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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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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Commercial property types – retail stores
Retail store operations are another form of commercial property investing. Stores can be found as part of small strip malls, neighborhood shopping centers, community shopping centers and regional shopping centers (for example, indoor malls).
Strip malls, those sets of small store buildings that tend to line both sides of busy commercial streets in every town around the country, make for a great entry opportunity for the small investor. Small two or three store buildings may actually be less expensive than purchasing a residential duplex or triplex house. And because tenants usually are placed on longer term leases, turnover and vacancy rates are traditionally lower as well. This makes managing the property easier too. Most strip store leases run three to five years, and usually include renewal options.
One key element to remember about strip malls though, is that building profitability is directly related to the profitability of the tenant businesses. If a tenant is not doing well, regardless of having a lease, they may be forced to close down – and you’ll need to find a new tenant. But if their business is a success, they’ll want to stay for longer periods, and rental increases are more easily accepted. The landlord will want to help the tenant’s business out as much as possible due this symbiotic relationship. Many leases are graduated leases, which start with a low rent in some initial period, then gradually increases as the tenant’s business increases.
Small shopping centers
Small shopping centers are situated close to residential neighborhoods for easy driving access to basic goods and services. Usually there is an anchor store of a supermarket, with many personal services stores surrounding it (like dry cleaning, laundry, barber shop or pharmacy). These centers also have plenty of available off-street parking associated with them. Leases for business in these centers usually will include a minimum rent plus some form of override – a small percentage of their gross sales will be added to (or drawn against) their base rent.
Community shopping centers
These types of retail centers are usually characterized by a much broader range of goods and services being offered, to a larger geographic area. Here, anchoring tenants include major department stores in addition to a supermarket. Movie theaters, large appliance dealers and furniture stores are just some of the fixtures that comprise tenants in these centers. In many instances, these groups of stores will be aligned as an outdoor mall. And due to the larger size of the centers, many competing business may be found there.
The greater the size of the center also requires the use of a professional management company to run the entire property. Lease terms for larger tenants may run 15 to 20 years, while smaller tenants may have lease terms that run between 5 to 10 years. Leases are traditionally of the “percentage lease” variety, with base rent being augmented by a percentage of gross sales, with annual adjustments.
Regional shopping centers
Regional shopping centers are comprised of large outdoor or indoor malls, that service areas from 15 to 20 miles away. Like in a community shopping center, businesses tend to be grouped together around several key anchor department stores. A full-time manager is required on-site at all hours of operation, but full-time maintenance crew and security personnel are also required costs for the center owner(s).
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Some basics of commercial property investments
Buying commercial property
Most property investors will tend to stick with investing in types of properties they know best, and feel most comfortable managing – usually residential real estate. But for those who are looking for greater profits at a quicker pace, then commercial property should be considered as well. Most investors will not be as well versed or comfortable with commercial property, so there is definitely more specialization required when investing in it. In addition, the absolute dollar amounts required (as well as financed) tend to be much greater than with residential property investing. With more risk comes more potential for return.
Unlike houses, commercial properties almost uniformly derive their value from rental income, not so much from general market appreciation. The greater the rental income, the greater the value of the commercial property. If you can purchase a building where rents are low, then manage to increase the rent-roll on the property, you can increase the overall value of the building. In addition, the quality of the leases you have with tenants in a commercial property will help determine its value. Poor tenants (read: poor paying) with very short leases will yield a less valuable property compared with a building that’s locked up with very strong tenants on long-term leases, with rent escalation clauses built into those leases.
Types of commercial investments
Commercial property investment runs the gamut from small apartment buildings to large-scale ones, small office buildings to large high rises, as well as office parks, shopping centers, strip malls, and many types of industrial buildings, including warehouses, manufacturing buildings and industrial parks.
With each successive commercial property type, the level of sophistication and specialization for that particular form is required. In may ways, relative to residential property investments, commercial properties require much less estimating and speculation, and therefore risk is actually lessened because as is the norm, actual income statements can be analyzed from existing, performing properties. That’s not usually the case with residential rentals, where the investor needs to make guesstimates as to market rents for vacant units, as well as for many expense items, such as fuel and electrical consumption. With commercial, past performance of a building will dictate it’s market value.
