Financing Secrets Of A Millionaire Real Estate Investor
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Bronchick, William.
Financing secrets of a millionaire real estate investor / William
Bronchick.
p. cm.
Includes index.
ISBN 0-7931-6820-1
(
7.25
×
9 pbk.)
1. Mortgage loans—United States. 2. Secondary mortgage
market—United States. 3. Real property—United States—Finance. 4.
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v
C
ONTENTS
1. Introduction to Real Estate Financing
1
Understanding the Time Value of Money 2
The Concept of Leverage 2
Owning Property “Free and Clear” 5
How Financing Affects the Real Estate Market 6
How Financing Affects Particular Transactions 7
How Real Estate Investors Use Financing 8
When Is Cash Better Than Financing? 9
What to Expect from This Book 10
Key Points 10
2. A Legal Primer on Real Estate Loans
11
What Is a Mortgage? 11
Promissory Note in Detail 12
The Mortgage in Detail 14
The Deed of Trust 15
The Public Recording System 15
Priority of Liens 16
What Is Foreclosure? 17
Judicial Foreclosure 17
Nonjudicial Foreclosure 18
Strict Foreclosure 19
Key Points 19
3. Understanding the Mortgage Loan Market
21
Institutional Lenders 21
Primary versus Secondary Mortgage Markets 22
Mortgage Bankers versus Mortgage Brokers 23
Conventional versus Nonconventional Loans 25
Conforming Loans 25
Nonconforming Loans 28
vi
CONTENTS
Government Loan Programs 28
Federal Housing Administration Loans 29
The Department of Veterans Affairs 30
State and Local Loan Programs 31
Commercial Lenders 31
Key Points 32
4. Working with Lenders 33
Interest Rate 33
Loan Amortization 34
15-Year Amortization versus 30-Year Amortization 36
Balloon Mortgage 37
Reverse Amortization 38
Property Taxes and Insurance Escrows 38
Loan Costs 39
Origination Fee 39
Discount Points 39
Yield Spread Premiums: The Little Secret Your Lender
Doesn’t Want You to Know 39
Loan Junk Fees 40
“Standard” Loan Costs 41
Risk 44
Nothing Down 45
Loan Types 46
Choosing a Lender 48
Length of Time in Business 49
Company Size 50
Experience in Investment Properties 50
How to Present the Deal to a Lender 51
Your Credit Score 52
Your Provable Income 56
The Property 56
Loan-to-Value 58
The Down Payment 59
Income Potential and Resale Value of the Property 60
Financing Junker Properties 60
Refinancing—Worth It? 61
Filling Out a Loan Application 61
Key Points 62
CONTENTS
vii
5. Creative Financing through Institutional Lenders
63
Double Closing—Short-Term Financing without Cash 63
Seasoning of Title 65
The Middleman Technique 67
Case Study #1: Tag Team Investing 69
Case Study #2: Tag Team Investing 70
Using Two Mortgages 71
No Documentation and Nonincome Verification Loans 72
Develop a Loan Package 75
Subordination and Substitution of Collateral 76
Case Study: Subordination and Substitution 77
Using Additional Collateral 79
Blanket Mortgage 79
Using Bonds as Additional Collateral 80
Key Points 82
6. Hard Money and Private Money
83
Emergency Money 83
Where to Find Hard-Money Lenders 84
Borrowing from Friends and Relatives 85
Using Lines of Credit 86
Credit Cards 86
Key Points 87
7. Partnerships and Equity Sharing
89
Basic Equity-Sharing Arrangement 90
Scenario #1: Buyer with Credit and No Cash 90
Scenario #2: Buyer with Cash and No Credit 91
Your Credit Is Worth More Than Cash 91
Tax Code Compliance 92
Pitfalls 93
Alternatives to Equity Sharing 93
Joint Ventures 94
Using Joint Venture Partnerships for Financing 94
Legal Issues 95
Alternative Arrangement for Partnership 95
Case Study: Shared Equity Mortgage with Seller 96
When Does a Partnership Not Make Sense? 97
Key Points 98
viii
CONTENTS
8. The Lease Option
99
Financing Alternative 100
Lease—The Right to Possession 100
Sublease 100
Assignment 100
More on Options, the “Right” to Buy 101
An Option Can Be Sold or Exercised 102
Alternative to Selling Your Option 102
The Lease Option 103
The Lease Purchase 103
Lease Option of Your Personal Residence 104
The Sandwich Lease Option 106
Cash Flow 107
Equity Buildup 107
Straight Option without the Lease 108
Case Study: Sandwich Lease Option 109
Sale-Leaseback 110
Case Study: Sale-Leaseback 111
Key Points 112
9. Owner Financing
113
Advantages of Owner Financing 115
Easy Qualification 115
Cheaper Costs 116
Faster Closing 116
Less Risk 116
Future Discounting 117
Assuming the Existing Loan 117
Assumable Mortgages 117
Assumable with Qualification 118
Buying Subject to the Existing Loan 118
Risk versus Reward 119
Convincing the Seller 120
A Workaround for Down-Payment Requirements 121
Installment Land Contract 122
Benefits of the Land Contract 124
Problems with the Land Contract 125
Using a Purcahse Money Note 125
Variation: Create Two Notes, Sell One 126
Another Variation: Sell the Income Stream 126
CONTENTS
ix
Wraparound Financing 127
The Basics of Wraparound Financing 127
Wraparound versus Second Mortgage 130
Mirror Wraparound 132
Wraparound Mortgage versus Land Contract 133
Key Points 133
10. Epilogue
135
Appendix A Interest Payments Chart 139
Appendix B State-by-State Foreclosure Guide 141
Appendix C Sample Forms 143
Uniform Residential Loan Application
[
FNMA Form 1003
]
144
Good Faith Estimate of Settlement Costs 148
Settlement Statement
[
HUD-1
]
149
Note
[
Promissory—FNMA
]
151
California Deed of Trust
(
Short Form
)
153
Mortgage
[
Florida—FNMA
]
155
Option to Purchase Real Estate
[
Buyer-Slanted
]
171
Wrap Around Mortgage
[
or Deed of Trust
]
Rider 173
Installment Land Contract 174
Subordination Agreement 176
Glossary 179
Resources 187
Suggested Reading 187
Suggested Web Sites 188
Real Estate Financing Discussion Forums 188
Index 189
1
CHAPTER
1
Introduction to Real
Estate Financing
Knowledge is power.
—Francis Bacon
In 1991, I made my first attempt at financing an investment prop-
erty through creative means. With a lot of guts and a little knowledge,
I made an offer that was accepted by the seller. I tendered $1,000 as
earnest money on the sales contract, then proceeded to try to make
the deal work. I failed, lost my $1,000, but I learned an important les-
son—a little knowledge can be dangerous. I decided then to become a
master at real estate finance.
Financing has traditionally been, and will always be, an integral
part of the purchase and sale of real estate. Few people have the funds
to purchase properties for all cash, and those that do rarely sink all of
their money in one place. Even institutional and corporate buyers of
real estate use borrowed money to buy real estate.
This book explains how to utilize real estate financing in the
most effective and profitable way possible. Mostly, this book focuses
on acquisition techniques for investors, but these techniques are also
applicable to potential homeowners.
2
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Understanding the Time Value of Money
In order to understand real estate financing, it is important that
you understand the time value of money. Because of inflation, a dollar
today is generally worth less in the future. Thus, while real estate val-
ues may increase, an all-cash purchase may not be economically feasi-
ble, because the investor’s cash may be utilized in more effective ways.
The cost of borrowing money is expressed in interest payments,
usually a percent of the loan amount. Interest payments can be calcu-
lated in a variety of ways, the most common of which is simple inter-
est. Simple interest is calculated by multiplying the loan amount by the
interest rate, then dividing it up into period
(
12 months, 15 years, etc
)
.
Example:
A $100,000 loan at 12% simple interest is $12,000
per year, or $1,000 per month. To calculate monthly simple-
interest payments, take the loan amount
(
principal
)
, multiply
it by the interest rate, and then divide by 12. In this example,
$100,000 × .12 = $12,000 per year ÷ 12 = $1,000 per month.
Mortgage loans are generally not paid in simple interest but
rather by amortization schedules
(
discussed in Chapter 4
)
, calculated
by amortization tables
(
see Appendix A
)
.
Amortization,
derived from
the Latin word “amorta”
(
death
)
, is to pay down or “kill” a debt. Amor-
tized payments remain the same throughout the life of the loan but are
broken down into interest and principal. The payments made near the
beginning of the loan are mostly interest, while the payments near the
end are mostly principal. Lenders increase their return and reduce
their risk by having most of the profit
(
interest
)
built into the front of
the loan.
The Concept of Leverage
Leverage
is the process of using borrowed money to make a re-
turn on an investment. Let’s say you bought a house using all of your
cash for $100,000. If the property were to increase in value 10 percent
☛
1 / Introduction to Real Estate Financing
3
The Federal Reserve and Interest Rates
The Federal Reserve
(
the Fed
)
is an independent
entity created by an Act of Congress in 1913 to
serve as the central bank of the United States.
There are 12 regional banks that make up the Fed-
eral Reserve System. While the regional banks are
corporations whose stock is owned by member
banks, the shareholders have no influence over the
Federal Reserve banks’ policies.
Among other things, the function of the Fed is
to try to regulate inf lation and credit conditions in
the U.S. economy. The Federal Reserve banks also
supervise and regulate depository institutions.
So how does the Fed’s policy affect interest
rates on loans? To put it simply, by manipulating
“supply and demand.” The Fed changes the money
supply by increasing or decreasing reserves in the
banking system through the buying and selling of
securities. The changes in the money supply, in
turn, affect interest rates: the lower the supply of
money, the higher the interest rate that is charged
for loans between banks. The more it costs a bank
to borrow money, the more they charge in interest
to consumers to borrow that money. The preced-
ing is a simplified explanation, because there are
other factors in the world economy that affect
interest rates and money supply. And, of course,
there are also widely varying opinions by econo-
mists as to what factors drive the economy and
interest rates.
4
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
over 12 months, it would now be worth $110,000. Your return on in-
vestment would be 10 percent annually
(
of course, you would actually
net less because you would incur costs in selling the property
)
.
Equity = Property value – Mortgage debt
If you purchased a property using $10,000 of your own cash and
$90,000 in borrowed money, a 10 percent increase in value would
still result in $10,000 of increased equity, but your return on cash is
100 percent
(
$10,000 investment yielding $20,000 in equity
)
. Of
course, the borrowed money isn’t free; you would have to incur loan
costs and interest payments in borrowing money. However, by rent-
ing the property in the meantime, you would offset the interest
expense of the loan.
Let’s also look at the income versus expense ratios. If you pur-
chased a property all cash for $100,000 and collected $1,000 per
month in rent, your annual cash-on-cash return is 12 percent
(
simply
divide the annual income, $12,000, by the amount of cash invested,
$100,000
)
.
If you borrowed $90,000 and the payments on the loan were
$660 per month, your annual net income is $4,080
(
$12,000 –
[
$660
× 12
])
, but your annual cash-on-cash return is about 40 percent
(
annual cash of $4,080 divided by $10,000 invested
)
.
Calculating Return on Investment
Annual return on investment
(
ROI
)
is the interest
rate you yield on your cash investment. It is calcu-
lated by taking the annual cash flow or equity
increase and dividing it by the amount of cash
invested.
1 / Introduction to Real Estate Financing
5
So, if you purchased ten properties with 10 percent down and
90 percent financing, you could increase your overall profit by more
than threefold. Of course, you would also increase your risk, which
will be discussed in more detail in Chapter 4.
Owning Property “Free and Clear”
For some investors, the goal is to own properties “free and clear,”
that is, with no mortgage debt. While this is a worthy goal, it does not
necessarily make financial sense. See Figure 1.1.
FIGURE 1.1
Owning Free and Clear versus Mortgaging
100%
Free and
Clear
90%
Financing
FREE AND CLEAR PROPERTY
Value = $100,000
Cash Investment = $100,000
Annual Net Income = $12,000
Return on Investment = 12%
90% FINANCED PROPERTY
Value = $100,000
Cash Investment = $10,000
Annual Net Income = $4,080
Return on Investment = 40.8%
10% Down
Payment
6
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Example:
Consider a $100,000 property that brings in
$10,000 per year in net income
(
net
means gross rents col-
lected, less expenses, such as property taxes, maintenance,
utilities, and hazard insurance
)
. The $100,000 in equity thus
yields a 10 percent annual return on investment
(
$10,000,
the annual net cash flow, divided by $100,000, the equity
investment
)
.
If the property were financed for 80 percent of its value
(
$80,000
)
at 7.5 percent interest, the monthly payment would be approximately
$560 per month, or $6,720 per year. Net rent of $10,000 per year
minus $6,720 in debt payments equals $3,280 per year in net cash
flow. Divide the $3,280 in annual cash flow by the $20,000 in equity
and you have a 16.4 percent return on investment. Furthermore, with
$80,000 more cash, you could buy four more properties. As you can
see, financing, even when you don’t necessarily “need” to do so, can
be more profitable than investing all of your cash in one property.
How Financing Affects the Real Estate Market
Because financing plays a large part in real estate sales, it also af-
fects values; the higher the interest rate, the larger your monthly pay-
ment. Conversely, the lower the interest rate, the lower the monthly
payment. Thus, the lower the interest rate, the larger the mortgage
loan you can afford to pay. Consequently, the larger the mortgage you
can afford, the more the seller can ask for in the sales prices.
Also, people with less cash are usually more concerned with
their payment than the total amount of the purchase price or loan
amount. On the other hand, people with all cash are more concerned
with price. Because most buyers borrow most of the purchase price,
the prices of houses are affected by financing. Thus, when interest
rates are low, housing prices tend to increase, because people can
afford a higher monthly payment. Conversely, when interest rates are
higher, people cannot afford as much a payment, generally driving
real estate prices down.
☛
1 / Introduction to Real Estate Financing
7
Since the mid-1990s, the prices of real estate have dramatically
increased in most parts of the country. The American economy has
grown, the job growth during this period has been good, but most
important, interest rates have been low.
How Financing Affects Particular Transactions
When valuing residential properties, real estate appraisers gener-
ally follow a series of standards set forth by professional associations
(
the most well-known is the Appraisal Institute
)
. Sales of comparable
properties are the general benchmark for value. Appraisers look not
just at housing sale prices of comparable houses, but also at the
financing associated with the sales of these houses. If the house was
owner-financed
(
discussed in Chapter 9
)
, the interest rate is generally
higher than conventional rates and/or the price is inflated. The price
is generally inf lated because the seller’s credit qualifications are
looser than that of a bank, which means the buyer will not generally
complain about the price.
Take a Cue from Other Industries
The explosion of the electronics market, the auto-
mobile market, and other large-ticket purchase
markets is directly affected by financing. Just
thumb through the Sunday newspapers and you
will see headlines such as “no money down” or
“no payments for one year.” These retailers have
learned that financing moves a product because it
makes it easier for people to justify the purchase.
Likewise, the price of a house may be stretched a
bit more when it translates to just a few dollars
more per month in mortgage payments.
8
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Appraisals on income properties are done in a variety of ways,
one of which is the “income” approach. The
income approach
looks
at the value of the property versus the rents the property can pro-
duce. While financing does not technically come into the equation, it
does affect the property’s profitability to the investor. Thus, a prop-
erty that can be financed at a lower interest rate will be more attrac-
tive to the investor if cash flow is a major concern.
How Real Estate Investors Use Financing
As discussed above, investors use mortgage loans to increase
their leverage. The more money an investor can borrow, the more he
or she can leverage the investment. Rarely do investors use all cash to
purchase properties, and when they do, it is on a short-term basis.
