Selling off only when necessary
When considering if you should ever sell off one or more of your investment properties, it’s intelligent to already have an exit strategy planned out. Even when you’re buying rental property, your exit strategy should be kept in mind. Cash flow is of utmost importance here. With current US bank mortgage rates taking a dip this week, remember that holding a lot of debt is an excellent strategy – as long as you maintain your positive cash flow. Only when a property is throwing off a negative cash flow should you consider releasing it.
If you utilize the rental property calculator on our site, or any other, you should be able to input your raw property information numbers data to see if your potential property will throw off a proper positive cash flow. Take into account that current property loans with lower mortgage interest rates should be input into the calculator. In this way, you’ll be able to get a truer picture of the anticipated cash flow on a property.
When it’s time to unload your rental property
If you’ve been living with a poorly performing investment property for some time (at least two years), then it certainly may make sense to unload it. However, consider the option of converting any of your existing investment property mortgages into interest-only loans, if possible. If not possible, consider, using your home as a source of funding. If you take out a home equity line of credit, and replace an existing principal and interest payment loan on a poorly performing investment property in your stable, you may find the monthly savings from the interest-only line to be the perfect solution to a negative cash flow scenario., Even it it helps enough to create a break-even scenario, it would be best to hold the property long term for capital appreciation.
Only sell the dogs of war
The only rental properties you want to unload are the ones that have been underperforming for a very long time (what I call the dogs of war), with no sign of turnaround…even after you’re able to pare down financing costs to interest-only on them. At that point, it would be wise to sell the investment property off. Remember, it’s always best to have your exit strategy in place when you first acquire a property. And try to forestall a quick unloading of any rental property by attempting to convert an existing principal and interest mortgage to an interest-only equity line. If that’s not possible, replace the mortgage with proceeds from an interest only home equity line. The savings may be enough to allow you to retain the investment property, while taking advantage of capital appreciation…not to mention the tax breaks associated with holding the rental property.
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Saving on investment property expenses
There are many ways a property investor can save on expenses when owning rental property. A major expense trimming can be had by simply searching for the best investment property mortgage rates. After all, finding excellent terms on any investment loan can save an investor many thousands each year. In addition, locating the optimum prime properties that can be purchased under current market valuation is another huge savings. However, buying a rental property and then knowing how to choose and handle the right tenants can realize the most cost savings of all.
Set your ground rules with your tenants
I always advocate for a written lease when renting out your units. Month to month rentals are fine – however, consider at least placing it in writing. A written document, even for a month to month rental, helps solidify your expectations. It also makes it more difficult for a tenant to negotiate with you down the road. In the lease, you’ll need to include exactly what you require for your rental: the monthly rent, the day payment is due each month, the penalties for late or bounced checks, and all the negative consequences (read: the eviction process) should the tenant break any of the rules.
Stick to the rules you set
Once you break your own rules for one tenant (as a nicety – giving them a break – just this once), you’ll end up getting into a bad, costly pattern with other tenants. This could prove disastrous to your business. Tenants talk. To one another. Never show weakness (that is, being a nice guy). Once you, do they will, by human nature, start taking advantage of your largesse. Always stick to your guns. If you have not received full rent from any given tenant by the fifteenth of the month, send them written notice immediately. Don’t wait a full month (or worse, longer) before getting tough. Impose late payment fees after the fifteenth of the month.
Evictions – the nuclear bomb of owning rental property
If you have not received full payment and late fees by the end of the month, you must start eviction proceedings against a bad tenant in order to protect yourself, and minimize the damage they are doing to you. Expect eviction proceedings to last up to two months, on average, depending on your local municipality’s court schedule. If you are unfamiliar with the eviction process, you’re certainly going to need the services of a local, experienced attorney you can trust to act expeditiously on your behalf to remove the delinquent tenant. It’s always a gut-wrenching, ugly experience. And obviously, quite costly as well.
