Traditional lending sources remain difficult to obtain
In the current investment property mortgages landscape, traditional bank loans remain a tough road for financing. And many property investors have had to hold onto their existing, long-held properties while paying off those older mortgages that were set at much higher rates. These investors are finding it nearly impossible to refinance their debt loads, and tap into their equity to help finance new investment property acquisitions. So it’s a double-whammy: not only can they not finance new opportunities, but their cash flows are reduced due to their old, higher-rate mortgages remaining in place.
New Lender Rules = Tighter Credit
The latest news from Washington means traditional bank mortgages will continue to be hard to obtain. This is because the new “qualified mortgage” definition could adversely affect investors who require jumbo mortgages that are too large to qualify for government backing. Most recently, the Consumer Financial Protection Bureau created a rule that spells out exactly how lenders can avoid legal liability under a new law that holds these lenders accountable for ensuring a borrower’s ability to repay a mortgage. Loans that meet the new qualified mortgage definition will get a clean bill of health – and they will have shown compliance with the new ability-to-repay part of this law.
Fortunately, some jumbo mortgages won’t be considered as qualified mortgages, and would be exempt from the new rules. Any loan that features an interest-only provision for an initial period won’t be considered as part of the new regulations. And any loan where a borrower’s total monthly debt payments exceed 43% of his or her income would also not be considered a qualified mortgage under the new rules.
Interest-only mortgages increased during the housing boom because they were marketed as being more affordable. It allows property investors the ability to carry a mortgage, and gain a tax deduction – all this while making a minimum loan payment. Later down the road, the investor can refinance or pay off the loan before they are required to make principal payments. Or at least, that was the thinking behind this type of mortgage. The debt-to-income rules, meanwhile, could wreak havoc with investors who have lots of cash and other assets, but whose incomes are harder to document. This includes some small business owners or self-employed professionals who have incomes that fluctuate widely from year to year.
The true meaning of these rules for property investors
Since the current real estate market is rebounding, investors are now looking to refinance their existing investment property mortgages and search for new, additional properties for their stable of investments. However, finding traditional bank loans for new investment property purchases, as well as trying to refinance existing loans has become much more difficult with the qualified mortgage rules. Even borrowers with excellent credit and income, who still show a steady rental revenue, are having trouble getting a bank mortgage on an investment.
As such, a great number of property investors have been financing recent acquisitions with their own cash. Of course, this is a horrible way to grow your business, since no leverage is being utilized. More importantly, these investors who bought all-cash thinking they’d be able to refinance afterwards, and pull out some of their equity on their income-producing properties, are being left high and dry when they find that traditional lenders, tied down by the qualified mortgage rules, are simply unable to extend mortgage loans to them.
Hard money lenders
Likewise, it is just as onerous for those investors who acquired investment property in recent years using hard money lenders. Since hard money loans are always short-term, those investors who could not refinance their investment property mortgages at a bank, and who are unable to come up with their own cash resources to pay off those loans, are being forced to sell those properties that they had originally intended to be long-term acquisitions.
To help fill this void, a recent trend has been for hard money lenders to offer additional short-term mortgages to fill the gap. These non-traditional lenders now offer two- to- five year loans on investment properties, all at a much higher interest rate than traditional banks would offer, of course. However, these mortgages have allowed many investors to retain their properties until they can qualify at a traditional bank. And they don’t have to place these properties on the market just yet. These loans, even at their higher rates, allow investors the ability to reduce their monthly costs, increasing their overall cash flow. And they also allow investors the ability to pull some cash out for future purchases.
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Looking for the diamond in the rough
When searching to buy investment property, it is a rarity to come upon a residential house where the seller will offer some form of owner financing. It is more common in commercial real estate, especially for rental buildings with over five units. However, whenever you come across the opportunity, by all means avail yourself of the chance to obtain some amount of paper being given by the owner to sweeten a deal.