They usually refinance the property to get their cash back or sell the
property for cash.
Tax Impact of Financing
Down payments made on a property as an investor
are not tax-deductible. In fact, a large down pay-
ment offers no tax advantage at all because the in-
vestor’s tax basis is based on the purchase price,
not the amount he or she puts down. However, be-
cause mortgage interest is a deductible expense,
the investor does better tax wise by saving his or
her cash. Think about it: the higher the monthly
mortgage payment, the less cash f low, the less tax-
able income each year. While positive cash flow is
desirable, it does not necessarily mean that a prop-
erty is more profitable because it has more cash
flow. A larger down payment will obviously in-
crease monthly cash flow, but it is not always the
best use of your money.
1 / Introduction to Real Estate Financing
9
The challenge is that loans for investors are treated as high-risk
by lenders when compared to noninvestor
(
owner-occupied proper-
ties
)
loans. Lenders often look at leveraged investments as risky and
are less willing to loan money to investors. Lenders assume
(
often cor-
rectly
)
that the less of your own money you have invested, the more
likely you will be to walk away from a bad property. In addition, fewer
investor loan programs mean less competition in the industry, which
leads to higher loan costs for the investor. The goal of the investor thus
is to put forth as little cash as possible, pay the least amount in loan
costs and interest, while keeping personal risk at a minimum. This is
quite a challenge, and this book will reveal some of the secrets for
accomplishing this task.
When Is Cash Better Than Financing?
Using all cash to purchase a property may be better than financ-
ing in two particular situations. The first situation is a short-term deal,
that is, you intend to sell the house shortly after you buy it
(
known as
“flipping”
)
. When you have the cash to close quickly, you can gener-
ally get a tremendous discount on the price of a house. In this case,
financing may delay the transaction long enough to lose an opportu-
nity. Cash also allows you to purchase properties at a larger discount.
You’ve heard the expression, “money talks, BS walks.” This is particu-
larly true when making an offer to purchase a property through a real
estate agent. The real estate agent is more likely to recommend to his
or her client a purchase offer that is not contingent on the buyer
obtaining bank financing.
The second case is one in which you can use your retirement ac-
count. You can use the cash in your IRA or SEP to purchase real estate,
and the income from the property is tax-deferred. In order to do this,
you need an aggressive self-directed IRA custodian
(
oddly enough,
most IRA custodians view real estate as “risky” and the stock market as
“safe”
)
. Two such custodians are Mid Ohio Securities,
<
www.mi
doh.com
>
, or Entrust Administration,
<
www.entrustadmin.com
>
.
10
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
What to Expect from This Book
This book will show you how to finance properties with as little
cash as possible, while maintaining minimum risk and maximum
profit.
The first few chapters describe the mortgage loan process, legal
details, and the banking industry. Chapter 4 covers different types of
lenders and loans, and the benefits of each. Chapter 5 covers how to
creatively use institutional loan programs as an investor. Chapters 6,
7, 8, and 9 cover creative, noninstitutional financing.
As with any technique on real estate acquisition or finance, you
should review the process with a local professional, including an attor-
ney. Also, keep in mind that while most of these ideas are applicable
nationwide, local practices, laws, rules, customs, and market condi-
tions may require variations or adaptations for your particular use.
Key Points
•
Interest rates affect property values.
•
Financing affects the value of a property to an investor.
•
Investors use financing to leverage their investments.
Understanding a Cash Offer
versus Paying All Cash
If you make a “cash offer” on a property, it does not
necessarily mean you are using all of your own
cash. It means the seller is receiving all cash, as op-
posed to the seller financing some part of the pur-
chase price
(
discussed more fully in Chapter 9
)
.
11
CHAPTER
2
A Legal Primer on
Real Estate Loans
If there were no bad people there would be no good lawyers.
—Charles Dickens
Before we discuss lenders, loans, and loan terms, it is essential
that you understand the legal fundamentals and paperwork involved
with mortgage loans. By analogy, you cannot make a living buying and
selling automobiles without a working knowledge of engines and car
titles. Likewise, you need to understand how the paperwork fits into
the real estate transaction. Without a working knowledge of the
paperwork, you are at the mercy of those who have the knowledge.
Furthermore, without the know-how your risk of a large mistake or
missed opportunity increases tremendously.
What Is a Mortgage?
Most of us think of going to a bank to get a mortgage. Actually,
you go to the bank to get a loan. Once you are approved for the loan,
you sign a promissory note to the lender, which is a legal promise to
12
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
pay. You also give the lender
(
not get
)
a mortgage as security for repay-
ment of the note. A
mortgage
(
also called a “deed of trust” in some
states
)
is a security agreement under which the borrower pledges his
or her property as collateral for payment. The mortgage document is
recorded in the county property records, creating a lien on the prop-
erty in favor of the lender. See Figure 2.1.
If the underlying obligation
(
the promissory note
)
is paid off, the
lender must release the collateral
(
the mortgage
)
. The release will
remove the mortgage lien from the property. If you search the public
records of a particular property, you will see many recorded mort-
gages that have been placed and released over the years.
Promissory Note in Detail
A note is an IOU or promise to pay; it is a legal obligation. A
promissory note
(
also known as a “note” or “mortgage note”
)
spells
out the amount of the loan, the interest to be paid, how and when pay-
ments are made, and what happens if the borrower defaults. The note
FIGURE 2.1
The Mortgage Transition
Promissory Note:
Legal Obligation to Pay
Security Instrument
(Mortgage or Deed of Trust)
Collateral for Note
Lender Borrowe
r
2 /A Legal Primer on Real Estate Loans
13
may also contain disclosures and other provisions required by federal
or state law.
Most lenders use a form of note that is approved by the Federal
National Mortgage Association
(
FNMA, or Fannie Mae
)
. A sample
form of this note can be found in Appendix C. The note is signed
(
in
legal terms, “executed”
)
by the borrower. The original note is held by
the lender until the debt is paid in full, at which time the original note
is returned to the borrower marked “paid in full.”
A Mortgage Note Is a Negotiable Instrument
Like a check, a mortgage note can be assigned and
collected by whoever holds the note. As discussed
in Chapter 3, mortgage notes are often bought,
sold, traded, and hypothecated
(
pledged as col-
lateral
)
.
A Promissory Note Is a Personal Obligation
Because promissory notes are personal obliga-
tions, the history of payments will appear on your
credit file, even if the debt is used for investment.
If you fail to pay on the note, your credit will be
adversely affected, and you risk a lawsuit from the
lender. Some notes are nonrecourse, that is, the
lender cannot sue you personally. Although not
always possible, you should try to make sure most
of your debt is nonrecourse.
14
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
The Mortgage in Detail
The security agreement executed by the borrower pledges the
property as collateral for the note. Known by most as a “mortgage,”
this document, when recorded
(
discussed below
)
, creates a lien in
favor of the lender. The mortgage agreement is generally a standard-
ized form approved by FNMA. While the form of note is generally the
same from state to state, the mortgage form differs slightly because
the legal process of foreclosure
(
the lender’s right to proceed against
the collateral
)
is different in each state. See Figure 2.2.
The mortgage document will state that upon default of the note,
the lender can exercise its right to foreclose on the property. Foreclo-
sure is the process of lenders exercising their legal right to proceed
against the collateral for the loan
(
discussed later in this chapter
)
. It
also places other obligations upon the borrower, such as
•
maintaining the property,
•
paying property taxes, and
•
keeping the property insured.
FIGURE 2.2
Parties to a Mortgage
Borrower/
Mortgagor
Lender/
Mortgagee
2 /A Legal Primer on Real Estate Loans
15
The Deed of Trust
Some states
(
e.g., California
)
use a document called a “deed of
trust”
(
AKA “trust deed”
)
rather than a mortgage. The
deed of trust
is
a document in which the trustor
(
borrower
)
gives a deed to the neutral
third party
(
trustee
)
to hold for the beneficiary
(
lender
)
. A deed of
trust is worded almost exactly the same as a mortgage, except for the
names of the parties. Thus, the deed of trust and mortgage are essen-
tially the same, other than the foreclosure process. See Figure 2.3.
The Public Recording System
The recording system gives constructive notice to the public of
the transfer of an interest in property. Recording simply involves
bringing the original document to the local county courthouse or
county clerk’s office. The original document is copied onto a com-
puter file or onto microfiche and is returned to the new owner. There
is a filing fee of about $6 to $10 per page for recording the document.
FIGURE 2.3
Parties to a Deed of Trust
Borrower/
Trustor
Lender/
Beneficiary
Trustee
16
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
In addition, the county, city, and/or state may assess a transfer tax
based on either the value of the property or the mortgage amount.
A deed or other conveyance does not have to be recorded to be
a valid transfer of an interest. For example, what happens if John gives
title to Mary, then he gives it again to Fred, and Fred records first?
What happens if John gives a mortgage to ABC Savings and Loan, but
the mortgage is not filed for six months, and then John immediately
borrows from another lender who records its mortgage first? Who
wins and loses in these scenarios?
Most states follow a “race-notice” rule, meaning that the first per-
son to record his document, wins, so long as
•
he received title in good faith,
•
he paid value, and
•
he had no notice of a prior transfer.
Example:
John buys a home and, in so doing, borrows
$75,000 from ABC Savings Bank. John signs a promissory
note and a mortgage pledging his home as collateral. Because
ABC messes up the paperwork, the mortgage does not get re-
corded for 18 months. In the interim, John borrows $12,000
from The Money Store, for which he gives a mortgage as col-
lateral. The Money Store records its mortgage, unaware of
John’s unrecorded first mortgage to ABC. The Money Store
will now have a first mortgage on the property.
Priority of Liens
Liens, like deeds, are “first in time, first in line.” Thus, if a prop-
erty is owned free and clear, a mortgage recorded will be a
first mort-
gage.
A mortgage recorded thereafter will be a
second mortgage
(
sometimes called a
junior mortgage
because its lien position is be-
hind the first mortgage
)
. Likewise, any judgments or other liens re-
corded later are also junior liens. Holding a first mortgage is a desirable
☛
2 /A Legal Primer on Real Estate Loans
17
position because a foreclosure on a mortgage can wipe out all liens
that are recorded behind it
(
called “junior lien holders”
)
. The process
of foreclosure will be discussed in more detail later in this chapter.
At the closing of a typical real estate sale, the seller conveys a
deed to the buyer. Most buyers obtain a loan from a conventional
lender for most of the cash needed for the purchase price. As dis-
cussed earlier, the lender gives the buyer cash to pay the seller, and
the buyer gives the lender a promissory note. The buyer also gives the
lender a security instrument
(
mortgage or deed of trust
)
under which
she pledges the property as collateral. When the transaction is com-
plete, the buyer has the title recorded in her name and the lender has
a lien recorded on the property.
What Is Foreclosure?
Foreclosure
is the legal process of the mortgage holder taking
the collateral for a promissory note in default. The process is slightly
different from state to state, but there are basically two types of fore-
closure: judicial and nonjudicial. In mortgage states, judicial foreclo-
sure is used most often, whereas in deed of trust states, nonjudicial
(
called power of sale
)
foreclosure is used. Most states permit both
types of proceedings, but it is common practice in most states to
exclusively use one method or the other. A complete state-by-state list
of foreclosure proceedings can be found in Appendix B.
Judicial Foreclosure
Judicial foreclosure is a lawsuit that the lender
(
mortgagee
)
brings against the borrower
(
mortgagor
)
to force the sale of the prop-
erty. About one-third of the states use judicial foreclosure. Like all law-
suits, a judicial foreclosure starts with a summons
(
a legal notice of
the lawsuit
)
served on the borrower and any other parties with infe-
rior rights in the property.
(
Remember, all junior liens, including ten-
18
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
ancies, are wiped out by the foreclosure, so they all need to be given
legal notice of the proceeding.
)
If the borrower does not file an answer to the lawsuit, the lender
gets a judgment by default. A person is then appointed by the court to
compute the total amount due including interest and attorney’s fees.
The lender then must advertise a notice of sale in the newspaper for
several weeks.
If the total amount due is not paid by the sale date, a public sale
is held on the courthouse steps. The entire process can take as little
as a few months to a year depending on your state and the volume of
court cases in your county.
The sale is conducted like an auction, in that the property goes
to the highest bidder. Unless there is significant equity in the prop-
erty, the only bidder at the sale will be a representative of the lender.
The lender can bid up to the amount it is owed, without having to
actually come out of pocket with cash to purchase the property. Once
the lender has ownership of the property, it will try to sell it through
a real estate agent.
If the proceeds from the sale are insufficient to satisfy the amount
owed to the lender, the lender may be entitled to a deficiency judg-
ment against the borrower and anyone else who guaranteed the loan.
Some states prohibit a lender from obtaining a deficiency judgment
against a borrower
(
applies only to owner-occupied, not investor prop-
erties
)
. In practice, few lenders seek a deficiency judgment against the
borrower.
Nonjudicial Foreclosure
A majority of the states permit a lender to foreclose without a law-
suit, using what is commonly called a “power of sale.” Upon default of
the borrower, the lender simply files a notice of default and a notice of
sale that is published in the newspaper. The entire process generally
takes about 90 days.
2 /A Legal Primer on Real Estate Loans
19
Strict Foreclosure
Two states—New Hampshire and Connecticut—permit strict
foreclosure, which does not require a sale. When the court proceed-
ing is started, the borrower has a certain amount of time to pay what
is owed. Once that date has passed, title reverts to the lender without
the need for a sale.
Key Points
•
A mortgage is actually two things—a note and a security instru-
ment.
•
Some states use a deed of trust as a security instrument.
•
Liens are prioritized by recording date.
•
Foreclosure processes differ from state to state.
What Is a Deficiency?
In order for a borrower to be held personally liable
for a foreclosure deficiency, there must be re-
course on the note. Most loans in the residential
market are with recourse. If possible, particularly
when dealing with seller-financed loans
(
see Chap-
ter 9
)
, have a corporate entity sign on the note in
your place. A corporation or limited liability com-
pany
(
LLC
)
protects its business owners from per-
sonal liability for business obligations. Upon
default, the lender’s legal recourse will be against
the property or the corporate entity, but not
against you, the business owner.
21
CHAPTER
3
Understanding the Mortgage
Loan Market
Neither a borrower nor a lender be; for loan oft loses both itself and friend.
—William Shakespeare
The mortgage business is a complicated and ever-changing indus-
try. It is important that you understand how the mortgage market
works and how the lenders make their profit. In doing so, you will
gain an appreciation of loan programs and why certain loans are
offered by certain lenders.
There are several categories of lenders that are discussed in this
chapter, and many lenders will fit in more than one category. In addi-
tion, some categories of lending are more of a lending “style” than a
lender category; this concept will make more sense after you finish
reading this chapter.
Institutional Lenders
The first broad category of distinction is institutional versus pri-
vate. Institutional lenders include commercial banks, savings and
22
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
loans or thrifts, credit unions, mortgage banking companies, pension
funds, and insurance companies. These lenders generally make loans
based on the income and credit of the borrower, and they generally
follow standard lending guidelines. Private lenders are individuals or
small companies that do not have insured depositors and are generally
not regulated by the federal government.
Primary versus Secondary Mortgage Markets
First, these markets should not be confused with first and second
mortgages, which were discussed in Chapter 2.
Primary mortgage
lenders
deal directly with the public. They
originate
loans, that is,
they lend money directly to the borrower. Often referred to as the
“retail” side of the business, lenders make a profit from loan process-
ing fees, not from the interest paid on the loan.
Primary mortgage lenders generally lend money to consumers,
then sell the mortgage notes
(
together in large packages, not one at a
time
)
to investors on the
secondary mortgage market
to replenish
their cash reserves.