Besides paying for the services of an attorney, there’s the issue of lost rent for the time period until you find a new tenant to replace the delinquent one…It’s not simply the time period that the bad tenant has not paid you. Until you get them out of your building, it’s going to be very difficult to even show the unit to prospective tenants. And many times, a bad tenant, just before they are finally evicted, will perform some form of “revenge” destruction inside your unit. A bad tenant can end up costing a property investor a tremendous amount of money.
Finding the “good” tenants
For this reason, it’s best to find only “good” tenants to avoid this scenario. Make sure you’ve properly vetted them – check their references well. Speak to their current and prior landlords, as well as their work references. Check their credit. Make sure they can afford your unit. To this end, their rent should only comprise no more than 33% of their current gross monthly income, as a general rule of thumb. If you follow these simple rules, you’ll be able to save a tremendous amount in unnecessary operating expenses. In this way you can turn each and every one of your rental buildings into a prime property.
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A tighter lending market
The extra costs with an investment property mortgage
The basics of rental property mortgage financing
While credit markets are much tighter for investment property, some generalities hold true when choosing from different rental property investment strategies. Occupancy rates help lower overall mortgage costs for rental property. Traditionally, 75% of current rent roll on a property can be used as an income qualifier for any given rental property. Loan-to-value ratios tend to start at 70% for investment property (while it’s 80% for home loans). Lower LTV’s (eg., down to 60% or 50% even) can substantially lower overall costs of the loan, including points and interest rate). In addition, when real estate investing, an excellent credit score (above 740) will also aid in reducing overall rental property financing costs. This can greatly expand what you can borrow, helping paint a brighter financial picture for your investment opportunities.
photos courtesy of realtor.com, todaysfacilitymanager.com, tenantscreeningblog.com
The mid-term elections recap: little change for real estate investing
The mid-term elections have come and gone on Tuesday this week, only just two days ago. And because both houses will be controlled by Republicans starting in January, it doesn’t necessarily mean that the party of big business will take existing banking laws and revamp them en masse, along with their protections to the American people. Current banking loan standards will most assuredly stay in place, and the concomitant tight credit atmosphere that comprises today’s investment property mortgage market shall unfortunately remain unfettered.
On the downside for property investors
The investment property mortgage marketplace will remain as is, with very tight credit available. There’s simply too much downside for Republicans if an easing of current banking reforms (created since the banking crisis of 2008) were to be repealed, and a new banking crisis were to develop anew. Of course, President Obama would never allow any stripping of current banking mortgage protections, would the Republican majority try to proffer any revisions to current law. Obama would simply use his veto power to stop any changes in their tracks.
Minimum wage laws – some good news for property investors
Even with the Republican’s sweeping into a Senate majority, thereby controlling both houses of Congress in two months, don’t expect any major change in effects for property investment opportunities. Republicans will be quite averse to legislating anything that could hurt big business (and, to a major extent, small business as well). Before the election, there was at least a hint of a Democratic push for a major hike in the federal minimum wage. That will be tossed to the junk heap now. In addition, the wave of Republicans winning major state governorships on Tuesday, will mean that, even on a state by state level, minimum wage hikes will most probably remain at or near inflationary levels only. Even with the mass of protests by fast food workers this past year, expect the prospect of a $15 per hour minimum wage to be a pipe dream for at least several more years.
Keeping costs down
How does this affect the average property investor investing in real estate? Simple. If you don’t already do the menial maintenance work around each of your rental properties yourself, then you probably hire others to clear the walkways of snow, rake the leaves, empty the gutters, etc. As you keep adding on investment properties to your empire, these seemingly small costs become quite large when taken together. Whether you hired the labor yourself – or had your property manager do so – you still end up paying for this maintenance on each rental property you own. The prospect of a hike in the minimum wage would have definitely put a dent in your rental property cash flow. So with the Republicans being victorious on a national scale, expect to keep your maintenance costs at or near current levels. And that’s some good news that property investors can cheer about as a result of Tuesday’s elections.