In addition, the high cost of most commercial property will be out of financial reach for an individual investor. However, investors can pool their financial resources (and credit lines) to form investing groups. Also, investing is Real Estate Investment Trusts (REIT’s) is also very popular. These are usually publicly traded funds that, like any stock-type of investment, you’d be simply investing in without having a say in the management of their respective property portfolios.
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Conventional investment property loans
Most conventional investment property mortgages are standard income and asset verified loans. They can be conventional 30 year terms, or short-term adjustable rate mortgages (ARMs) with balloon payments.
These loans usually require a minimum of 30% down in most instances. In that case, you’d be obtaining a loan of 70% of the purchase price. Your loan-to-value ratio (LTV) would therefore be 70%. When buying investment property, you’ll usually want to try to obtain the greatest return on investment (ROI). Leverage (also known as cranking) is one of the ways you can purchase multiple properties over time, and thereby maximize your ROI. Depending upon your credit rating, as well as the type of property you’re purchasing, the down payment required may be higher, and could go up to 50% – and therefore your LTV would be a low 50% as well. In addition, the points charged on the loan (pre-paid interest) are roughly twice as high as for a conventional home loan.
There are some lenders today who will make no income verification, or no income and no asset verification type loans to investors. Due to the inherent extra risk of these loans (from the lender’s perspective), you can expect to pay more in the way of higher interest rates, as well as more points on these type mortgages.
Commercial investment property loans
When considering the purchase of 5-family or above rental buildings, or more typical commercial space (for example, office buildings, retail stores, warehouse buildings), you’ll need to obtain a commercial loan. Lenders have separate divisions to evaluate and extend credit on these type properties. Since commercial properties are much more specialized, their inherent risk need to be evaluated as a niche within most banks.
Lenders will rely very heavily on the expertise of commercial appraisers, who themselves are sort of like the Jedi knights of the appraisal industry. Unlike conventional residential mortgages, expect much heavier scrutiny of your assets and income, as well as the existing income statement of the property you’re considering purchasing. Also expect rates and points to be higher than standard residential loans.
FHA 203K (fixer-uppers)
If you know you’ll be living in a multi-family rental building, then you can consider an FHA 203K type of mortgage. If you won’t be living there, this type of loan will not be allowed.
If you find a 2 to 4 family rental property that needs a ton of work, and you’d like to finance the renovation costs as part of the first mortgage (rather than self-financing the improvements, or trying to obtain a second mortgage after the work is completed), you can consider an FHA 203K type loan.
Before the mortgage can be approved by the lender, your contractor will need to have all the improvements, their time frame and his payment schedule approved by the bank. (You can also choose to make the payments to the contractor directly, and then you’ll be reimbursed by the bank – also known as a draw.)
These loans can be structured in a step fashion. In the first step, you receive the funds to close on the property. In the next step, some funds are released to your contractor when he begins the renovation work. Funds are then released to him in succeeding steps based on the intervals of work completed on the project, until it is completed.
This type of loan is great for leveraging all the necessary improvements needed on a run-down multi-family property. It also helps increase your ROI on this owner-occupied type of investment.
Home equity lines
Use the equity in your home to create a credit line for further property investments. This is a great way to finance investment property. The costs for loan acquisition are typically low for home equity loans, especially compared with conventional mortgages. And you can structure the loan as a revolving credit line. So when you sell a property, you can pay off the credit line. Then you can take it out again when you’re ready to purchase the next house. And home equity lines typically allow for interest only payments during their first 10 years. This will help increase your cash flow on your investment properties, as your monthly costs, relative to standard mortgages, will be much lower, since you’re not paying back any principal in monthly installments. Rather, you’ll be paying the principal off when you repay the credit line when you sell off any given property.
Always ask a seller of a property you’re considering making an offer on if they will extend some form of seller financing. Most will usually say no, but it never hurts to ask. Even if they won’t (or can’t) extend you a first mortgage, try to obtain a second mortgage. Again, always ask if it‘s possible.
Hard money loans
When you’ve exhausted all other avenues of property investment loans, crunch the numbers to see if hard money lenders will make a deal workable. Usually used if you have poor credit, or poor cash reserves, as their name implies, you’ll pay for the privilege of doing business with hard money lenders. Their investment mortgage rates are usually at least double conventional mortgage loan rates. And their points charged (pre-paid interest) can be triple or quadruple conventional points charged.
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