Portfolio lenders
don’t sell their loans to the secondary market,
but rather they keep the loans as part of their portfolio
(
some lenders
sell part of their loans and keep others as part of their portfolio
)
. As
such, they don’t necessarily need to conform their loans to guidelines
established by the Federal National Mortgage Association
(
FNMA
)
or
the Federal Home Loan Corporation
(
FHLMC
)
. Small, local banks that
portfolio their loans can be an investor’s best friend, because they can
bend the rules to suit that investor’s needs.
Larger portfolio lenders can handle more loans, because they
have more funds, but they are not as flexible as the small banks. Larger
portfolio lenders can also give you an unlimited amount of loans,
whereas FNMA/FHLMC lenders have limits on the number of loans
they can give you
(
currently loans for nine properties, but these limits
often change
)
. The nation’s larger portfolio lenders include World
Savings and Washington Mutual.
3 / Understanding the Mortgage Loan Market
23
The largest buyers on the secondary market are FNMA
(
or “Fannie
Mae”
)
, the Government National Mortgage Association
(
GNMA, or
“Ginnie Mae”
)
, and the FHLMC
(
or “Freddie Mac”
)
. Private financial in-
stitutions such as banks, life insurance companies, private investors,
and thrift associations also buy notes.
FNMA is a quasi-governmental agency
(
controlled by the govern-
ment but owned by private shareholders
)
that buys pools of mortgage
loans in exchange for mortgage-backed securities. GNMA is a division
of the Department of Housing and Urban Development
(
HUD
)
, a gov-
ernmental agency. Because most loans are sold on the secondary mort-
gage market to FNMA, GNMA, or FHLMC, most primary mortgage
lenders conform their loan documentation to these agencies’ guide-
lines
(
known as a “conforming” loan
)
. Although primary lenders sell
the loans on the secondary mortgage market, many of the primary
lenders will continue to collect payments and deal with the borrower,
a process called
servicing.
Mortgage Bankers versus Mortgage Brokers
Many consumers assume that “mortgage companies” are banks
that lend their own money. In fact, a company that you deal with may
be either a mortgage banker or a mortgage broker.
A
mortgage banker
is a direct lender; it lends you its own money,
although it often sells the loan to the secondary market. Mortgage
Why Sell the Loan?
Lenders sell loans for a variety of reasons. First,
they want to maximize their cash reserves. By law,
banks must have a minimum reserve, so if they
lend all of their available cash, they can’t do any
more loans. Second, they want to minimize their
risk of interest rate fluctuations in the market.
24
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
bankers
(
also known as “direct lenders”
)
sometimes retain servicing
rights as well.
A
mortgage broker
is a middleman who does the loan shopping
and analysis for the borrower and puts the lender and borrower to-
gether. Many of the lenders through which the broker finds loans do
not deal directly with the public
(
hence the expression “wholesale
lender”
)
.
Using a mortgage banker can save the fees of a middleman and
can make the loan process easier. A mortgage banker can give you
direct loan approval, whereas a broker gives you information second-
hand. However, many mortgage banks are limited in what they can of-
fer, which is essentially their own product. In addition, if you present
your loan application in a poor light, you’ve already made a bad im-
pression. I am not suggesting you lie or mislead a lender, but under-
stand that presenting a loan to a lender is like presenting your taxes to
the IRS. There are many ways to do it, all of which are valid and legal.
Using a mortgage broker allows you to present a loan application to a
different lender in a different light
(
and you are a “fresh” face
)
.
A mortgage broker charges a fee for his or her service but has
access to a wide variety of loan programs. He or she also may have
knowledge of how to present your loan application to different lend-
ers for approval. Some mortgage bankers also broker loans. As an
Loan Servicing
Loan servicing is an immensely profitable business
for mortgage banks and other lenders. Servicing
involves collecting the loan payments, accounting
for tax and insurance escrows, dealing with cus-
tomer issues, and mailing notices to the customer
and the Internal Revenue Service
(
IRS
)
. The aver-
age fee charged for servicing is about ³⁄₈ percent of
the loan amount. This may not sound like much,
but try multiplying it by a billion dollars!
3 / Understanding the Mortgage Loan Market
25
investor, it is wise to have both a mortgage broker and a mortgage
banker on your team.
Conventional versus Nonconventional Loans
Conventional financing, by definition, is not insured or guaran-
teed by the federal government
(
see discussion of government loans
later in this chapter
)
. Conventional loans are generally broken into
two categories: conforming and nonconforming. A
conforming loan
is one that conforms or adheres to strict Fannie Mae/Freddie Mac loan
underwriting guidelines.
Conforming Loans
Conforming loans are a low risk to the lender, so they offer the
lowest interest rates. Conforming loans also have the strictest under-
writing guidelines.
Conforming loans have the following three basic requirements:
1.
Borrower must have a minimum of debt.
Lenders look at the
ratio of your monthly debt to income. Your regular monthly ex-
penses
(
including mortgage payments, property taxes, insur-
ance
)
should total no more than 25 percent to 28 percent of
your gross monthly income
(
called “front-end ratio”
)
. Further-
Mortgage Brokering
Keep in mind that mortgage brokering is an unli-
censed profession in many states. If there is no li-
censing agency to complain to in your state, make
sure you have personal references before you do
business with a mortgage broker.
26
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
more, your monthly expenses plus other long-term debt pay-
ments
(
e.g., student loan, automobile, alimony, child support
)
should total no more than 36 percent of your gross monthly
income
(
called “back-end ratio”
)
. These ratios can sometimes
be increased if the borrower has excellent credit or puts up a
larger down payment.
2.
Good credit rating.
You must be current on payments. Lend-
ers will also require a certain minimum credit score
(
discussed
in Chapter 4
)
.
3.
Funds to close.
You must have the requisite down payment
(
generally 20 percent of the purchase price, although lenders
often bend this rule
)
, proof of where it came from, and a few
months of cash reserves in the bank.
FHA-insured loans
(
discussed later in this chapter
)
allow higher
LTVs but are more limited in scope and are not generally available to
investors
(
discussed later in this chapter
)
.
Under writing
Underwriting is the task of applying guidelines
that provide standards for determining whether or
not a loan should be approved. Understand that
loan approval is the final step in the loan applica-
tion process before the money is handed over
(
known as “funding” a loan
)
. Note that many lend-
ers will give “preapproval” of a loan. Preapproval
is really a half-baked commitment. Until a loan is
approved in writing, the bank has no legal commit-
ment to fund. And, in many cases, loan approval is
often given with conditions attached that must be
satisfied before closing.
3 / Understanding the Mortgage Loan Market
27
Private mortgage insurance.
Private mortgage insurance
(
PMI
)
requirements apply only to first mortgage loans; thus, you can get
around PMI requirements by borrowing a first and second mortgage
loan. So long as the first mortgage loan is less than 80 percent loan-to-
value, PMI is not required. However, the second mortgage loan may
have a high interest rate, so that the blending of the interest rate on
the first and second mortgage loans exceeds what you would be pay-
ing with a first mortgage and PMI. Use a calculator to figure out which
is more profitable for you
(
the formula for interest rate blending is dis-
cussed in Chapter 5
)
.
One way around the large down payment is to purchase PMI. Also
known as “mortgage guaranty insurance,” PMI will cover the lender’s
additional risk for a high loan-to-value ratio
(
LTV
)
program. The in-
surer will reimburse the lender for its additional risk of the high LTV.
PMI should not be confused with mortgage life insurance, which
pays the borrower’s loan balance in full when he or she dies
(
not rec-
ommended—regular term life insurance is a better deal for the money
)
.
What Is the Loan-to-Value
(
LT V
)
Ratio?
Loan-to-value ratio is the percentage of the value of
the property the lender is willing to lend. For ex-
ample, if the property is worth $100,000, an 80
percent LTV loan will be for $80,000. Note that
LTV is not the same as loan-to-purchase price, be-
cause the purchase price may be more or less than
the appraised value
(
discussed in more detail in
Chapter 5
)
.
28
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Nonconforming Loans
Nonconforming loans
have no set guidelines and vary widely
from lender to lender. In fact, lenders often change their own noncon-
forming guidelines from month to month.
Nonconforming loans are also known as “subprime” loans, be-
cause the target customer
(
borrower
)
has credit and/or income verifi-
cation that is less than perfect. The subprime loans are often rated
according to the creditworthiness of the borrower—“A,” “B,” “C,”
or “D.”
An “A” credit borrower has had few or no credit problems within
the past two years, with the exception of a late payment or two with
a good explanation. A “C” credit borrower may have a history of sev-
eral late payments and a bankruptcy.
The subprime loan business has grown enormously over the past
ten years, particularly in the refinance business and with investor
loans. Every lender has its own criteria for subprime loans, so it is
impossible to list every loan program available on the market. Suffice
it to say, the guidelines for subprime loans are much more lax than
they are for conforming loans.
Government Loan Programs
The federal government and state government sponsor loan pro-
grams to encourage home ownership. Most of the loan programs are
geared towards low-income neighborhoods and first-time homebuyers.
If you are dealing in low-income properties, you should be aware of
these guidelines if you intend to sell properties to these target home-
buyers. Also, some of these programs are geared to investors as well.
3 / Understanding the Mortgage Loan Market
29
Federal Housing Administration Loans
HUD is the U.S. Department of Housing and Urban Development,
an executive branch of the federal government. The Federal Housing
Administration
(
FHA
)
is an arm of HUD that administers loan pro-
grams. HUD does not lend money but rather insures lenders that make
high LTV loans. Because high LTV loans are risky for lenders, the FHA-
insured loan programs cover the additional risk. Not all lenders can
make FHA-insured loans; they must be approved by HUD.
The most common FHA loan program is the 203
(
b
)
program,
designed for first-time homebuyers. This program allows an owner-
occupant to put just 3 percent down and borrow 97 percent loan-to-
value. This program is for owner-occupied
(
noninvestor
)
properties,
but investors should be familiar with the program because they may
wish to sell a property to a buyer who may use the program.
The two most common HUD loans available for investors are the
Title 1 Loan and the 203
(
k
)
loan.
Confusion of Terms
Some mortgage professionals will use the expres-
sion “conventional” to mean “conforming,” and
vice-versa. So, when a mortgage broker says that
“you’ll have to go with a nonconforming loan,” the
loan documentation may still have to substantially
conform with FNMA guidelines. In fact, even loans
that do not conform with FNMA or conventional
standards are underwritten on FNMA “paper”
(
the
actual note, mortgage, and other related docu-
ments
)
. Lenders do this with the intention of even-
tually selling the paper, even if it may begin as a
portfolio loan.
30
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Title 1 loan.
The Title 1 loan insures loans of up to $25,000 for
light to moderate rehab of single-family properties, or $12,000 per
unit for a maximum of $60,000 on multifamily properties. The interest
rates on these loans are generally market rate, although local participa-
tion by state or municipal agencies may reduce the rate
(
see below
)
.
An interesting note on Title 1 loans is that it is not limited to own-
ers of the property. A lessee or equitable owner under an installment
land contract
(
discussed in Chapter 9
)
may qualify for the loan.
FHA 203
(
k
)
loan.
The 203
(
k
)
program is for an investor who
wants to live in the home while rehabbing it. It allows the investor-
occupant to borrow money for the purchase or refinance of a home
as well as for the rehab costs. It is an excellent alternative to the tradi-
tional route for these investors, which is to buy a property with a tem-
porary
(
“bridge”
)
loan, fix the property, then refinance it
(
many
lenders won’t offer attractive, long-term financing on rehab proper-
ties
)
.
The 203
(
k
)
loan can be for up to the value of the property plus
anticipated improvement costs, or 110 percent of the value of the
property, whichever is less. The rehab cost must be at least $5,000,
but there is no limit to the size of the rehab
(
although it cannot be
used for new construction, that is, the basic foundation of the prop-
erty must be used, even if the building is razed
)
. The program can be
used for condominiums, provided that the condo project is otherwise
FHA qualified. Cooperative apartments, popular in New York and
California, are not eligible.
The Department of Veterans Affairs
The Department of Veterans Affairs
(
VA
)
guarantees certain loan
programs for eligible veterans. As an occupant, an eligible veteran can
borrow up to 100 percent of the purchase price of the property. When
a borrower with a VA-guaranteed loan cannot meet the payments, the
lender forecloses on the home. The lender next looks to the VA to
cover the loss for its guarantee, and the VA takes ownership of the
home. The VA then offers the property for sale to the public.
3 / Understanding the Mortgage Loan Market
31
State and Local Loan Programs
Many states and localities sponsor programs to help first-time
homebuyers qualify for mortgage loans. The programs are aimed at im-
proving low-income neighborhoods by increasing the number of own-
ers versus renters in the area. Most of these programs are for owner-
occupants, not investors, but it may also help to know about these pro-
grams when you are selling homes.
Some state and local programs work in conjunction with HUD
programs, such as Title 1 loans. Contact your state or city department
of housing for more information on locally sponsored loan programs.
A list of links to state programs can be found at
<
www.hsh.com/pam
phlets/state_hfas.html
>
.
Commercial Lenders
Most of the discussion so far has been about financing of single-
family homes and small multifamily residential homes. What about
large multifamily projects and commercial projects, such as shopping
centers, strip malls, and office buildings? Many of the same concepts
do apply, except for the financing guidelines.
Commercial lenders generally do not have industry-wide loan cri-
teria. Instead, each lender has its own criteria and will review loans
on a project-by-project basis. Lenders will look at the experience of
Condominium Financing Pitfalls
Condominiums can be difficult to finance in gen-
eral, as compared to single-family homes. In gener-
al, stay away from units in developments that have
a large concentration of investor-owners. Condo
developments that have a 50 percent or more con-
centration of nonoccupant owners are very diffi-
cult to finance through institutional lenders.
32
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
the investor as well as the income and expenses of the particular col-
lateral. In other words, commercial lenders are more concerned with
whether the property will generate enough income to pay the loan,
not whether the borrower has good credit
(
although a borrower with
poor credit will generally have a hard time getting any type of loan
from an institutional lender
)
. A commercial appraisal is required,
which is more detailed and expensive than a residential appraisal. A
commercial loan will require the borrower to have a substantial
reserve of cash to handle vacancies.
Commercial loans also can be made for residential buildings of
five units or more, but there is a minimum loan amount required by
each lender
(
generally a $300,000 to $500,000, depending on the
property values in your marketplace
)
. Oddly enough, multimillion dol-
lar loans are often made without recourse to the borrower. In other
words, if the project fails, the borrower
(
often a corporate entity
)
is
not liable for the debt. The lender’s sole recourse is to foreclose against
the property. For this reason, the lender is more concerned with the
property than the borrower.
Key Points
•
Most lenders sell their loans to the secondary market.
•
Loans come in three basic categories: conforming, noncon-
forming, and government.
•
The government does not lend money, but rather it guarantees
loans.
•
Commercial lenders look to the property rather than the
borrower.
33
CHAPTER
4
Working with Lenders
Except for the con men borrowing money they shouldn’t get and the widows who have
to visit with the handsome young men in the trust department, no sane person ever
enjoyed visiting a bank.
—Martin Meyer
Now that you understand how loans and the mortgage market
works, you can begin to understand how to approach financing. In
Chapter 3, we discussed a variety of loan
programs
that differ based
on the lender, the type of property, and the borrower. We will now
turn to loan
types
that are generally available in most of the loan pro-
grams discussed thus far and the advantages and disadvantages of
each. Before doing so, let’s explore some of the relevant issues we
need to consider when borrowing money.
Interest Rate
The cost of borrowing money, that is, the interest rate, is one of
the most important factors. As discussed in Chapter 1, interest rates
affect monthly payments, which in turn affect how much you can
34
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
afford to pay for a property. It may also affect cash flow, which affects
your decision to hold or sell property.