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The seesaw swings both ways with leverage
The main advantage of leverage
The main drawback of using leverage
Beware the dangerous housing “bubbles”
One of the fundamentals of real estate investing is quite straightforward and simple – don’t ever sell any of your investment properties. Once you sell, you’ll have to pay capital gains tax, and you’ll lose the cash flow from the investment (assuming it is positive), as well as losing the ability to leverage your equity in the properties for future investment acquisitions. This third feature is probably the most important and financially productive for your ongoing success as a real estate investor. It truly comprises one of the most basic of property investment fundamentals – namely, using other people’s money to grow your real estate investments.
Positive cash flows
Never selling any of your rental properties also means you’ll pay stricter attention to detail – like ensuring you always run at a positive cash flow for each property you acquire. I once purchased a four-family house with generous owner financing. I paid slightly over market value for the property because of several reasons. First, I knew I’d be holding the property for the long-term. Second, in return for “giving in” to the seller’s price demands, I secured an incredible below-market rate of interest with excellent terms from him directly. I didnt have to apply with a bank, or pay bank fees associated with closing one of their investment property loans.
But wait, there’s more…
In addition, the owner-financing was for a first mortgage with no balloon payment in a short period of time. And because of the term and interest rate the monthly payments were ridiculously low. I knew I had a cash cow from day one on this rental property. I was using other people’s money (in this case, the seller), and I had added another rental mortgage to my stable without incurring any hit to my credit rating for taking on more debt. (Private mortgages do not show up on credit reports). So I left my credit rating intact, and could still use this new property for future leveraging of my equity in it when needed for other rental property acquisitions.
Overpaying for a property as a positive move
So even though I knew I was overpaying in the short run, I knew I was adding a great positve cash flow to my stable of investment properties for the long term. And by holding onto it, I was deriving the benfits of the excellent cash flow it was throwing off, the ability to leverage my equity in it at will, and I did not have to pay capital gains taxes on it as long as I held it. It was truly a triple winning rental property combination. So be sure to analyze the cash flow aspects of any rental property deal when encountering a “stubborn” seller who “must” get his price. You never know when that stubborn seller may turn a dog of a rental property into a cash flow bonanza for you. Always ask for owner financing to obtain your investment mortgage loan, and see what they say. You could end up with a marvelous real estate investment acquisition in the process.
photos courtesy of houstonmortgagetexas.com, anchorloans.com, zillow.com
The inside scoop on this legal trick
Of all the tricks and investment property financing tips I point out in my real estate investing articles, the VA mortgage loophole is one of the better ones. Veterans Administration (VA) mortgage loans, traditionally offering financing of 100% of the purchase price on a home for veterans, are designed specifically for homes – that is, owner–occupied houses. However, VA loans, like most FHA loans, allow for financing of 1-4 family homes as long as the purchaser will be an owner-occupant. So if you qualify for a VA loan, you would be able to purchase a two, three, or four family investment property, live in one unit, and rent out the other units in the building. All the while taking advantage of 100% financing provided by the VA, in a de facto rental mortgage loophole.
As long as you are the owner-occupant at the time of the loan, you could qualify and take advantage of low rental home mortgage rates. But let’s say you do this, then decide to move after a period of time. The loan would stay in place, and in theory, you could look to repeat the procedure. Keep in mind that any veteran has an amount that he would be qualified to borrow without having to make a down payment on the property. If all of a veteran’s allowance is not used up on one property, he could utilize the remainder to obtain 100% financing on another property. In this way, you could start building up investment properties utilizing strictly VA loans.
