Tight inventory

Times are tight for inventory and likely to remain so until 2014 according to some forecasts. Short sales are booming though as a relative percentage.

Mortgages and lending

It's generally tough to get a mortgage these days with the tight lending standards. Freddie Mac rules allow up to four mortgages per person. Fannie Mae allows up to 10. Most banks have what's called overlays, or additional rules on top of the Freddie and Fannie rules which further limit a person's ability to qualify for a loan.

The most common overlays I've encountered include:
  - No more than 4 total loans per individual.
  - Debt to income ratio must be less than 45%.
  - Rental income must be shown on two consecutive tax returns (Schedule E) before rents can be credited against your debt to reduce your debt to income ratio to allow you to qualify for up to 10 loans.

There are institutions out there which do not have these overlays and like in my case have been able to provide me with up to 10 loans even though I have only one tax return showing rental income. Post to this blog if you need a referral.

When shopping for a mortgage you can deal with either brokers or direct lenders.

Brokers are folks who likely work for themselves or with a small firm and connect borrowers with banks that fund loans. They act essentially like a middle-man. It's helpful to develop a good relationship with an experienced broker as they can find you funding options that you might not be aware of through their network of lenders. Oftentimes brokers can connect you with lenders who may not have as many overlays as larger institutions and thus be more likely to fund loans for investors. Brokers provide personalized service and should be there throughout the mortgage application and funding of your loan.

Direct lenders are financial institutions who can directly provide you a loan. Instead of interacting with a broker you will work directly with a loan officer from the institution. For example, you can call up Wells Fargo and speak to someone in their loans department and start a mortgage application. This person will likely be your assigned loan officer and be working with you from start to finish. A typical loan officer at a large institution like Wells will likely tell you that they cannot fund more than four loans due to their overlays. However, it's possible to find loan officers within these institutions who are fully educated and can push the boundaries of the existing rules to accommodate your specific needs. There are institutions out there who will give up to 10 loans to investors with no overlays on top of the Fannie Mae rules. I'm currently working with one direct lender with significant flexibility and able to get financing where larger companies have turned me down.

Dan Green's blog and website are a great resource. I get his daily email feed and almost every day he has articles which are extremely informative:

http://themortgagereports.com/

The Mortgage Man coaster (Google Affiliate Ad)

Walking away when it makes sense

I recently walked away from a turn-key deal after having already sunk about $1000 in expenses for due diligence. In the end, the numbers didn't make sense because I would have been in for significant negative equity. In other words, I would have paid 35% more than the market value of the property. I had to remind myself to stay disciplined.

The four main aspects of buy-and-hold real estate investing to consider are : cash flow, leverage, equity, and tax benefits. You have to position yourself to maximize each one of those areas to maximize the return on your investment.

This deal was obviously poor from the equity standpoint. Having to pay more than the market value for a property never makes sense just like it never makes sense to have negative cash flow. Why subsidize your tenant's living expenses?

A negative equity situation also means I would have had to bring extra cash to make up the difference in price and appraised value in order to get a loan. This would have resulted in a 50% down payment and therefore would have been a poorly leveraged deal.

In the end I walked away because I believed I had to stay true to my investing principles and I understood that $1000 was a small loss compared to letting $25K effectively disappear if I had bought the property.

You can read the thread where I had a discussion about this topic on BiggerPockets:

http://www.biggerpockets.com/forums/311/topics/79686-investing-into-negative-equity-but-below-replacement-cost

Closing with financing on a foreclosure or short sale

Getting a loan for a foreclosure or short sale can take much more time than you'd expect. There are literally a thousand reasons why closing can be delayed. Every loan I've gotten has been delayed for one reason or another and I'm amazed how unpredictable those reasons were. So here are my suggestions / observations :

Allow at least 6 weeks to close. If your contract is only for 30 days to close I can guarantee you won't hit that deadline. Extend the closing date. Trust me you'll be happier you asked for the extension early.