Loan Amortization
There are many different ways a loan can be structured as far as
interest payments go. The most common ways are simple interest and
amortized.
As discussed in Chapter 1, a simple interest loan is calculated by
multiplying the loan balance by the interest rate. So, for example, a
$100,000 loan at 12 percent interest would be $12,000 per year, or
$1,000 per month. The payments here, of course, represent interest-
only, so the principal amount of the loan does not change.
An amortized loan is slightly more involved. The actual mathe-
matical formula is beyond a book like this, so we’ve provided a sample
interest rate table in Appendix A. However, you can find a thousand
Internet Web sites that will do the calculations instantly online
(
try
mine at
<
www.legalwiz.com
>
—click on “calculators”
)
. The amortiza-
tion method breaks down payments over a number of years, with the
payment remaining constant each month. However, the interest is cal-
culated on the remaining balance, so the amount of each monthly pay-
ment that accounts for principal and interest changes. For the most
part, the more payments you make, the more you decrease the amount
of principal owed
(
the amount of the loan still left to pay
)
. See Figure
4.1.
The loan
term
or duration is important to figuring your payment.
By custom, most loans are amortized over 30 years or 360 monthly
payments. The second most common loan term is 15 years. The pay-
ments on a 15-year amortization are higher each month, but you pay
the loan off faster and thus pay less interest in the long run.
4/Working with Lenders
35
FIGURE 4.1
Amortization of $100,000 Loan at 8% Interest Over 30 Years
Payment # Date Payment Interest Principal Loan Balance
1 02-01-2003 733.76 666.67 67.09 99,932.91
2 03-01-2003 733.76 666.22 67.54 99,865.37
3 04-01-2003 733.76 665.77 67.99 99,797.38
4 05-01-2003 733.76 665.32 68.44 99,728.94
5 06-01-2003 733.76 664.86 68.90 99,660.04
6 07-01-2003 733.76 664.40 69.36 99,590.68
7 08-01-2003 733.76 663.94 69.82 99,520.86
8 09-01-2003 733.76 663.47 70.29 99,450.57
9 10-01-2003 733.76 663.00 70.76 99,379.81
10 11-01-2003 733.76 662.53 71.23 99,308.58
11 12-01-2003 733.76 662.06 71.70 99,236.88
12 01-01-2004 733.76 661.58 72.18 99,164.70
13 02-01-2004 733.76 661.10 72.66 99,092.04
14 03-01-2004 733.76 660.61 73.15 99,018.89
15 04-01-2004 733.76 660.13 73.63 98,945.26
16 05-01-2004 733.76 659.64 74.12 99,871.14
17 06-01-2004 733.76 659.14 74.62 98,796.52
18 07-01-2004 733.76 658.64 75.12 98,721.40
19 08-01-2004 733.76 658.14 75.62 98,645.78
20 09-01-2004 733.76 657.64 76.12 98,569.66
21 10-01-2004 733.76 657.13 76.63 98,493.03
22 11-01-2004 733.76 656.62 77.14 98,415.89
23 12-01-2004 733.76 656.11 77.65 98,338.24
24 01-01-2005 733.76 655.59 78.17 98,260.07
25 02-01-2005 733.76 655.07 78.69 98,181.18
26 03-01-2005 733.76 654.54 79.22 98,102.16
27 04-01-2005 733.76 654.01 79.75 98,022.41
28 05-01-2005 733.76 653.48 80.28 97,942.13
29 06-01-2005 733.76 652.95 80.81 97,861.32
30 07-01-2005 733.76 652.41 81.35 97,779.97
31 08-01-2005 733.76 651.87 81.89 97,698.08
32 09-01-2005 733.76 651.32 82.44 97,615.64
33 10-01-2005 733.76 650.77 82.99 97,532.65
34 11-01-2005 733.76 650.22 83.54 97,449.11
35 12-01-2005 733.76 649.66 84.10 97,365.01
36 01-01-2006 733.76 649.10 84.66 97,280.35
37 02-01-2006 733.76 648.54 85.22 97,195.13
38 03-01-2006 733.76 647.97 85.79 97,109.34
39 04-01-2006 733.76 647.40 86.36 97,022.98
40 05-01-2006 733.76 646.82 86.94 96,936.04
41 06-01-2006 733.76 646.24 87.52 96,848.52
42 07-01-2006 733.76 645.66 88.10 96,760.42
43 08-01-2006 733.76 645.07 88.69 96,671.73
44 09-01-2006 733.76 644.48 89.28 96,582.45
45 10-01-2006 733.76 643.88 89.88 96,492.57
46 11-01-2006 733.76 643.28 90.48 96,402.09
349 02-01-2032 733.76 56.28 677.48 7,764.01
350 03-01-2032 733.76 51.76 682.00 7,082.01
351 04-01-2032 733.76 47.21 686.55 6,395.46
352 05-01-2032 733.76 42.64 691.12 5,704.34
353 06-01-2032 733.76 38.03 695.73 5,008.61
354 07-01-2032 733.76 33.39 700.37 4,308.24
355 08-01-2032 733.76 28.72 705.04 3,603.20
356 09-01-2032 733.76 24.02 709.74 2,893.46
357 10-01-2032 733.76 19.29 714,47 2,178.99
358 11-01-2032 733.76 14.53 719.23 1,459.76
359 12-01-2032 733.76 9.73 724.03 735.73
36
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
15-Year Amortization versus 30-Year Amortization
In general, 15-year loans tend to have a slightly lower interest
rate. In addition, you reach your financial goal of “free and clear”
faster. However, there are three downsides to the 15-year loan. The
first is that you are obligated to a higher payment that reduces your
cash flow. Second, the higher monthly obligation appears on your
credit report, which affects your debt ratios and thus your ability to
borrow more money
(
discussed later in this chapter
)
. Third, your
monthly payment is less interest and more principal. While this may
sound like a good thing, it doesn’t give you the same tax benefits; in-
terest payments are deductible, principal payments are not.
Unless the interest rate on the 15-year note is significantly lower,
opt for the 30-year note. You can accomplish the faster principal pay
down by making extra interest payments to the lender.
Example:
On a $100,000 loan amortized at 8% over 30
years, your payment is $733.76. If you make an additional
principal payment each month of $100, the loan would be
fully amortized in just over 20 years, saving you $62,468.87
in interest.
You can use a financial calculator to calculate how much extra
you need to pay each month to reduce the loan term
(
again, try mine
at
<
www.legalwiz.com
>
—click on “calculators”
)
. And, of course,
Three Negatives to a 15-Year Loan
1. Higher monthly payments
2. Increased debt ratios
3. Less of a tax deduction
☛
4/Working with Lenders
37
when times are hard and the property is vacant, you aren’t obligated
to make the higher payment.
Balloon Mortgage
A
balloon
is a premature end to a loan’s life. For example, a loan
could call for interest-only payments for three years, then be due in
full at the end of three years. Or, a loan could be amortized over 30
years, with the principal balance remaining due in five years. When
the loan balloon payment becomes due, the borrower must pay the
full amount or face foreclosure.
A balloon provision can be risky for the borrower, but if used
with common sense, it may work effectively by satisfying the lender’s
needs. Balloon notes are often used by builders as a short-term financ-
ing tool. These types of loans are also known as “bridge” or “mezza-
nine” financing.
Biweekly Mortgage Payment Programs
An entire multilevel marketing business has been
made out of the selling people the idea of a bi-
weekly mortgage program. Basically, if you pay
your loan every two weeks rather than monthly,
you make two extra payments per year. With the
additional payments going towards principal, the
debt amortizes faster. Before plunking down sev-
eral hundred dollars to a third party to do this for
you, ask your lender. Many lenders will set up a
direct deposit program from your bank account
for biweekly payments.
38
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Reverse Amortization
Regular amortization means as you make payments the loan bal-
ance decreases. Reverse amortization means the more you pay, the
more you owe. How is that possible? Simple—by making a lower pay-
ment each month than would be possible for the stated interest rate.
A reverse amortization loan increases your cash flow but also increases
your risk because you will owe more in the future. If you bought the
property below market, a reverse amortization loan may make sense,
especially if real estate prices are rising rapidly
(
another option may
be a variable rate loan, discussed later in this chapter
)
.
Property Taxes and Insurance Escrows
In addition to monthly principal and interest payments on your
loan, you’ll have to figure on paying property taxes and hazard insur-
ance. Many lenders won’t trust you to make these payments on your
own, especially if you are borrowing at a high loan-to-value
(
80 per-
cent LTV or higher
)
. Lenders estimate the annual payments for taxes
and insurance, then collect these payments from you monthly into a
reserve account
(
called an “escrow” or “impound account”
)
. The
lender then makes the disbursements directly to the county tax collec-
tor and your insurance company on an annual basis. Thus, the total
amount collected each month consists of principal and interest pay-
ments on the note, plus taxes and insurance—hence the acronym
PITI.
Reverse Amortization Loans for the Elderly
Many mortgage banks are advertising reverse am-
ortization loans to elderly homeowners as a way to
reduce their monthly payments. These loan pro-
grams are not intended for investors as described
above.
4/Working with Lenders
39
Loan Costs
Origination Fee
The cost of a loan is as important as the interest rate. Lenders and
mortgage brokers charge various fees for giving you a loan
(
and you
thought they just made money on the interest rates!
)
. Traditionally,
the most expensive part of the loan package is the loan origination
fee. The fee is expressed in
points,
that is, a percentage of the loan
amount: 1 point = 1 percent. So, for example, if a lender charges a
“1 point origination fee” on a $100,000 loan, you would pay 1 per-
cent, or $1,000, as a fee.
Discount Points
Another built-in profit center is the charging of “discount points.”
The lender will offer you a lower interest rate for the payment of
money up front. Thus, if you want your interest rate to be lower, you
can “buy down” the rate by paying ¹⁄₂ point
(
percent
)
or more of the
loan up front. Buying down the rate only makes sense if you plan on
keeping the loan for a long time; otherwise buying down the interest
rate is a waste of money.
Borrowers nowadays are smarter and try to beat the banks at
their own game by refusing to pay points. Banks even advertise “no
cost” loans, that is, loans with no discount points or origination fees.
Yield Spread Premiums: The Little Secret Your Lender
Doesn’t Want You to Know
The lower the interest rate, the better off you are, or are you?
Lenders advertise “wholesale” interest rates on a daily basis to mort-
gage brokers, who then advertise rates to their customers. This whole-
sale interest rate can be marked up on the retail side by the mortgage
broker.
40
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Example:
Say, for example, your mortgage broker offers you
an interest rate of 7.25% on a $200,000, 30-year fixed loan.
The monthly payment on this loan would be $1,364.35,
which is acceptable to you. However, the wholesale rate of-
fered by the lender may be 7.00%, which is $1,330.60 per
month. This difference may not seem like much, but over 30
years, it amounts to about $12,000 in additional interest paid.
The mortgage broker receives a “bonus” back from the
lender for the additional interest earned. This bonus is called
a yield spread premium
(
YSP
)
because it represents the addi-
tional yield earned by the lender for the higher interest rate.
Loan Junk Fees
Even without points and at par
(
no markup on the interest rate
)
,
there is no such thing as a no-cost loan. Lenders sneak in their profit
by disguising other fees, such as the following:
•
Administrative Review
•
Underwriting Charge
•
Documentation Fee
Are Yield Spread Premiums Legal?
At this time,YSPs are legal as long as they are dis-
closed on the loan documents. Although it is not
technically a fee to the borrower, YSPs are not ille-
gal “kickbacks” to the mortgage broker either. You
will, however, see the fee noted on the HUD-1 clos-
ing statement as POC
(
paid outside of closing
)
.
☛
4/Working with Lenders
41
These charges are given fancy names but are really just ways for
the lender to make more profit. Lenders also pad their actual fees, such
as the cost of obtaining credit reports, courier charges, and other “mis-
cellaneous fees”
(
one lender admitted to me that he pays less than $15
for a credit report yet charges the borrower $85!
)
. Understand that
lenders are in business to make money, so if a loan sounds too good to
be true, it probably is—look carefully at their fees and charges.
“Standard” Loan Costs
While every lender has its own fees and points it charges, there
are certain costs you can expect to pay with every loan transaction.
These fees should be listed in the lender’s good faith estimate as well
as on the second page of the closing statement. The closing statement
is prepared at closing by the escrow agent on a form known as a HUD-
1, in compliance with the Real Estate Settlement Procedures Act
(
RESPA
)
, a federal law. A sample of this form can be found in Appen-
dix C. All of the following charges appear on page two of the form:
•
Title insurance policy.
While a lender secures its loan with a
security instrument recorded against the property, it wants a
guarantee that its lien is in first position
(
or, in the case of a
Good Faith Estimate
By law, a lender is required to give you a list of the
loan fees up front when you apply for the loan.
Unscrupulous lenders are notorious for adding in
last-minute charges and fees that you won’t dis-
cover until closing. Of course, you are free to back
out at that point, but who wants to lose a good real
estate deal? Lenders know this reality, so make
sure you get as much as you can in writing before
closing the loan.
42
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
second mortgage, second position
)
. A lender’s policy of title
insurance guarantees to the lender it is in first position
(
or, in
the case of a second mortgage, second position
)
. This policy
costs anywhere from a few hundred dollars to a thousand dol-
lars, depending on the amount of the loan and when the last
time a title insurance policy was issued on the property; the
more recently another policy was issued, the cheaper the pol-
icy. Also, if you are purchasing an owner’s title insurance pol-
icy in conjunction with the lender’s policy
(
very common
)
, the
fee for the lender’s policy is substantially reduced.
•
Prepaid interest.
While this is not a “fee,” it is a cost of financ-
ing you pay up front. Because interest is paid for the use of
money the month before, you need to figure on paying pro-
rated interest. For example, let’s assume your monthly pay-
ment on the mortgage note will be $1,000. If you close your
loan on the 15th of the month, your first payment won’t be due
for 45 days. The lender will collect 15 days of interest at clos-
ing for the use of the money that month, which is $500.
•
Application fee.
While standard among some lenders, this fee
is really a “junk” fee. Nobody should charge you for asking you
to do business with them. Lenders often waive this fee if they
fund your loan.
•
Document recording fees.
Because the mortgage or deed of
trust will be recorded at the county, there are fees charged.
The usual range is about $5 to $10 per page, and the typical
FNMA Mortgage or deed of trust is anywhere from 12 to 20
pages. In addition, some states and localities
(
e.g., New York
)
charge an additional tax on mortgage transactions based on
the amount of the loan.
•
Reserves.
If the lender is escrowing property taxes and insur-
ance, it will generally collect a few months extra up front.
While technically not a cost, it is cash out of your pocket.
4/Working with Lenders
43
•
Closing fee.
The lender, company, attorney, or escrow company
that closes the loan charges a fee for doing so. Closing a loan in-
volves preparing a closing statement, accounting for the mon-
ies, and passing around the papers. The closer actually sits
down with the borrower and explains the documents and, in
most cases, takes a notary’s acknowledgment of the borrower
(
a mortgage or deed of trust must be executed before a notary
in order for it to be accepted for recording in public records;
the promissory note is not recorded but held by the lender until
it is paid in full
)
. The closer also makes sure the documents find
their way back to the lender or the county for recording.
•
Appraisal.
Virtually all loans require an appraisal to verify
value. An appraisal will cost you between $300 and $500, and
even more if the subject property is a multiunit or commercial
building. Appraisers often charge additional fees for a “rent
survey,” which is a sampling of rent payments of similar prop-
erties. The lender will want this information to verify that the
property can sustain the income you projected.
•
Credit report.
Lenders charge a fee for running your credit
report. The lender may charge as much as $85 for a full credit
report. Vendors often run short-form credit reports, which are
much cheaper. The lender may run a short-form version first
to get a quick look at your credit, then a full report at a later
time
(
called a “three bureau merge” because it contains infor-
mation from the three major credit bureaus
)
.