Another investment mortgage loan possibility
The VA also offers another excellent choice of financing for veterans. It’s called the Interest Rate Reduction Refinance Loan (IRRRL). This program would allow a veteran to refinance a property that had been formerly bought with a mortgage from the VA. This would be done, ostensibly, to obtain a lower rate of interest on the loan. This Interest Rate Reduction Refinance Loan also has some unique provisions regarding owner-occupancy. For example, it does not require the owner to live at the property – only that he once lived at the property. This would offer a veteran the ability to buy a multi-family property, live in it, and then eventually obtain this IRRRL mortgage at some point in the future. In this scenario, one could then move out and purchase yet another multi-family under four units, live in one of them – and obtain yet another VA first mortgage with no money down. You can see how much leverage these types of investment mortgage loans can produce…and they’re not really investment mortgage loans per se.
Using your equity as leverage
Finally, a veteran would be able to utilize his equity in each succeeding investment property he acquires in order to leverage the acquisition of even more rental properties. He could use the IRRRL route of mortgage financing, or decide to utilize other forms of non-VA, traditional rental mortgage loans from banks or other lenders. Either way, he’d be substantially increasing his investment property acquisitions by wisely using leverage to its optimum advantage, simply by taking the accrued equity from each of his properties and plowing it back into other property investment purchases.
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Understanding the psychology of lender risk
The reason investment property loans are more expensive, harder to obtain, and more restrictive than loans on personal homes, is that investment property mortgages are inherently riskier than home lending. Fannie Mae and Freddie Mac charge higher rates for investor property loans, much more than for primary home loans because of these higher risk factors. It’s a simple axiom – the greater the risk, the higher the cost. Of course, the opposite axiom is likewise the same – the lower the risk, the smaller the cost. For lenders, real estate investors are inherently more dangerous as a group to make loans to than are homeowners.
Thinking like a bank thinks…
Banks have to look objectively, and ruthlessly so, at their bottom line. What’s their worst case scenario in any lending situation? Naturally, a foreclosure. And in the case of those investing in rental property who are unable to make their monthly loan payments, since they have no emotional stake in the property, they will be more likely to walk away from their loan obligations in any worst-case scenario. Much more so than any homeowner would, since homeowners are emotionally grounded to their home – which is most probably their single greatest asset. This helps explain why total mortgage costs run higher for real estate investments, as well as why investment property mortgage rates are higher than homeowner rates.
Real estate investors understand that buying a rental property is simply a game of numbers. A homebuyer views their purchase decision in much more emotional ways – deciding what emotional benefits will accrue him if he buys a particular home. Conversely, this makes it much more difficult for the homebuyer to give up “his baby” so to speak. And this single reason is what makes lenders value the homebuyer as much less risk than anyone buying rental property.
Mortgage rate differentials
Regardless of the specific area of the U.S. you may look to buy in, real estate investments will have mortgages that will generally run about half a point greater than home loans on average. In addition, many fees tend to be added to loans on investment properties – many more than home mortgages. Thus, the overall cost of any rental property mortgage will be greater as well. Some of the factors involved in the overall costs associated with an investment property loan include the borrower’s current credit score, the loan-to-value ratio for the loan, the property character (ie. – single family, duplex, multi-family, multifamily with owner-occupying one unit) and the specific mortgage program being applied (FHA, Fannie Mae, Freddie Mac or no government-insured program).
In many instances, when in investing in real estate, lenders set up loan-to-value (LTV) ratios at higher overall amounts than home loans. The greater the amount you put down on the rental property you’re trying to finance, the less overall risk to the lender. Most lender these days have maximum loan-to-value ratios of 70% of the purchase price, where you, the buyer, must put down at least 30%. But if you put down 40%, or even 50%, you’ll find your interest rate and overall costs of the mortgage loan will come down substantially. This is also because you are helping to substantially lessen the lenders overall risk. (After all, it’s much harder to walk away from a property you have 50% down in equity than it is if you had only 30% down.)
