goes “you make money when you buy a property, not when you sell it.”  What this really means is that it is critical for you to understand the nuts and bolts about putting together a deal both from your perspective as an owner and from the point of view of lenders.  That’s a big part of what I am going to try to lay out for you.

I am a product of Robert Kiyosaki (among many other things).  I played is board game “Cash Flow” in August of 2004 and decided to try to put it into practice in my life.  By November of 2007, I owned 79 rental units.

One of the most powerful and simple concepts that Kiyosaki talks about is cash flow. Basically all it means is that when all is said and done, a property needs to have more money coming in then it has going out.  There are all kinds of sophisticated was to analyze property (and you should get familiar with them), but really what would be the point of buying a property that is not paying for itself?  Sure some people would tell you there are tax benefits to having a property lose money, but there are so many expenses you can write off in real estate, why not have it be profitable while you are also getting some tax benefits.  Also, the discipline required to find and acquire a rental property that actually cash flows will never fail to set you in good stead.

The reason why the concept of cash flow was so powerful to me right from the start was that I knew that I did not want to have to get a job.  I wanted my real estate investments to support me in the short-term and allow me to build wealth and plan for retirement in the long-term. I simply could not afford to buy properties that did not cash flow.  Again, cash flow means that after the rents have come in every month and all the bills have been paid, there is some money left over (to pay yourself).

When I started, I used to run my numbers by hand. I would write out all the property expenses and subtract then from the income.  I wanted to really understand what was going on.  In time, I built and extremely simple spreadsheet that I still use to this day.  Some investors might say my calculations lack sophistication because I don’t compare pre-tax and after-tax income. Or that I am not a real investor because I don’t use cap rates to analyze property.  Perhaps they are right.  What I have found, however, is that often times people use sophisticated calculations to mask the fact that the property is not actually cash flowing right now (which is the true indicator of profitability in my book).  Realtors are particularly guilty of this sin.

You need to develop a consistent standard to help you determine if you should buy a particular property, because there will always be a ton of people wanting to sell you property. It is actually the most common thing I say to people when they ask me my opinion about buying rental property: Does it cash flow?  Once I break out the spreadsheet, the answer is usually no.

This may be a little off topic here, but let me dispel the myth that there are no properties worth buying that are listed in the Multiple Listings (MLS).  My first two properties were listed in the multiple listing.  The best multi-family property I have bought to date was listed in the MLS.  There are opportunities everywhere and the more you refine your analysis skills, the better you will be able to see them and ignore the hype.

I used to carry around a pile of the listings for all the properties I looked at to remind me how many deals I had to research before finding just one I wanted to buy.  The ratio that I have heard is you look at 100 properties to find 10 to make offers on and you end up buying one.  It really does work that way.  What happens, however, in this process is that you get so much practice running numbers and analyzing properties is that when you find a good deal, you are ready to act.  It also helps you build your analysis muscle so that after a year or so of doing it, you get to the point where with just the gross rent and the address, you know if it is worth your time to drive by the property.

Yes, I did just say DRIVE BY the property.  Your smart phone and your Google Earth and your Truilla’s can only take you so far.  For better or worse, people choose to live in a place, a geographic location, a fixed point in space.  And if you are going to be the one trying to rent out a space for people to live in, you want to make sure you pick one that is desirable to people.  There are all kinds of amazing things that happen when you get out of your car and walk around a property (or several hundred).  You start to learn about foundations and roofing materials that are used in particular price brackets and neighborhoods. You begin to understand what features you can expect to see at certain price points.   You learn which areas have sewers and which places to avoid because they are on septic. And finally, you might encounter one of the greatest sources of information: the neighbors.

Often times, neighbors know more about a property then real estate agents and even the owner.  They, after all, are the ones who live next door to the property.  Neighbors often know who lived there, when and if they moved out, whether there was police activity, if there are boundary disputes, how cooperative the owner is, and the list goes on and on.  You cannot meet those neighbors through your computer screen.

OK, so I have gotten a little far afield from where I started talking about leverage and borrowing money.  Basically, when I did my first transaction, I wanted to use my own money to prove to myself that I could do it.  I needed to build my confidence in myself before I felt comfortable asking other people to use their money.  Interestingly, though, once I started using more leverage (less of my own money) I actually started to tighten up my numbers and get clearer about making a specific plan for the property.  I was willing to be more fluid with my own money than with someone else’s. So leverage actually began to hold me to a higher standard.