•
Survey.
A lender may require that a survey be done of the prop-
erty. A
survey
is a drawing that shows where the property lies
in relation to the nearest streets or landmarks. It will also show
where the buildings and improvements on the property sit in
relation to the boundaries. If a recent survey was performed, it
may not be necessary to do a new survey. Rather, the lender
may ask for a survey update from the same surveyor or another
surveyor. In some parts of the country, an “Improvement Loca-
tion Certificate” is used; it is essentially a drive-by survey.
44
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
•
Document preparation fees.
Some lenders will charge you an
attorney’s fee for document preparation. Larger lenders have
in-house attorneys and paralegals. Smaller lenders hire outside
service companies to prepare the loan documents. The reason
documents are not always done “in house” is because of the
complexities of compliance with lending regulations. Docu-
ment preparation companies pay lawyers to research the laws
and draft documents for compliance. Based on the informa-
tion provided by the lender, the document preparation com-
pany prepares the forms for the lender. The fee for this service
is generally a few hundred dollars, which is passed on to the
borrower.
Now that you know how lenders make their money, you can ne-
gotiate your loan with confidence. Virtually every fee a lender asks for
can be negotiated. However, don’t expect the lender to waive every
fee, charge no points, and get no back-end fees
(
yield spread premi-
ums
)
. The lender has to make a profit to be willing to do business with
you. Profit is also important to you as an investor, but so is the availabil-
ity of the money you borrow. If you want a lender that is willing to
work hard for you, make sure you are willing to pay reasonable com-
pensation. Pinching pennies with your lender will not get it excited
about pushing your loan through the process faster. However, know-
ing what fees are negotiable will allow you to get a loan at a fair interest
rate and pay a reasonable fee to get it.
Risk
In addition to profit and cash flow, one of the major factors you
should consider in borrowing money is risk. While maximum lever-
age is important to the investor, it is also higher risk to the investor.
The more money you borrow, the more risk you could potentially
incur. That is, while you have less investment to lose, you may be per-
sonally liable for the debt you have incurred.
4/Working with Lenders
45
With larger commercial projects, the lender’s main concern is
the financial viability of the project itself. In that case, the borrower
does not necessarily have to sign personally on the promissory note.
The lender’s sole legal recourse is to foreclose the property.
With smaller residential loans, the investor/borrower signs per-
sonally on the note and is thus liable personally for the obligation.
While the lender can foreclose the property, there may be a defi-
ciency owed that is the personal obligation of the borrower. In the
late 1980s, many leveraged investors learned this lesson the hard way
when they were forced to file for bankruptcy protection. A smart
investor finances properties with a cash cushion, positive
(
or at least
breakeven
)
cash flow, and at a reasonable loan-to-value ratio.
Nothing Down
While “nothing-down” financing is viable, it does not necessarily
mean a 100 percent loan-to-value. For example, buying a $150,000
property for $150,000 with all borrowed money is not a bad deal if the
property is worth $200,000. That’s a 75 percent LTV. Buying a prop-
erty for close to 100 percent of its value and financing it 100 percent
with personal recourse is very risky. If you don’t have the means to
support the payments while the property is vacant, you may be in for
trouble. Like any business, real estate is about maintaining cash flow.
So, in considering your loan, factor in the following issues:
•
Are you near the top of an inf lated market?
•
Is the local economy’s outlook good or bad?
•
If purchasing, are you buying below market?
•
How long do you intend to hold the property and for what pur-
poses?
•
Are prices likely to drop before you sell it?
•
Will you be able to refinance the property in the future?
46
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
•
Are you personally obligated on the note, or is the debt nonre-
course
(
or signed for by your corporate entity
)
?
All of these factors are relevant to risk and to whether you want
to leverage yourself without a backup plan.
Loan Types
In Chapter 3, we discussed broad categories of loans, such as
conventional versus government loans, conforming versus noncon-
forming loans, brokered loans versus portfolio loans, etc. These dis-
tinctions are really lending “styles” more than loan types. Virtually
every lender or loan category involves variation of the loan term and
interest rate. The loan term is the length of time by which the loan is
amortized. The loan term is fixed, whereas the interest rate can vary
throughout the term of the loan. Each loan type
(
fixed versus variable
interest rate, 15-year versus 30-year
)
has a place for the borrower/
investor, and we will explore the benefits and detriments of each.
The most common type of real estate loan is a fixed-rate, 30-year
amortization. A fixed-rate loan is desirable because it provides cer-
tainty. It hedges your bet against higher interest rates by allowing you
to lock in a low interest rate. If interest rates fall, you can always refi-
nance at a lower rate at a later time.
With interest rates uncertain in the future, many lenders are
offering variable-rate financing. Known as an adjustable-rate mort-
gage
(
ARM
)
, there are dozens of variations to suit the lender’s profit
motives and borrower’s needs.
ARMs have two limits, or caps, on the rate increase. One cap reg-
ulates the limit on interest rate increases over the life of the loan; the
other limits the amount the interest rate can be increased at a time.
For example, if the initial rate is 6 percent, it may have a lifetime cap
of 11 percent and a one-time cap of 2 percent. The adjustments are
made monthly, every six months, once a year, or once every few
years, depending on the “index” on which the ARM is based. An
4/Working with Lenders
47
index is an outside source that can be determined by formulas, such
as the following:
•
LIBOR
(
London Interbank Offered Rate
)
—based on the interest
rate at which international banks lend and borrow funds in the
London Interbank market.
•
COFI
(
Cost of Funds Index
)
—based on the 11th District’s Fed-
eral Home Loan Bank of San Francisco. These loans often
adjust on a monthly basis, which can make bookkeeping a real
headache!
•
T-bills Index—based on average rates the Federal government
pays on U.S. treasury bills. Also known as the Treasury Con-
stant Maturity, or TCM.
•
CD Index
(
certificate of deposit
)
—based on average rates
banks are paying on six-month CDs.
The index you choose will affect how long your rate is fixed for
and the chances that your interest rate will increase. Which one is
best? Because that depends on what is going on in the national and
world economy, you have to review your short-term and long-term
goals with your lender before choosing an index.
ARMs are very common in the subprime market and with port-
folio lenders, but they can be very risky because of the uncertainty of
future interest rates. However, like a balloon mortgage, an ARM can
be used effectively with a little common sense. If you plan to sell or
refinance the property within a few years, then an ARM may make
sense.
48
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
For more information on ARM loans, you can download the offi-
cial consumer pamphlet prepared by the Federal Reserve Board and
the Office of Thrift Supervision at my Web site,
<
www.legalwiz.com/
arm
>
.
Choosing a Lender
Choosing a lender that you want to work with involves several
factors, not the least of which is an open mind. You need a lender that
can bend the rules a little when you need it and get the job done on a
deadline. You need a lender that is large enough to have pull, but small
enough to give you personal attention. And, most of all, you need a
lender that can deliver what it promises.
Hybrid ARM
Ask your lender about a hybrid ARM, that is, an
ARM that is fixed for a period of three, five, or
even seven years. After that time, the rate will
adjust, usually once
(
hence the expression “3/1
ARM” or “5/1 ARM”
)
. The initial rates on these
loans are not as good as a six-month ARM but will
give you more f lexibility and certainty
(
generally,
the longer the rate is fixed for, the higher interest
rate you’ll pay
)
. Also, watch for prepayment pen-
alties that are often built into ARM loans.
4/Working with Lenders
49
Length of Time in Business
Because the mortgage brokering business is not highly regulated
in most states, there are a lot of fly-by-night operations. Bad news trav-
els faster than good news in business, so bad mortgage brokers don’t
last too long. Look for a company that has been in business for a few
years. Check out the company’s history with your local better busi-
ness bureau. If mortgage brokers are licensed with your state, check
to see if any complaints or investigations were made against them.
Also, ask for referrals from other investors and real estate agents.
Many mortgage brokers will bait you with “too good to be true” loan
programs that most investors won’t qualify for. Once they have you
hooked, it may be too late to switch brokers, and now you are forced
to take whatever loan they can find for you. It’s not that all of these
mortgage brokers are crooks; it’s often the case that the broker is just
not knowledgeable about the particular loan programs they offer. In
many cases, the particular lender they were dealing with was the cul-
prit. Many wholesale lenders offer programs to mortgage brokers,
Prepayment Penalties
Lenders are smart investors, too. If interest rates
are falling, lenders don’t want you to pay off a
higher interest rate loan. They discourage you from
refinancing by adding a prepayment penalty
(
PPP
)
clause to your loan. The PPP provision states that if
you pay the loan in full within a certain time pe-
riod
(
usually within one year to three years
)
, you
must pay a penalty. The common penalty ranges
from 1 percent to 6 percent of the original loan bal-
ance. Make sure that your loan does not have a PPP
if you plan on refinancing or selling the property
in the next few years.
50
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
then when the loan comes through, the underwriter changes its mind
or asks for more documentation. In some cases, it is the old bait and
switch; in other cases, it is simply a miscommunication between the
wholesale lender and the mortgage broker. Thus, it is important that
you ask the mortgage broker if it has dealt with the particular lender
or loan program in the past.
Company Size
A company that is too big can be problematic because of high
employee turnaround. Also, the proverbial “buck” gets passed around
a lot. If you are dealing with a mortgage broker, it is often a one-per-
son operation. Dealing with a one-man operation may be good in
terms of communication if he or she is a go-getter. On the other hand,
the individual may be hard to get a hold of, because he or she is
answering the phone all day.
A small to midsized company is a good bet. You will be able to
get the boss on the phone, but he or she will have a good support staff
to handle the minor details. Also, a midsized company may have
access to more wholesale lenders than a one-person company.
Experience in Investment Properties
It is important to deal with a mortgage broker or banker that has
experience with investor loans. Owner-occupant loans are entirely
different than investor loans. And, it is important that the broker or
lender you are dealing with has a number of different programs. It is
often the case that you find out a particular loan program won’t work,
in which case you need to switch lenders
(
or loan programs
)
in a
heartbeat to meet a funding deadline.
4/Working with Lenders
51
How to Present the Deal to a Lender
For the most part, lenders follow guidelines established by FNMA
and Freddie Mac, as well as their own lending guidelines. If you are
looking for the best interest rate, then you must be able to conform to
FNMA guidelines, which include a high credit score, provable income,
and verifiable assets.
If you are not going with a conforming loan, then there are the
following basic guidelines a lender will look at:
•
Your credit score
•
Your provable i ncome
•
The property itself
•
Your down payment
Six Questions to Ask Your Lender
1. How many regular investor clients do you have?
2. Do you get any back-end fees from the lender?
3. What percentage of your loans don’t get funded
(
completed
)
?
4. What kind of special nonconforming loan pro-
grams do you have for investors?
5. What income and credit requirements do I need?
6. What documentation will I need to supply you
with?
52
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Your Credit Score
Much of the institutional loan industry is driven by credit. While
having spotless credit is not a necessity, it is certainly a good asset, if
used wisely.
Your credit history is maintained primarily by three large com-
panies, known as the credit bureaus: Equifax, TransUnion, and Expe-
rian
(
formerly TRW
)
. Your credit report has “headers” that contain
information about your addresses
(
every one they can find
)
, phone
numbers
(
even the unlisted ones
)
, employer, Social Security number,
aliases, and date of birth. This information is usually reported by banks
and credit card companies that report to the credit bureaus
(
be careful
about giving your unlisted address or phone number to your credit
card company—it may end up on your credit file
)
. Some information
comes from public records, such as court filings and property records.
Your credit report also contains a history of nearly every charge
card, loan, or other extension of credit that you ever had. It will show
the type of loan
(
e.g., installment loan or revolving credit
)
, the maxi-
mum you can borrow on the account, a history of payments, and the
amount you currently owe. It will also show information from public
records, such as judgments, IRS liens, and bankruptcy filings. Some
debts are reported by collection agencies, such as unpaid phone, util-
ity, and cable TV bills. Your credit report will also show every com-
pany that pulled your credit report within the past two years
(
called
an “inquiry”
)
.
How long does information stay on my credit report?
In theory,
information stays on your credit report indefinitely. However, federal
law—the Fair Credit Reporting Act
(
FCRA
)
—requires that any nega-
tive remarks be removed upon request after seven years
(
except for
bankruptcy filing, which may remain for ten years
)
. If you don’t ask,
however, negative information won’t always go away.
4/Working with Lenders
53
How do I get negative information removed from my credit
report?
You may find some information on your report that is just
plain wrong. Accounts that are not yours, judgments against people
with similar names, and duplicate items are very common. Some
items are more subtle, such as the fact that a debt is listed as still un-
paid when in fact is was discharged in your bankruptcy. Ask the credit
bureau in writing to reinvestigate the information. Under federal law,
the bureau must reinvestigate and report back within 30 days. In
some states, the law requires a shorter time period. If the bureau does
not report back within the requisite time period, the item must be re-
moved.
If you have “bad” items on your credit report, such as late pay-
ments, charge-offs, judgments, or a bankruptcy, the credit bureaus can
legally report this information. However, if the information is stated in
an incorrect or misleading format, you can still ask the bureaus to re-
investigate the information. Sometimes you will get lucky and the bu-
reau does not report back within the required time period. In this
event, the information must be removed.
Communicating with Credit Bureaus
Send your letter by certified mail, return receipt re-
quested. If you do not get results within the time
period specified by your state law or the FCRA,
you can write a sterner letter threatening to sue un-
der state or federal law. You can also try to contact
the creditor directly. Keep in mind that a creditor
may also be liable for reporting wrong informa-
tion. Before jumping into court, try contacting
your regional Federal Trade Commission office and
your state Attorney General’s Consumer Fraud
Department.
54
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
What things affect my credit?
Credit reports are based on a com-
puter model, called a FICO score, developed by Fair Isaac, and Co.
(
FICO, www.fairisaac.com
)
. Although the FICO formula is not gener-
ally known to the public, certain things tend to improve your score,
such as the following:
•
Installment loans
(
e.g., home mortgage, automobile
)
that are
paid on time
•
A few open credit lines with low balances
•
A history of living at the same address
•
Owning a home
Beyond the obvious late payments, judgments, and bankruptcy,
there are certain subtle things that lower your score, such as the
following:
•
Too many revolving credit card accounts
•
Too many inquiries
•
High balances on credit cards
•
Too many recently-opened accounts
Disputing Items on Your Credit Report
Do not be too specific with your request. For ex-
ample, if a bureau reports that you had a judgment
against you and it was paid, do not volunteer that
information
(
a record of a judgment rendered and
paid off is still worse than no judgment in the first
place
)
. Simply state that the information is incom-
plete and request that it be reinvestigated. In some
cases, it is less work for the credit bureau to re-
move the item than to recheck it.
4/Working with Lenders
55
How can I improve my credit?
A good credit score is generally
above 660. Some loans are so stringent that they require a FICO score
above 700. If your score is above 700, you have excellent credit. The
bad news is, if you keep borrowing, your score will fall, even if you
are current on all payments. So, in short, use your credit wisely. You
can check your own FICO score at
<
www.fairisaac.com
>
.
If you do not have late payments but want to improve your credit
score, you should
•
stay away from multiple department store cards—too many
open accounts;
•
bring a copy of your credit report when shopping for a loan—
car dealers may run your credit a dozen times in one day of
shopping, leaving damaging “inquiries.”
•
separate your credit file from your spouse’s and remove each
other’s names from your credit cards; if you have authorization
to use your spouse’s card, it ends up on your credit file, too.
Can I get a loan with bad credit?