Using rents as income qualifiers
Traditionally, banks will allow 75% of gross rents currently in place on units in any property you’re thinking of acquiring to help offset the monthly carrying cost of the loan. Keep in mind that this applies only to actual rentals…not hypothetical “market” rents. In addition, the tenants need to already be in place. Typically, the same 75% figure can be used to offset monthly loan costs in any refinance situation for your rental property.
You should also remember that lenders usually require those buying rental property to have better credit scores than their homebuyer counterparts. Lenders like to see scores of at least the low to mid-700’s before extending any rental property mortgage. (That’s not to say that it’s impossible to obtain a loan if your score is in the 600’s – but it will be more difficult, and certainly, it will come with a much higher interest rate. The bank, after all, is always looking to defray their risk.)
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The Coming Borrowing Crunch
All property investors need to be aware of a potential disaster in the next several years that could make obtaining mortgage funds increasingly difficult. Lenders may find themselves in such a downward spiral of red ink, that the current credit crunch will pale in comparison to what lies ahead. And what would the cause of this downward spiral be? None other than the simple home equity line of credit. A line of credit that I have consistently advocated here as a solid way to raise funds for increased property buying opportunities, as well as leverage, with some of the lowest interest rates and best terms available.
A recent article from Reuters (“Insight: A New Wave of U.S. mortgage trouble threatens,” by Peter Rudegeair, 11/26/13) notes the coming potential for disaster striking the U.S. banking industry: “U.S. borrowers are increasingly missing payments on home equity lines of credit they took out during the housing bubble, a trend that could deal another blow to the country’s biggest banks.” The article goes on to explain that “the loans are a problem now because an increasing number are hitting their 10-year anniversary, at which point borrowers usually must start paying down the principal on the loans as well as the interest they had been paying all along. More than $221 billion of these loans at the largest banks will hit this mark over the next four years, about 40 percent of the home equity lines of credit now outstanding.”
The chilling effect on property investors
If, as experts are predicting, default rates go up, even a small amount, on the vast majority of home equity lines as they hit their 10 year re-set years, and the monthly repayment nut goes up substantially because of the double-whammy of adding principal to the payment, as well as anticipated higher interest rates being rolled in beginning in 2015, the overall repayment amount may be unaffordable to many who took out their equity lines. Banks holding these second mortgage loans may not be able to recoup the losses in any default because the first mortgage would need to be paid of first, and the lender holding the equity second mortgage may not see a dime in any default scenario. Now, maybe the housing market will increase its robust performance of late. But I wouldn’t bet on it.
Over the next several years, as these equity line 10 year anniversaries roll out, and many are defaulted on, lenders will need to hunker down even more – and will curtail their lending – not only of equity loans, but first mortgages as well. Overall, credit will become increasingly tighter. Not overnight…but much like stepping in quicksand, slowly, and over several years credit markets will begin to tighten up even more.
Just how bad could things get?
The Reuters article also points out just how bad things could get: “What is happening with home equity lines of credit illustrates how the mortgage bubble that formed in the years before the financial crisis is still hurting banks, even seven years after it burst. By many measures the mortgage market has yet to recover: The federal government still backs nine out of every ten home loans, 4.6 million foreclosures have been completed, and borrowers with excellent credit scores are still being denied loans.
The only way banks would have to alleviate the stress on the system would be to take proactive measures. The Reuters article goes on to explain: “Banks have some options for reducing their losses. They can encourage borrowers to sign up for a workout program if they will not be able to make their payments. In some cases, they can change the terms of the lines of credit to allow borrowers to pay only interest on their loans for a longer period, or to take longer to repay principal.”
A return to cash as king
Ultimately, like in the last several years, cash investors will rule. Be aware of this as you plan your long-term acquisition strategy. The belt-tightening by lenders will come slowly, as more equity lines go into default when they hit their respective 10 year anniversary re-sets. Like a python squeezing it’s victims to death, property investors need to know that they too can be squeezed out of mortgage opportunities in the coming years.
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