The appraisal is most often the limiting factor in terms of time and loan approval. Appraisers carried a significant part of the blame for the mortgage mess due to lax standards and are now heavily regulated. They are conservative in their numbers and are careful to make sure each detail is taken care of. They also seem to take their time to get the appraisal completed. It can be frustrating but unfortunately it's part of the process. The appraisal must come in at a condition level of C4 or better on a scale of C1 to C6 where C1 is the best possible condition (brand new construction in pristine condition). If the appraiser flags deferred maintenance then these repairs must be done as a condition for funding, in other words the repairs must be completed in order to close.

Remember to have the utilities on for the appraisal!!! I've had to pay extra fees for the appraiser to go back just to confirm the utilities are on.

Provide all of the documents your loan officer requests ASAP. Don't delay or that will hold up your loan. Things take long enough as it is. You never want to be the limiting factor.

Your credit score is a key resource

Investors who have fewer than 10 loans may want to make sure they take good care of their credit score so that they qualify for the best rates when getting a loan. Usually a score of 740 or higher qualifies for the best rates. Always pay your credit cards on time and try to have the credit limit on every card raised as high as possible in order to lower your used credit to total credit ratio below 30%. This is usually the cutoff that lenders use. There are plenty of websites / blogs on tips to raise or maintain your credit score.

My personal experience has been interesting. I started off with a score over 800 about 1.5 years ago. Since then I have gotten 6 loans and my score has come down to the 740 level due to the number of new accounts being opened in a short time. I'd prefer to be able to get the best rate but at the same time I don't want to pass up any opportunities because I may face paying a higher rate. So if you're going to start investing take steps now to have the highest score you possibly can.

Step by step procedure for purchasing a property

Here is the basic procedure for rental property purchase. I will expand on each item in detail in future posts.

- Get pre-qualified with lender.
- Identify property to buy with help from agent.
- Submit offers and negotiate price, contingencies, and special terms.
- Read and sign purchase contract if your offer is accepted.
- Send earnest money and option check (if applicable) to agent or deliver directly to title company.
- Submit signed and executed purchase contract to lender for them to start your file.
- Send all personal information and documents to lender as they request them.
- Get quotes from insurance agent for liability and hazard insurance on the property.
- During the inspection period, check out the property yourself if possible and use a good inspector. If possible go over the property and inspection report with the general contractor who will be overseeing the rehab work.
- Take pictures of the property to document its condition. If the condition changes for any reason you may be able to get a price concession prior to closing. Or if the place gets trashed you could walk away and get your earnest money back.
- The appraisal is usually the limiting factor in terms of time. Make sure the appraisal is ordered as soon as possible. Make sure the utilities are all turned on when the appraiser goes to the property. Otherwise the appraiser has to go back at a later date to confirm the utilities and you will be charged for the second inspection.
- Once the loan is approved, sign paperwork and the property is yours!
- Post property for rent and coordinate rehab.

Leverage is powerful

Leverage amplifies the capability of your resources of time and money to allow you to accomplish more with less.

A mortgage is one of the most powerful tools for investing and is one major leverage point. You use the bank's money towards the majority of the purchase, but all of the property value appreciation is yours and all of the rents collected are yours.

You can also leverage people. Pay good people to make use of their skills, experience and time. This includes having a solid team of agents, inspectors, property managers, mortgage brokers, insurance agents, repair people, accountants and lawyers.

There are of course risks and concerns associated with using leverage. If a property loses value then you could be upside down on your mortgage and owe more than the property is worth, making it difficult if not impossible to sell the property without taking a loss. Since the mortgage is secured by the physical property you stand to lose the property and any equity you've built up in that property if you stop making payments and the bank takes possession through foreclosure. When you leverage people make sure you're applying them effectively towards your objectives or you'll end up paying them without gaining any benefit. Carefully consider how each team member fits into your overall strategy and their purpose for being there.