The key advantage to owner financing
Any money you don’t have to put up yourself when you buy investment property offers you the opportunity to increase your leverage on the purchase. And if you don’t have to borrow from a bank (or worse, a hard money lender) then you will be saving your credit line possibilities for further down the road. And if an owner is willing to take back mortgage paper for at least some part of the purchase price, you will be ahead of the game. Even if that amount is small, or not a first mortgage, it will benefit you. Every little bit of leverage goes a long way. Of course, if you can obtain a first mortgage from the seller, even better still.
Costs to obtain owner financing
You can expect to pay for the seller’s attorney’s fees for preparing the mortgage. However, you’d be doing the same thing (paying attorney fees) if a bank was involved in granting you a mortgage. If a seller is willing to offer a first mortgage, you can expect to negotiate a break in interest rate if you are paying market rate or slightly more for the property’s purchase price. Conversely, if you have negotiated a great price on the building, expect to pay a slightly higher interest rate on the loan than a conventional bank mortgage would currently offer.
The leverage game
While owner financing helps you greatly in increasing your overall financing leverage and future options, don’t waste your time making it your number one pursuit when searching to buy investment property. It is still an elusive task and will take an inordinate amount of your time. It would be better to use your time more wisely – time that could be spent on more fruitful property searching. Don’t pass up a great deal simply holding out to obtain seller financing. But if you do manage to come across a willing seller offering some amount of owner financing, by all means, don’t pass it up.
You’ll negotiate just as hard as you would normally – but now you’ll be negotiating not just on price, but overall terms of the mortgage as well: interest rate, amortization schedule, and payoff term. Expect any owner financing to be short term – usually 1 to 5 years, but with amortization based on 15 or 30 years, with a balloon payment at the end of the overall term. Like with commercial paper, you’ll eventually have to refinance the overall remaining mortgage amount at the end of the term.
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Using hard money lenders
Hard money loans are basically a form of short-term borrowing available to property investors. They are like bridge loans, in that they are designed to get in and out of very quickly. Hard money loans are typically used by those in dire financial straits, like borrowers facing foreclosure or bankruptcy. But property investors utilize their services as well – and with good reason. Simply put, hard money loans are a much better alternative to all cash deals.
The average hard money investment property loan is supplied with capital put up by private investors – usually as a pool of money that is used to drive much greater profits for its investors. This private capital is traditionally unregulated, which gives the hard money industry a kind of “Wild, Wild West” feel to it’s practices and reputation. Pejoratively, many consider hard money lenders as sharks feeding off the misery of those in bad financial straits. As a property investor, you will certainly need to approach any hard money investment property loan with a great deal of caution and foresight prior to signing on the dotted line.
Who hard money is designed for…
That said, if you do not have excellent credit, or if you’re self-employed with much income written off, or if you are investing money from a self-directed IRA, then it may be difficult for you to obtain conventional mortgage financing. You could pay all cash for your next property acquisition. But hard money lenders allow you the ability to utilize leverage – even in the short term.
Think of hard money lending as a local train on the real estate train line. Conventional bank loans are quite onerous to qualify for, but they offer the best rates and terms for property investors. They are like the express trains on the line. Hard money investment property loans are like local trains in that you will need to continually be stopping off at more points along the route. Points where you need to pay off your existing short term loan’s balloon payment by taking out another short-term loan to supercede it.
Is this more costly, time consuming and fear-provoking? Absolutely. But, hey – you’re a property investor. You should be used to living with debt and risk – and be comfortable with it. Your safety is knowing there are always going to be hard money lenders out there with their private funds to ensure you make it through to your next “stop” on the line.