Eventually, it will come down to a point of your willingness to take a risk.  But it is very different to take an informed risk versus a reckless risk.  An informed risk is one in which you have done your research, built your skills and experience, made valuable professional contacts and then make the choice to borrow an amount of money that still might make your heart skip a beat.  A reckless risk is one in which you rely on someone else to tell you that it is “the deal of a lifetime,” you refuse to pay for solid professional advice and you just believe that all the pieces will magically fall into place.  In that scenario, you should be hyperventilating if you are signing loan documents.

Once you get the process down-more money coming in than going out-it becomes easy to start to grow your numbers. Think of the income and expenses like beans, rather than dollars.  No matter how many zeros there are after a number, there needs to be more beans coming in than there are going out.  Nothing magical changes when you buy a million dollar property (well, actually you realize how much more you are building in equity just by doing the same thing you were doing before, more on that later).  In fact, it is even more important to have strong cash flow because chances are good you don’t have $10,000 lying around to make the monthly mortgage payment if the property cannot support itself.

At this point you might be wondering why I am spending all this time talking about property research in a section that is supposed to be about financing.  It is because what property you choose to try to acquire is going to have a profound impact on your ability to get financing.

Once you are convinced that a property is worth buying, it becomes a lot easier to convince someone else that they want to put their money on the line to help you close the deal.  There are a lot of creative financing strategies out there, but we are going to start with the basics: How to convince a bank or credit union to give you a mortgage for your first rental property.

Working with Lending Institutions

It has taken me a number of years to start to understand how a bank or credit union looks at the world.  And that worldview changed significantly post recession.  Well, actually, I would say it just intensified rather than altered dramatically.  When dealing with a bank or credit union, you should think of them like a super conservative, super paranoid wealthy uncle who oddly wants to give all his money away before he dies.  If you don’t have one of them, use your imagination.

Let’s break this down, starting with conservative.  Lending institutions have very strict standards that they use to determine how and how much money they will lend you.  One of the first terms you need to know is loan to value ratio (LTV). Basically, what this means is that the bank is only willing to loan you a certain percentage of the value of the property.  The “value” of the property will be determined by an appraisal. Depending on the type of property, LTV’s can vary from 70 to 80%, with the limits tending to be higher on single family house.  For example, if you are looking at a house with a sales price of $100,000, the bank will be likely willing to lend you $80,000.  On a property with four or more units, the limits are more likely to be 70-75% ($250,000 sales price, mortgage at 70% LTV would be $175,000).

A note on appraisals: Appraisers are independent reviewers who are hired by the bank to determine the value of the property.  Appraisers seem to be the group of people who are experiencing the most residual effects from the recession.   Usually, if a property is fairly priced and sold under normal conditions (no one is being held at gun point), the appraisal comes in at or around the sales price.  In some situations, that may not be the case. Post-recession, some appraisers seem to be valuing properties in an ultra conservative manner.  Most likely this is due to the fact that over inflated values help to contribute to the housing collapse.  Values may also come in lower in a refinance situation, particularly if you are taking out equity from the property.

Back to the LTV issue, the bank is only willing to loan you a certain percentage of the value of the property because that helps to reduce their risk.  The concept is that if you have $20,000 of your own cash in the deal, you are less likely to stop paying the mortgage because you would lose your cash.  LTV’s are higher on a primary residence, because most people don’t intentionally want to make themselves homeless by having the bank foreclose on their house.  So for the purposes of planning your real estate investment strategy, you should assume that you are going to need to have some of your own money available.

In future posts, I will explore some creative ways to come up with the down payment that the bank is going to want to see before they will lend you money.

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Simple Financial Planning Can Go a Long Way

I learned this tip by accident, but now I swear by it.

Don’t have your mortgage/commercial loan payment due at the beginning of the month.  I find the best dates are between the 15th and the 25th.  This arrangement allows me to focus on collecting rents and communicating with any tenants who are late during the first two weeks of the month.  Then once the funds have all been collected, I can focus on paying my major bills.

If you are planning to acquire a new rental property, plan to close on the property after the 15th, so that your payment is due after the 15th.  Your closing date normally determines when your first payment will be due.  If that doesn’t work for your transaction, negotiate with your lender to adjust the payment date.  Even if it costs you a few hundred dollars in interest at closing, it is well worth it in the end. Collecting late rent is one of the headaches of being a landlord, so off-setting your loan payments from your tenant’s rent payments will help reduce the stress of late payments from tenants.

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