Whether you can get a loan
with poor credit depends on the type of loan. Unsecured loans, such
as credit cards and bank signature loans, usually require a good credit
history. Secured loans, such as home mortgages and car loans, are a
bit more flexible. Lenders are more aggressive and will take larger
risks when the loan is secured by collateral. The lender may require a
larger down payment and charge a higher interest rate for the risk of
lending to an individual with poor credit.
56
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Your Provable Income
FNMA loan regulations require proof of requisite income to sup-
port the loan payments. Proof of income requires strict documenta-
tion, such as
•
two years of W-2 forms,
•
past two pay stubs, and
•
two years of tax returns.
If you are self-employed, or at least a 25 percent owner of a bus-
iness, you need to show that you have been in business at least two
years. Proof of self-employment requires copies of tax returns show-
ing the business income.
“I Don’t Like Credit Cards—Should I Pay
Them Off and Cancel Them?”
Never pay off completely or cancel a credit card!
A person with no credit at all is worse off than a
person with a bad credit history. You may think
that credit cards are evil, but you may not be able
to get a phone, a job, or even a utility account
without a credit score. A person with an empty
credit file looks somewhere between “suspicious”
and “scary” to a company inquiring about your
credit. Have a credit card or two, and use them
once or twice a year, even if it is just to pay to fill
up your gas tank.
4/Working with Lenders
57
The Property
An understated point thus far is the property itself. Part of the
lender’s risk analysis is the property they are collateralizing with
the loan. The lender has to keep in the back of its mind the worst-case
scenario: a borrower’s default and ensuing foreclosure. In other
words, the lender asks itself, “Would I want to own this property?”
The appraisal.
The first thing a lender will do is order an ap-
praisal. Some lenders have in-house staff, but most use independent
contractors. Because the appraiser charges his or her fee whether or
not the loan is approved, the lender generally collects the appraisal fee
(
about $350
)
from the borrower up front.
There are three generally accepted approaches to appraising
property: the market data approach, the cost approach, and the in-
come approach.
Market data approach.
The market data approach is the most
commonly used formula for single-family homes, condominiums, and
small apartments. Basically, a licensed appraiser looks at the three
most “similar” houses in the vicinity that have sold recently. He or she
then compares square footage and other attributes. The number of
bedrooms and baths, age of the property, improvements, physical
condition, and the presence of a garage will affect the price, but
square footage is usually the most important factor. As you might
expect, there are exceptions to this rule. For example, the style of
house, its location, and proximity to main roads, and whether it has a
view or beach access will greatly affect the value. For the most part,
however, if you leave these issues aside, square footage, number of
bedrooms and baths, and physical condition are the most relevant fac-
tors. Keep in mind that bedrooms and baths on the main level add
more value than bedrooms and baths in a basement or attic.
The income approach.
With income properties, an appraiser will
also use the income approach method, particularly if comparable
properties are not available for comparison. The income approach is
58
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
basically a mathematical formula based on certain presumptions in the
marketplace
(
based, of course, on opinion
)
. The formula is as follows:
Value = Net operating income ÷ Capitalization rate
Net operating income is the potential
(
not actual
)
rents the prop-
erty will command, less average vacancy allowance and operating
expenses. Operating expenses include property management, insur-
ance, property taxes, utilities, maintenance, and the like, but not
mortgage loan payments.
Capitalization rate is a little more subjective and difficult to cal-
culate. Capitalization, or “cap” rate, is the rate of return a particular
investor would expect to receive if he or she purchased a similar
property at a similar price. The cap rate is derived from looking at
similar properties and the net operating income associated with
them. Obviously, estimating cap rate is not an exact science but a
trained guess.
Gross rent multiplier.
For single-family rentals, duplexes, and
other small projects, an appraiser may use the “gross rent multiplier”
to help determine value. This formula basically looks at similar prop-
erties and their rental incomes. By dividing the sales prices of similar
properties by the monthly rent received, the appraiser can come up
with a rough formula to compare with the subject property.
Loan-to-Value
Loan-to-value
(
LTV
)
is an important criterion in determining the
lender’s risk. In maximizing leverage, the investor wants to invest as
little cash as possible. However, the lender’s point of view is that the
more equity in the property, the less of a loss it would take if it had to
foreclose.
FNMA-conforming loan guidelines generally require an investor
to put 20 percent cash down on a purchase, which means an 80 per-
cent LTV. Nonconforming loans may permit as little as 5 percent down
for investors, depending on the financial strength of the borrower.
Thus, an investor with excellent credit and provable source of income
4/Working with Lenders
59
may be able to borrow as much as 95 percent of the purchase price of
an investment property. On the other hand, an investor with mediocre
credit and who is self-employed for a short period of time may be
required to put 20 percent down. There are a hundred variations,
depending on the particular lender’s underwriting criteria.
The Down Payment
You need to show at least two months of bank statements to the
lender to prove that you have the requisite down payment on hand. If
the down payment money suddenly “appeared” in your account, you
need to show where it came from. If it was a gift, for example, from a
relative, you’ll need a letter from that relative stating so. Basically, the
lender wants to make sure you didn’t borrow the money for the down
payment
(
although some lenders will permit you to borrow the down
payment from your home equity line of credit, discussed in Chapter 6
)
.
If your credit report shows recently high balances or a lot of recent
inquiries from credit card companies, this may be a red flag for the
lender. In short, don’t expect to borrow the down payment from a
credit card or other unsecured line and think the lender won’t notice.
Loan-to-Value versus Loan-to-Purchase Price
Loan-to-value is determined by the amount of the
loan compared to the appraised value of the prop-
erty. If the investor is buying a property for less
than the appraised value, then the lender’s LTV cri-
teria should change, correct? Actually, not—most
lenders’ LTV criteria are based on the appraised
value or purchase price, whichever is less. Based
on various studies done by lenders, the statistical
chance of a borrower’s default decreases if the bor-
rower has more of his or her own money invested.
60
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Income Potential and Resale Value of the Property
The particular property being financed is relevant to the lender’s
risk. If the property is a single-family home in a “bread and butter”
neighborhood, the lender’s risk is reduced. Because middle-class
homes in established neighborhoods are easy to sell, a lender feels
secure using them as collateral. However, if the property is in a neigh-
borhood where sales are not brisk, the lender’s risk is increased. Also,
if the property is very old or nonconforming with the neighborhood
(
e.g., one bedroom or very small
)
, then the lender will be tighter with
their underwriting guidelines. On the other hand, the stronger the
local economy, the more likely a lender will be to waive the strictest
of their loan guidelines.
Financing Junker Properties
One of the major headaches you will run into as an investor is try-
ing to finance fixer-upper properties. Many banks shy away from
these loans because a subpar property doesn’t meet the strict FNMA
lending guidelines. Also, lenders based their LTV and down payment
requirements on the purchase price, not the appraisal. Thus, you are
penalized as an investor for getting a good deal.
Example:
A property is worth $100,000 in good shape and
needs $15,000 in repairs. The investor negotiates a purchase
price of $70,000. The lender offers 80% LTV financing,
which should be $80,000, right? Wrong! The lender offers
80% of the purchase price or appraised value, whichever is
less.
So, the lender would expect the borrower to come up
with 20% of $70,000, or $14,000, offering $56,000 in
financing.
Dealing with junker properties requires a lender that understands
what it is you do. A small, locally owned bank that portfolios its loans
will be your best bet. The lender may even lend you the fix-up money
for the deal. An appraisal will be done of the property, noting its cur-
rent value and its value after repairs are complete. The lender will lend
☛
4/Working with Lenders
61
you the money for the purchase, holding the repair money in escrow.
When the repairs are completed, the lender will inspect the property,
then authorize the release of the funds in escrow.
Refinancing—Worth It?
A corollary to financing properties is the concept of refinancing.
When and how often should you refinance your investment proper-
ties? Should you take advantage of falling interest rates?
The rule of thumb is that you should not refinance your loan
unless it is a variable rate or your new rate is 2 percent lower than your
existing rate
(
that is, 2 points lower—not 2 percent of your current
rate—such as 8 percent down to 6 percent
)
. However, this rule of
thumb is just that—a guideline. There are costs involved in getting a
loan, and it takes several years of payments at the lower rate to recoup
your investment. Also, keep in mind that if your existing loan has
been amortized for several years, you are starting to pay less interest
and more principal on your current loan; refinancing means starting
all over again.
The bottom line is to use common sense and a calculator—figure
out whether the interest savings is worth the extra cost
(
and poten-
tially the risk
)
of refinancing.
Filling Out a Loan Application
You should be familiar with FNMA Form 1003, a standard loan
application form used by most mortgage brokers and direct lenders to
gather information about your finances. You should also have one
filled out on your computer that you can provide to your lender
(
you
can download a fillable Form 1003 on my Web site at
<
www.legal
wiz.com/1003.htm
>
. You should always fill out a Form 1003 truth-
fully and honestly, but, like income tax returns, there are many “gray
areas” when it comes to stating your income, debt, and assets. If you
have any doubt, have your mortgage broker review it before submit-
ting it to the lender.
62
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Key Points
•
Lenders make their profit in a variety of ways—the key is under-
standing how they do it, and paying the minimum you need to
get a good loan at a fair price.
•
Choose a mortgage company that has the requisite experience
and can handle your business.
•
Understand the basic loan criteria before you apply for a loan.
•
Refinance only when the numbers make sense.
Cash Out Refinancing
Many investors refinance every few years as prop-
erty values increase, using the extra cash to buy
more properties, as suggested in Robert Allen’s
best-selling book,
Nothing Down for the ’90s.
While this process does increase your leverage, it
also increases your risk. There is nothing inherent-
ly wrong with taking out cash in a refinance, so
long as the cash is used wisely. Spending the mon-
ey as profit is not a smart use. Paying off credit
cards with that money isn’t always a smart use of
cash either because you are taking unsecured debt
and substituting it with secured debt. While it may
seem like the monthly payments are lower, the ex-
pense of the refinance hardly makes it worthwhile.
And if you end up with a high LTV and/or negative
cash flow on the property and housing prices fall,
you are in for a world of financial hurt.
63
CHAPTER
5
Creative Financing through
Institutional Lenders
The power of thought—the magic of the mind!
—Lord Byron
While having a good mortgage broker or lender on your side is
very valuable, you still need to have a few tricks in your back pocket
to make things work. One of the main challenges for the investor is to
buy properties with little or no cash, yet still have a low enough pay-
ment to avoid negative cash flow. This chapter will discuss some of
the ways to do so.
Double Closing—Short-Term Financing without Cash
If your intention is to buy a property and turn it around quickly
for a cash profit, it is almost a sin to pay loan costs. Known as a
flip,
the investor wants to make $5,000 to $10,000 turning a property that
he or she buys at a bargain price. This process can be accomplished
without traditional bank financing, much less a down payment.
64
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
If a particular seller and buyer cannot be present at the same time,
a closing can be consummated
in escrow
(
an incomplete transaction,
waiting for certain conditions to be met, such as the funding of a loan
)
.
Thus, the seller can sign a deed and place it into escrow with the clos-
ing agent. When the buyer completes his or her loan transaction, the
deed is delivered and the funds are disbursed. In many cases, you can
buy and sell the property to a third party in a back-to-back
double
closing
(
also called
double escrow
in some states
)
. You do not need
any of your own cash to purchase the property from the owner before
reselling it to another investor/buyer in a double closing.
The seven-step double-closing process works as follows:
1. Party A signs a purchase agreement with party B at a below-
market price.
2. Party B signs a purchase agreement with party C, offering the
property at market price.
3. The only party coming to the table with cash is party C.
Assuming party C is borrowing money from a lender to fund
the transaction, party C’s bank will wire the funds into the
bank account of the closing agent.
4. Party A signs a deed to party B. This deed is
not delivered
but
deposited in escrow with the closing agent. Party B signs a
deed to party C, which is deposited in escrow with the clos-
ing agent.
5. Party C signs the bank loan documents, at which point the
loan is funded and the transaction is complete.
6. The closing agent delivers funds to party A for the purchase
price and the difference to party B.
7. The closing agent records the two deeds one after another at
the county land records office.
5 / Creative Financing through Institutional Lenders
65
As you can see, no cash was required by party B to close the
transaction. Party B’s funds came from the proceeds of the sale from
party B to party C. If the second sale does not happen, the first trans-
action, which is closed in escrow, cannot be completed. At that point,
the deal is dead.
If you are doing a double closing, you are acting as both buyer
and seller. A double closing is actually two separate transactions. If
you do not want party C to meet party A, the double closing can be
completed in two phases rather than all at once. Obviously, you can-
not give the seller funds until your buyer gives you funds. Thus, one
of the two transactions must be closed in escrow until the other is
complete. Often, this escrow closing may last an hour. The bottom
line is you cannot close with the owner if your third-party buyer does
not deliver funds to you.
If you are interested in more information about the f lipping pro-
cess, pick up a copy of my book,
Flipping Properties
(
Dearborn Trade,
2001
)
.
Seasoning of Title
In recent years, some lenders have been placing “seasoning”
(
time of ownership
)
requirements on loan transactions. Some lenders
are afraid to fund the second part of a double closing because of the
possibility that the buyer’s purchase price is inflated. The lenders are
acting mostly out of irrational fear because of a recent barrage of real
estate scams reported in the newspapers.
Property flipping scams.
There has been a lot of negative press
lately about double closings. Scores of people have been indicted
under what the press has called “property f lipping schemes.” Some
lenders, real estate agents, and title companies will tell you that dou-
ble closings are illegal. In fact, they are nothing of the sort.
The illegal property-f lipping schemes work as follows. Unscru-
pulous investors buy cheap, run-down properties in mostly low-
66
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
income neighborhoods. After they do shoddy renovations to the prop-
erties, they sell them to unsophisticated buyers at an inflated price.
In most cases, the investor, appraiser, and mortgage broker conspire
by submitting fraudulent loan documents and a bogus appraisal. The
end result is a buyer who has paid too much for a house and cannot
afford the loan. Because many of these loans are FHA-insured, the U.S.
Senate has held hearings to investigate this practice.
Despite the negative press, neither flipping nor double closings
are illegal. The activities described above simply amount to loan
fraud, nothing more. As a result, some lenders have placed seasoning
requirements on the seller’s ownership. If the seller has not owned
the property for at least 12 months, the lender will assume that the
deal is fishy and refuse to fund the buyer’s loan. There really is no solu-
tion to this issue other than to deal with other lenders that don’t have
the seasoning hangup. Make sure you stay in control of the loan pro-
cess and steer your buyers to a mortgage company that doesn’t have a
problem with double closings.
Two possible solutions.
If the buyer has found a lender that is
really stuck on the seasoning issue, you have two options:
(
1
)
assign
your contract to the end-buyer or
(
2
)
have the original owner buy you
out of the deal.
If you assign your contract to your end-buyer, he or she will close
directly with the owner. However, the end-buyer may not have enough
cash to pay you the difference between your purchase price with the
owner and his or her purchase price with you. You need to trust that
the parties involved will pay you at closing from the seller’s proceeds!
The safer way to solve the problem is to approach the owner and
ask him or her to buy you out of the deal.
Buying you out
means that
the owner is going to pay you to cancel the sales agreement with you
so that he or she can enter into a purchase contract directly with your
end-buyer. Ideally, it would be best if the owner paid you in cash
before he or she closed with your end-buyer. If the owner wants to
wait until the end-buyer closes the sale with him or her to pay you the
cash, put the agreement in writing in the form of a promissory note,
5 / Creative Financing through Institutional Lenders
67
secured by a mortgage on the property. Thus, at closing, you will be
paid off as a lien holder.
The Middleman Technique
Many foolish investors and unscrupulous mortgage brokers have
been known to “overappraise” a property, effectively financing a
property for 100 percent of its value. The mortgage broker then
passes the buyer’s down payment back to the buyer under the table so
that the deal is done with nothing down. Not only is this practice ille-
gal, it is foolish, unless the property can be rented for more than the
loan payment.