While paying all cash for a property is the “safe” way of investing, it provides no way to leverage your financial strength. Assuming you could not obtain conventional financing, hard money lenders offer the next best alternative to all cash deals. While your cash flow will be severely impacted because of the relatively exorbitant interest payments on hard money loans, even a small positive cash flow will yield great leverage over several years of making timely payments on the loan. Remember, besides the cash you put up on the property as your down payment, you will be paying off the principal on your hard money loan each month – thereby helping to increase your return on investment (ROI). Over several years, a small positive cash flow will yield much greater ROI’s than an all cash purchase would.
Costs for hard money investment property loans
If you’re going swimming amongst the sharks, your protective shark cage is knowledge. You need to know ahead of time that typical hard money loans carry interest rates that can run anywhere between 12 and 18 percent. Balloon payment are de rigeur, and these mortgages usually come due within 1 to 3 years. In all but rare instances, hard money lenders require being in the first mortgage position, so they can get their money out first if you default.
In addition, typical loan-to-value (LTV) ratios on hard money investment property loans range between 50% to 65%. And this LTV is based upon the “quick sale” market value of the property…that is – what the property will fetch today – not three months from now after you’ve fixed it up. Another potentially scary cost to take into account are points (up front interest charges). Typically, they can run anywhere between 4 to 8 percent of the total mortgage amount.
Not for the faint of heart
As a borrower, the hard money loan is definitely not for the faint of heart. You should already be comfortable taking on more debt, especially of the short term variety. You should also be well aware of the consequences in case of default.
The hard money lender takes on the increased risk of borrowers with less-than-stellar credit. For this, they are able to charge exorbitant interest rates, with onerous terms, and even more Draconian conditions if the borrower defaults.
A mature, responsible investment property investor/borrower should not be scared off by the terms of a hard money loan. They realize they can use the leverage to their advantage to help grow their real estate holdings. And they enter into hard money investment property loans with eyes wide open.
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Now is the time to utilize all investment property finance options
The latest news for property investors is that according to the National Association of Realtors, pending house sales are rising. Their index of pending home sales indicates a 4.1% increase in March compared to February, and is almost 13% higher than March of last year. This information reflects contracts on houses that have been signed but have not closed yet.
The index is also now showing that pending home sales are at their highest level since April of 2010. In this first quarter alone, closings were at their highest level for a first quarter in five years. The indications from the March pending home sales index now suggest that actual second quarter sales will be very good as well.
Sales are considered “pending” when contracts have been signed but the deal has not closed, so the sale has not been finalized yet. Closings usually take 1 to 2 months after contracts are signed to finalize. The latest pending home sales index is based on a very large national sample and represents about 20% of existing sales transactions.
The bottom has been reached
As I had written back in mid-March, I firmly believe from all the economic indicators over the last couple months that the bottom of the real estate market has been reached. Now is clearly the best time to be considering all your investment property finance options. Increased sales are very gradually lowering the inventory of houses on the market, including short sales and foreclosures. So as this year goes on, stabilization of the market will see a slight increase in house values.
Other indicators showing a clear-cut flat-lining and bottoming out of the real estate market include first quarter sales results, especially in the Northeast. In this region, house inventories have remained steady, days on the market have been dropping slightly, and house prices have remained flat overall during the last few months. Compared to the precipitous price drops, inventory increases, and increased time on the market data of the last several years, a flat-lining of the market is good news indeed.
The ramifications for the property investor
So what does this all mean for the property investor? As I’ve been saying for months now, if you haven’t already decided to get into the market by either purchasing your first investment property, or adding on to your stable of properties, then this is the time to do it. You need to get in before prices start rising. All signs point to the second half of 2012 as a continued slow recovery period. However, it is expected that 2013 will start to see some serious price increases occurring in the real estate market across the country.
So clearly this is the time to get in on the investment property bandwagon, as prices remain at their relatively lowest point in years. The bottom has definitely been reached. And you should be exploring all your investment property finance options now. Whether you decide upon utilizing conventional mortgages, FHA 203K renovation loans, owner financing or hard money lenders, the window is slowly closing on making good deals on investment property while they remain priced at historically low levels.
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