Again, there is nothing special about buying a property with no
money down unless it is profitable to do so. If you can purchase the
property at a substantially below-market price
and
with no money
down, you then have a good deal. This is buying 100 percent loan to
purchase, not 100 percent loan to value.
The problem with buying a property at a below-market price is
that conventional lenders tend to penalize you with their loan regula-
tions. As discussed earlier, FNMA-conforming loan guidelines usually
require that an investor put up 20 percent of his or her own cash as a
down payment. The 20 percent rule applies even if the purchase price
is half of the property’s appraised value. A common, but illegal, prac-
tice is for the buyer to put up the down payment and for the seller to
give it back to the buyer after closing. People may get away with it all
the time, but this practice is loan fraud.
The middleman technique is a legal way to get around the 20 per-
cent down rule. The process requires the following three important
factors:
1. A middleman buyer
2. A negotiated purchase price that is 10 percent to 20 percent
below market value
68
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
3. A lender that does not require evidence of a cash down pay-
ment
Use a middleman partner to buy the house from the owner at a
discount and sell it to you for its full appraised value. Do a double clos-
ing at which time the middleman buys the property and simulta-
neously sells to you. The reason for the middleman buyer is to
increase the purchase price, because most lenders base their LTV on
the lesser of the purchase price or the appraised value. Thus, even if
you negotiate a 20 percent discount in the purchase price, the maxi-
mum loan you can get is based on the purchase price, not the ap-
praised value.
Example:
Sammy Seller has a property worth $100,000 and
is willing to accept $80,000 for an all-cash sale. Matthew
Middleman signs a purchase contract to buy it from Sammy
for $80,000. Matthew Middleman then signs a contract to sell
the same property to Ira Investor for $100,000. The terms of
the contract are $80,000 cash and a note for $20,000, due in
ten years. Ira applies for a loan with First National Bank for
80 percent of the purchase price, or $80,000. At a double
closing, Sammy signs a deed to Matthew, which is held in
escrow. Matthew signs a deed to Ira, which is also held in es-
crow. First National Bank funds the loan by wiring the money
into the account of the escrow agent. The closing agent
writes Sammy a check for $80,000. Ira signs a note to Mat-
thew for $20,000. The closing agent records the two deeds
back-to-back. Sammy gets his $80,000. Ira gets his property
for only a few thousand dollars down
(
his loan costs
)
. Mat-
thew gets a note from Ira for $20,000. See Figure 5.1.
Epilogue:
A month or two after closing, Matthew and
Ira become partners when Ira deeds a one-half interest in
the property to Matthew in exchange for complete satisfac-
tion of the note.
☛
5 / Creative Financing through Institutional Lenders
69
Case Study #1: Tag Team Investing
I stumbled across a property that was bank-owned and offered by
auction to the public. Like many foreclosures, the property was in
need of repair
(
approximately $10,000 worth, in this case
)
. The mar-
FIGURE 5.1
Middleman Double-Closing Technique
Warning:
Keep in mind that you should disclose to
the lender up front that you are not putting up any
cash in the deal. Do not, I repeat, do not pay the
seller cash at closing and take it back under the
table in exchange for a note. This practice is loan
fraud, punishable by up to 30 years in federal pris-
on.
See 18 U.S.C. Sec. 1014.
Deed
Deed
Sammy Seller
Matthew Middleman
Ira Investor
Escrow Agent
70
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
ket value of the property in its existing condition was about $180,000.
The bank was willing to accept a bid of $134,000, which was 74 per-
cent of its value.
I brought in a middleman to submit the bid of $134,000 to the
bank. The terms of the offer were all cash, which the lender would
receive, as explained in a moment.
The middleman then signed a contract to sell the property to me
for $180,000. The terms of the sale from the middleman to me were
$9,000 cash and a $27,000 promissory note
(
no payments, interest
only, due in five years
)
. The $27,000 note was to be secured by a sec-
ond mortgage on the property, because I intended to borrow 80 per-
cent of the purchase price
(
$144,000
)
and secure the new loan with
a new first mortgage on the property.
After the double closing, I owned the property subject to a new
first mortgage of $144,000 to an institutional lender and a second
mortgage of $27,000 to the middleman investor. The bank that owned
the property received their $134,000 in cash, and the middleman
investor walked away with about $9,000 in cash. I was out of pocket
about $11,000, which was the down payment
(
$9,000
)
, plus closing
costs
(
$2,000
)
.
I later sold the property for $185,000, at which time the middle-
man investor agreed to accept a 50 percent discount on the $27,000
note. I used proceeds from the sale to pay the middleman. In the
meantime, the payments on the $144,000 first mortgage note were
less than I was able to rent the property for.
Case Study #2: Tag Team Investing
A client of mine
(
we’ll call him Chuck
)
used the middleman
method to buy a $1.6 million house with no money down. The prop-
erty was banked-owned as the result of a foreclosure. Chuck set up a
simple living trust for himself with his buddy as trustee. The trust
signed a contract
(
executed by Chuck’s buddy, the trustee
)
to buy the
house from the bank for $950,000. Chuck then signed a contract to
buy the house from the trust for $1.6 million, the property’s appraised
5 / Creative Financing through Institutional Lenders
71
value. Chuck gave the trust $400,000 cash and borrowed $1.2 million
from an institutional lender. Because Chuck was the beneficiary of the
trust, he received the proceeds of the sale
(
his $400,000 down pay-
ment, plus the $250,000 loan proceeds
)
, netting nearly $250,000 cash
in his pocket. Needless to say, he has yet to reach into his pocket for a
monthly payment on his new loan!
Using Two Mortgages
In the Case Studies above, we got around the 20 percent down
payment financing requirement by using a seller-carryback loan
(
dis-
cussed in more detail in Chapter 9
)
. This type of loan is known as an
80-15-5 loan; you borrow a first mortgage loan for 80 percent of the
purchase price, ask the seller to accept a note for 15 percent of the
purchase price, and put down the balance of 5 percent in cash. There
are many variations to this formula, such as 80-10-10
(
80 percent first
mortgage, 10 percent second mortgage, 10 percent down
)
.
In Case Study #2, the seller accepted a note and second mortgage
for part of the purchase price. The 10 percent
(
or more
)
can also be
borrowed from a third party, such as an institutional lender. The ad-
Walk the Fine Line Carefully
In Chuck’s example, the lender never asked
(
nor
did Chuck misrepresent
)
the relationship between
the trust and himself. However, if the lender does
ask about the relationship between you and the
middleman, be truthful. Don’t mislead or misrep-
resent anything to the lender you are borrowing
from. It’s one thing to be creative with a lender;
it’s another thing to lie.
72
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
vantage of using two loans as opposed to one 90 percent or 95 per-
cent LTV loan, is that the underwriting requirements are easier on the
80 percent LTV first mortgage loan
(
and you avoid the PMI require-
ment, discussed in Chapter 3
)
. Generally speaking, nonconforming
lenders aren’t as concerned with the source of the down payment or
whether the borrower offers cash or a note
(
or other financing
)
for
the balance of the purchase price. So long as the primary lender is in
a first mortgage lien position at 80 percent LTV or less, they are fine
with the seller accepting a note or the borrower obtaining some of
the difference in the form of a second mortgage loan.
No Documentation and Nonincome Verification Loans
Conforming loans generally require strict proof of income, as-
sets, and other debts. If, for example, you cannot prove income to a
lender, whether it is because you are self-employed for a short time or
Tax Consequences to the Middleman
You may be wondering, “If the middleman sells the
property to you at a profit, isn’t this taxable in-
come?” Yes and no. Although it looks like a profit
is made, there is no real gain. The middleman, in
Chuck’s case, was a trust of which Chuck was the
taxable owner, so there was no gain. In Case Study
#1, the middleman’s profit was a note, which is an
installment sale. Installment sale income is taxed
when the gain is actually received, not when the
note is executed. In that particular case, no gain
was received until the note was paid in full
(
in my
case, it was only paid 50 percent, which was tax-
able income to the middleman
)
.
5 / Creative Financing through Institutional Lenders
73
can’t otherwise prove income, there are nonincome verification
(
NIV
)
loans.
NIV loans
(
also known as “stated income” loans
)
require less doc-
umentation than traditional loans. Lenders often advertise these pro-
grams as “no doc” loans, meaning the borrower does not have to come
up with any documentation other than a credit report and a loan
application.
Get Out the Calculator
Using a first and second mortgage in lieu of one
larger loan may not make sense until you do the
numbers. Surely, a second mortgage loan as de-
scribed here will carry a higher interest rate be-
cause of the lender’s increased risk of being in
second position. Make sure the “blended” interest
rate between the first and second mortgages does
not exceed what you otherwise would be paying
with a larger, single first mortgage loan. Also, keep
in mind that a larger first mortgage loan may also
mean you are paying private mortgage insurance,
so that must be factored into the monthly payment.
How to Calculate a Blended Interest Rate
Multiply each interest rate times the amount it
relates to the total debt, then add them together.
For example, if you have an $80,000 first mort-
gage loan at 8%, and a $20,000 second mortgage
loan at 10%, the blended rate is
(
8% × .8
)
+
(
10%
× .2
)
= 8.4%.
74
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Some loans are called “no ratio” loans, in that you don’t have to
justify your total debt
(
mortgages plus other continuing obligations,
such as car loans and student loans
)
compared to your income.
Few, if any loans are true “no documentation” loans. Most of these
offered programs are bait and switch tactics: The lender says they
don’t need documentation, but when the loan is being processed, the
lender will ask for more and more documentation. Often, the lender
will see some red flags that trigger the additional inquiry.
The best defense to these tactics is a good offense; speak to your
lender or mortgage broker up front. Identify documentation issues up
front, educate the lender about your finances, and be truthful. The
more a lender suspects you are hiding something, the more documen-
tation the lender will ask for.
Here is a real-world example: Carteret Mortgage,
<
www.nva-
mortgage.com
>
, lists the following general guidelines for one of its
no-ratio mortgage loans:
•
Minimum middle credit score must be 640.
•
Five credit accounts are required; three may be from alterna-
tive sources—utility, auto insurance, etc.
•
Bankruptcy and foreclosures must be discharged for three
years with reestablished credit.
•
Two years’ employment with same employer.
•
Two months’ PITI reserves are required with an LTV less than
80 percent. Six months’ reserves are required otherwise.
•
10 percent minimum down payment is required from your
own funds. No gifts.
You should ask for this kind of information up front from your
mortgage broker or lender. The more information you know about
what a lender needs, the more information you can provide.
5 / Creative Financing through Institutional Lenders
75
Develop a Loan Package
You should present a loan package of your own to any new lender.
This package should include the following:
•
Your completed FNMA Form 1003 loan application
(
See Ap-
pendix C.
)
•
A recent copy of your credit report, with written explanations
of negative information
•
A copy of the purchase contract for the subject property
•
A copy of the down payment check and documented proof of
where it came from
•
Copies of recent tax returns, pay stubs, and W-2s
(
if applica-
ble
)
•
Recent appraisal of the property if you have one, or a market
analysis prepared by a real estate agent
•
Copies of existing leases or information of rental value of sim-
ilar properties
Watch What You Say on NI V Loans
Just because you don’t have to provide documen-
tation of your income to the lender, it doesn’t
mean you have a license to lie. Most lenders will
make you sign an authorization to release federal
income tax returns. They may not check now, but
if your loan goes into default, they may obtain cop-
ies of your tax returns. If the income you report on
your loan application is way out of sync with your
tax returns, you may be answering to loan fraud
charges.
76
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
•
Copies of recent bank statements, retirement plan accounts,
and brokerage accounts
•
Any other relevant financial information concerning assets or
liabilities.
•
References from other bankers, lenders, or prominent mem-
bers of your community, such as a judge, politician, or bank
president
The more information you provide up front, the less surprises
the lender runs into, and hence the less likely it will be suspicious and
ask for more documentation.
Subordination and Substitution of Collateral
Subordination
is asking someone who holds a mortgage
(
or
deed of trust
)
on your property to agree to make his or her lien
sub-
ordinate,
or second in line, to another lien. For example, suppose you
own a property worth $100,000 that has a first mortgage to ABC Sav-
ings Bank for $65,000. If you want to borrow $30,000 from First
National Bank secured by a second mortgage, you would have to pay
a much higher interest rate because First National’s mortgage would
be subordinate, or second, to the lien in favor of ABC Savings Bank.
See Figure 5.2. A second lien position is riskier than a first lien posi-
tion, so the interest rate is generally higher to compensate the lender
for its increased risk. If you could convince ABC Savings Bank to move
its lien to second position, First National would now be a first mort-
gage holder and thus give you a better interest rate.
Keep in mind that you can use subordination to draw cash on
properties you already own. If you* purchased a property with seller
financing, simply ask the former owner to subordinate his or her mort-
gage to a new first. This may require you to give the seller some incen-
tive, such as additional cash or paydown of the principal. Either way,
subordination is an excellent way to finance a purchase or draw
money out of existing properties.
5 / Creative Financing through Institutional Lenders
77
Substitution of collateral
is a method of moving a lien from one
property, or collateral, to another. The substituted property does not
necessarily have to be real estate. You can use a car or boat title as the
substitute collateral. Better yet, get the mortgage holder to release the
mortgage with no substitute collateral! To get someone to take a note
without collateral, you need to offer a substantial cash down payment.
Think about this: If the note you give the seller is not secured by the
property, you can refinance or sell the real estate without paying off
the note.
Case Study: Subordination and Substitution
A property owner
(
we’ll call her Mrs. Seller
)
called me to discuss
selling her house. After some negotiations, we agreed to purchase the
property for $63,000 as follows:
•
$35,000 cash at closing of title
•
Promissory note and second mortgage
(
subordinate to a new
first
)
for $28,000, payable in installments of $350 per month,
no interest
FIGURE 5.2
Subordination
Free and
5% e
q
uit
y
65% LTV 1st Mort
g
a
g
e
30% LTV 2nd Mort
g
a
g
e
78
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
She owned the house free and clear, so why would she do such a
thing? The answer is, to have her needs met. After some discussion,
she told me that she was sick of the upkeep of the property and
wanted a brand-new doublewide mobile home. The $35,000 cash was
for the new home, and the $350 per month would pay her mobile
home lot rent
(
just so you know that I didn’t “steal” the property from
some little old lady!
)
.
I went to a hard-money lender
(
discussed in Chapter 6
)
and bor-
rowed $37,500 at 12 percent interest
(
only $35,000 went to the seller;
the extra cash was for the points on the loan
)
. I closed escrow, placing
a new first mortgage in favor of the hard-money lender, and a second
mortgage
(
subordinate to the first
)
in favor of the seller for $28,000.
My total monthly payments were $725 per month, and I rented the
property to a nice family for $800 per month.
A few years later, I wanted to sell the property, so I called Mrs.
Seller and asked if she would be willing to take a discount on the
amount we still owed her, which was approximately $20,000
(
remem-
ber the original amount was $28,000
)
. She said that she liked the
monthly payments and didn’t want me to pay her off! With that, she
agreed to accept $10,000, release the mortgage from the property, and
allow us to continue making payments on the $10,000 balance of the
unsecured promissor y note. Not only did we profit from the sale of the
property, we also walked away from closing with an extra $10,000
cash in our pockets! The extra cash was due to the fact that we only
paid her $10,000 towards the balance of the $20,000 debt still remain-
ing. We continued to make monthly payments on the note, but be-
cause the security
(
mortgage
)
was released from the property, we
received the cash from the proceeds of the sale.
As you can see, subordination and substitution of collateral are
two powerful tools to make you more money in real estate.
5 / Creative Financing through Institutional Lenders
79
Using Additional Collateral
If the lender you are dealing with feels uncomfortable with the
collateral or your LTV requirements, offer additional security for the
loan. There are several ways to securitize a loan, other than with a lien
on the subject property.
Blanket Mortgage
A blanket mortgage is a lien that covers multiple properties. De-
velopers often use a blanket mortgage that covers several lots. When
each lot is developed and sold, the lien is released from that lot. A blan-
ket mortgage
(
or deed of trust
)
is just like a regular lien, except that it
names several properties as collateral. When recorded in county
records, the lien is now placed on each property named in the security
instrument. See Figure 5.3.
Zero-Interest Financing: The Exception
to the “Cash Flow Is King” Rule
In Mrs. Seller’s case, the payments on the high-
interest-rate first mortgage plus the owner-carry
second mortgage were only slightly less than the
market rent for the property. However, because
the payments on the owner-carry second were for
zero interest, the equity pay-down far exceeded
the value of the cash flow. Zero-interest financing
is one of the rare instances where monthly cash
flow is not the investor’s first concern.
80
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
If you have other property with equity, even raw land, you can
offer this property as additional security for the loan. Be cautious,
however, with offering your personal residence as security; failure to
make payments can make you homeless!
Using Bonds as Additional Collateral
A bond, like a note, is a debt instrument. In return for the loan,
the investor is paid in full at a future date. Bonds generally pay interest
at fixed periods, unless they are zero-coupon bonds. The cash value
of a bond at any given time is based on the maturity date and its
present value, which in turn is based on whether investors are spec-
ulating interest rates will rise or fall in the future. As interest rates fall,
bond prices rise, and vice-versa. And, logically, the later the maturity
date, the less the present value of the bond.
Municipal and government bonds are virtually the same as cash;
they can be traded, sold, and hypothecated
(
used as collateral
)
. U.S.
Treasury bonds are safe, secure investments from a risk standpoint.
FIGURE 5.3
Blanket Mortgage
Lender
Investor
Single
Promissor
y
Note
Blanket
Mortgage on
all Properties
5 / Creative Financing through Institutional Lenders
81
From an investment standpoint, they are a fair to good bet, depending
on interest rates and market inflation.
Most laypeople think of bonds as being a secure investment. Of
course, institutional lenders are generally too savvy to accept the face
value of a bond as collateral. However, when dealing with a private
motivated seller, an owner-carry offer that is cross-collateralized with
U.S. Treasury bonds sounds appealing. When making an offer to a
seller with owner financing, offer the face value of the bond as collat-
eral. Although the present value may be less, the very idea of a bond
as additional collateral sounds safe. Furthermore, bonds can be used
in lieu of a down payment.
Example:
Sonny Seller owns a house free and clear and is
asking $100,000 for his house. Brian Buyer offers Sonny
$110,000 as follows: $30,000 in U.S. Treasury bonds and an
$80,000 note secured by a mortgage on the property. The
$30,000 in bonds, if they matured in 30 years, can be bought
for a fraction of their face value, depending on the market
interest rates. In the seller’s mind, he’s receiving more than
the asking price, but the buyer is paying much less than the
asking price
(
sometimes sellers are stuck on asking price
just because they are ashamed to tell their neighbors they
took less!
)
.
For an excellent reference on using bonds as collateral for real
estate financing, I recommend
Formulas for Wealth
by Richard Pow-
elson, Ph.D.
(
Skyward Publishing, 2001
)
. For more information on
bonds, try
<
www.savingsbonds.gov
>
.
☛
82
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Key Points
•
Avoid loan costs on flips—use the double closing.
•
Use the middleman technique to overcome lender down pay-
ment requirements.
•
Don’t let lack of income hold you back—use NIV loans.
•
Think beyond the property for collateral: substitute, subordi-
nate, and cross-collateralize.
83
CHAPTER
6
Hard Money and
Private Money
A loan shark is simply a thief without a Wall Street office.
—Lyndon H. LaRouche, Jr.
An often overlooked and very valuable source of funding is pri-
vate money. Small companies and individual investors called “hard-
money lenders” are an excellent resource for quick cash. Private
lenders are often known as hard-money lenders because they charge
very high interest rates. I have personally borrowed at 18 percent
with 8 points as an origination fee! These rates may sound outra-
geous at first blush, but it is the availability of the money not the cost
that matters.
Emergency Money
I recently won with the high bid on a condominium auctioned by
the Department of Veterans Affairs
(
VA
)
. I made the bid in the name of
a corporation rather than my individual name. I was assured by my
mortgage broker that the lender that had my loan application would
84
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
permit me to finance the purchase in a corporation. At the 11th hour,
the lender changed its mind, requiring me to close in my individual
name. I asked the VA for permission to amend the purchase contract
to name me, rather than my corporation. The VA refused, and I now
had less than five days to close or lose the deal. Because my winning
purchase bid was an excellent price, I opted for using hard money to
purchase the property. I paid 14 percent interest for a few months,
then refinanced the property at a good interest rate. All in all, the high
cost of the hard-money loan was worth it and saved me in a pinch.
Hard-money lending criteria are based on the collateral
(
the prop-
erty
)
rather than the financial strength of the borrower. For this rea-
son, hard-money lenders are often referred to as “equity” lenders. A
hard-money lender looks at a loan, thinking, “Would I want to own
this property for the amount of money I lend this person?” Hard-
money lenders generally go no higher than a 75 percent loan-to-value.
The goods news, however, is that many hard-money lenders will base
their loan on appraised value, not purchase price. So, if you negotiate
a very good purchase price, you may end up with an 85 percent loan-
to-purchase ratio.
Hard-money lenders can be expensive but also easy to deal with
if you are in a hurry for the money. In many cases, the availability of
the money is more important than the cost of borrowing it.
Where to Find Hard-Money Lenders
Hard-money lenders are fairly easy to find, once you know where
to look. The first place is your local newspaper, under “money to loan.”
The ads will usually look something like this:
Stop Foreclosure! Real Estate Loans.
Fast and Easy. No Credit Required.
48-Hour Funding. Call Fred 555-1134.
6 / Hard Money and Private Money
85
Many hard-money lenders advertise on the Internet. Try a Yahoo!
search of the Internet for hard-money lender Web sites. Not all hard-
money lenders call themselves that; some use the title “equity based
lender.” It is best to find one that is located within your state. A refer-
ral from another local real estate investor is helpful, too. For a referral
to a local real estate investors club in your city, try the National Real
Estate Investors Association at
<
www.nationalreia.com
>
.
Borrowing from Friends and Relatives
Friends and relatives seem like obvious choices for borrowing
money, but they may be as skeptical as an institutional lender. They
may try to boss you around and nag you about when you expect to
repay the money you borrowed. They may also want to be part of the
daily decision-making process, which would interfere with your bus-
iness. And, of course, they may be emotional about their money,
whereas institutional lenders don’t take money matters personally.
Borrower Beware!
Soliciting money from private investors can
be a dangerous practice. Federal securities laws may apply to public
solicitations of money as a “public offering.” In addition, state securi-
ties regulations
(
known as “Blue Sky Laws”
)
may also apply. Simply
running a blind ad in the paper stating, “Private Money Wanted for
Real Estate Purchase—12% Return” may result in a call from your state
Attorney General’s Office. If you are approaching a friend, relative, or
individual investor to borrow money secured by a specific property,
then you are probably OK; borrowing money for a “pool” of funds
becomes trickier. Also, when you deal with strangers, multiple par-
ties, or the public at large, you should seek the advice of a local attor-
ney knowledgeable about state and federal securities regulations.
86
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Using Lines of Credit
A home equity line of credit
(
HELOC
)
can be an excellent financ-
ing tool, if it is used properly. A HELOC is basically like a credit card
secured by a mortgage or deed of trust on your property. In most
cases, it will be a second lien. You only pay interest on the amounts
you borrow on the HELOC. You can access the HELOC by writing
checks provided by the lender.
HELOCs are being advertised on television as a way to consolidate
debt, but they can be used much more effectively by investors. When
you need cash in a hurry for a short period of time, a HELOC can be
very useful. For example, if a seller tells you to give him “$75,000 cash
on Friday and I’ll sell you my house for a song,” you need to act in a
hurry. Another example of cash in a hurry is a foreclosure auction,
which, in many states, requires payment at the end of the day of the
auction. When you need cash in a hurry, there’s no time to go to the
bank.
While the HELOC may be a high-interest-rate loan, it is a tempo-
rary financing source that can be repaid when you refinance the prop-
erty.
Do not use your HELOC as a down payment or any other long-
term financing source—it will genera lly get you into financial trou-
ble.
Furthermore, an institutional lender may not lend you the balance
if you borrowed the funds for the down payment.
Warning:
Failure to pay your HELOC means you lose your home!
Use your HELOC wisely and only if it means losing a steal of a deal if
you don’t!
Credit Cards
You may already have more available credit than you realize.
Credit cards and other existing revolving debt accounts can be quite
useful in real estate investing. Most major credit cards allow you to
take cash advances or write checks to borrow on the account. The
transaction fees and interest rates are fairly high, but you can access
this money on 24 hours’ notice. Also, because credit card loans are
6 / Hard Money and Private Money
87
unsecured, there are no other loan costs normally associated with a
real estate transaction, such as title insurance, appraisals, pest inspec-
tions, surveys, etc.
Often, you will be better off paying 18 percent interest or more
on a credit line for three to six months than paying 9 percent interest
on institutional loans that have up-front costs that would take you
years to recoup. Again, use credit cards carefully and only as a tempo-
rary solution if the deal calls for it.
Key Points
•
Hard money is an excellent short-term financing tool.
•
HELOCs and credit cards are excellent sources for fast cash.
Deducting HELOC Interest
There are limits on the deductions you can take on
your personal tax return for interest paid on your
HELOC. Generally speaking, you can only deduct
that portion of interest on debt that does not ex-
ceed the value of your home and is less than
$100,000. But, if you do your real estate invest-
ments as a corporate entity, you can always loan
the money to that entity and have the entity take
the deduction as a business interest expense. This
transaction must, of course, be reported on your
personal return and must be an “arms-length”
transaction
(
i.e., documented in writing and with-
in the realm of a normal business transaction
)
.
Consult with your tax advisor before proceeding
with this strategy.
89
CHAPTER
7
Partnerships and Equity Sharing
The guy with the experience approaches the guy with the money. When the deal is com-
plete, the guy with the experience has the money, and the guy who had the money has
experience.
—Anonymous
If you are low on cash or have cash and are low on time, a part-
nership or equity-sharing arrangement may be for you. Using part-
ners to finance real estate transactions is the classic form of using
other people’s money
(
OPM
)
. Experienced investors are always will-
ing to put up money to be a partner in a profitable real estate transac-
tion. As with many businesses, talent is more important than cash. If
you can find a good real estate deal, the money will often find its way
to you!
Partnership arrangements work in a variety of circumstances.
The most common scenario involves one party living in the property
while the other does not. Another scenario may involve all of the par-
ties living in the property. These arrangements are common among
family members. Parents often lend their children money for a down
payment on a house, with a promise of repayment at a later date. If
90
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
the repayment of the debt is with interest and/or relates to the future
appreciation of the property, we have a basic equity-sharing arrange-
ment.
Another common financing arrangement between multiple par-
ties is a partnership wherein none of the parties live in the property.
This chapter will discuss the basic partnership investment. Larger
investments through limited partnerships and other corporate enti-
ties in a “pool” of money are known as “syndications.” These invest-
ments are generally classified as securities, so compliance with state
and federal regulations is complex. Thus, syndications are generally
not recommended for financing smaller projects because the legal
fees for compliance with securities laws will far exceed the benefit of
raising capital through multiple investors.
Basic Equity-Sharing Arrangement
The common equity-sharing arrangement involves one party liv-
ing in the property and the other putting up cash and/or financing.
Both the occupant and the nonoccupant enjoy tax benefits and share
the profit, as described later in this chapter. First-time homebuyers
make the best resident partners while family members, sellers, and
real estate investors fill the nonresident partner role.
Scenario #1: Buyer with Credit and No Cash
A lot of potential homebuyers have the income to qualify for a
mortgage loan, but only with a substantial down payment. With a
small down payment, the monthly loan payments may be too high. A
potential homebuyer could borrow the money for the down payment,
but nobody but a fool
(
or a parent
)
would lend $25,000 or more unse-
cured. Furthermore, loan regulations generally do not permit the use
of borrowed money as a down payment.
7/ Partnerships and Equity Sharing
91
An equity-sharing partner could put up the money in exchange
for an interest in the property. The resident partner would obtain the
loan, live in the property, make the monthly loan payments, and main-
tain the property. The nonresident partner who puts up the down-
payment money is free from management headaches and negative
cash flow. After a number of years
(
typically five to seven
)
, the prop-
erty is sold, the mortgage loan balance is paid in full, and the profits
are split between the parties. Obviously, the strategy works best in a
rising real estate market.
Scenario #2: Buyer with Cash and No Credit
The second equity-sharing scenario would be a buyer with cash
but an inability to qualify for institutional financing. The resident part-
ner would put up the down payment, the nonresident partner would
obtain the loan. After a number of years, the property is sold, the mort-
gage loan balance is paid in full, and the profits are split between the
parties.
Your Credit Is Worth More Than Cash
Just because you put up credit and no cash does not mean you
aren’t at risk. Cash is easy to come by, but good credit takes years to
build, and only months to ruin. As I write this book, an investor friend
of mine
(
we’ll call him Brian
)
recalls his first deal. Brian was a neo-
phyte investor who was approached by an experienced investor with
the following proposal: “You put up your credit to get the loan; I’ll put
up the cash for the down payment.” Brian bought the property with
the investor in this manner, but Brian did not manage the property.
Brian received a call from the lender a year later and was informed
that the mortgage loan had not been paid in several months. Brian was
unable to locate his partner who had apparently collected the rents
and skipped town.
The moral of this story: Use your credit wisely—cash can be re-
couped in a few months, but credit blemishes can take years to fix.
92
FINANCING SECRETS OF A MILLIONAIRE REAL ESTATE INVESTOR
Tax Code Compliance
Equity sharing arrangements are governed by Section 280A of
the Internal Revenue Code
(
IRC
)
. Labeled a Shared Equity Financing
Agreement
(
SEFA
)
, IRC Section 280A permits the nonresident partner
investment property tax benefits
(
namely depreciation
)
. In addition,
the resident partner can take advantage of the benefits of owning a
principal residence
(
namely, the mortgage interest deduction
)
.
The nonresident partner is essentially treated for tax purposes as
a landlord, taking depreciation for his or her ownership interest to the
extent he or she receives rent. So, for example, if fair market rent for
the property is $1,000 per month and the resident/nonresident equity
split is 60/40, then the resident must pay $400 in rent to the nonresi-
dent partner if the nonresident wants to take the depreciation deduc-
tion. In turn, the nonresident partner returns the rent to property
expenses for which the resident partner is responsible
(
in this way,
the cash contribution by the resident partner is not increased—it is just
shifted to conform with the tax code
)
. If the resident does not pay
rent, but rather makes all of the mortgage interest payments directly
to the lender, then the investor receives no tax benefits, leaving them
all to the resident. The agreement can be made in a number of ways,
depending on the needs of the parties and their needs for the tax de-
ductions.
The parties must have a co-ownership agreement that complies
with IRC Section 280A in order to reap the benefits of this mixed use
tax plan. If the relationship is deemed a “partnership” by the IRS, then
the rules of IRC Section 280A are not applicable. A highly recom-
mended book that covers the tax implication in detail is
The New
Home Buying Strategy
by Marilyn Sullivan, Esq.,
<
www.msullivan
.com
>
.
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