Keeping good records is critical

It's important to clearly record all of your financial transactions. This serves two purposes. First, it allows you to accurately track how your money flows in and out of your business to get a true sense of the quality of your investment. Second, you will have to rely solely on these records for tax reporting and for a paper trail proof to the IRS in case of an audit.

For expenses, keep all receipts and check images and make notes. Record details such as what the expense was for, date of service, and if appropriate, the miles you had to drive in your personal vehicle related to this expense (which is deductible).

For bank deposits, make sure to record where the deposit came from and why. Mortgage companies now require explanations for all funding bank account deposits when you apply for a loan.

It's also a good idea to keep important documents such as loan applications, title insurance and hazard insurance policies, purchase and sale contracts,
closing documents (eg. HUD settlement statement), property tax bills, and property management contracts and statements. Be sure to ask the title company to send you a copy of the signed and executed documents shortly after closing. I like to scan documents as PDFs to store on the computer as well as to keep hard copies in a fire resistant safe. Chances are these documents will rarely be needed, but you'll be glad you have these in an organized place when you do need them.

Create separate accounts for investing

To show the IRS that you're a serious investor and trying to run a business be sure to create accounts separate from your personal ones. This includes email, bank, and credit card accounts. I also have my properties insured under a different insurance company and with a different insurance broker. Doing things this way keeps the books cleaner and also makes things easier to track for tax purposes. You want to make sure there is a clean paper trail in case you get audited. For example, don't mix personal credit card charges with charges for your investments and don't mix deposits from your personal job or other sources of income with your investment income deposits. A good source of information is a yearly publication by the folks at Nolo. It's well worth the few bucks to buy this book from Amazon or to consult your tax attorney to prepare things properly in order to avoid additional hassle with the IRS if you're audited.

Vacancies

I'm currently facing three of my five houses being vacant for various reasons. It's not easy to swallow having to carry these with my own cash, but I have to remind myself it's part of being in this business. In the long run the vacancy rate where my houses are located is low. Sometimes patience is needed.

Due diligence

You'll hear this term often when it comes to buying real estate. To me it means finding out as much information on as many aspects of an investment as possible and thinking critically about whether that property fits your goals. When I'm evaluating a property I will look at the following:

Financial
- Market value of property by looking at recent comparable sales, pending sales, and listings (at least three of each)
- Market rent by looking for recent comparable leased and current listings.
- Property taxes by looking on county websites
- Cost of hazard insurance by shopping for insurance.

Property details
- Neighborhood quality by talking to agent and property manager and anyone with local knowledge including neighbors and other investors.
- Economic status and trends of the area by looking on websites like citysearch.com and local government sites.
- School ratings by looking on websites including Trulia's school map.
- Flood zone determination using websites such as floodsmart.com or asking insurance agents when getting quotes.

Rehab
- Work required and cost by talking with general contractor and property manager.
- What the norms are for the area in terms of expected amenities, for example, whether granite countertops are desirable and fetch more rent.

Good due diligence applies to things beyond just the property. For example, it applies to finding a good property manager or agent or mortgage broker. This is a relationship business. So ask for references and other contacts with whom you can speak to learn more.

Turn-key properties

Beginners and folks with less risk tolerance should consider turn-key properties. These are properties that have been remodeled (or rehabbed) and already rented out and under property management. There are a number of investors who sell this as a product. Basically they take all the initial risk and upfront cost of finding, purchasing, rehabbing, and renting a property out. All you have to do is pick one you like and pay their asking price, either all cash or with financing (getting a mortgage). As soon as you take possession of the property you begin to receive a return on your investment without the hassle of doing any work other than the due diligence to see if the investment is a good one for you.

My first two properties were turn-key rentals. The return on investment is obviously lower than if you do all the work yourself because it involves a middle man. However, this is a great way to get in and start learning about the business and how things work. Some investors only buy these types of properties, not only because it's easier and less time consuming, but because it involves less up-front risk. Finding and buying a distressed property, doing the rehab work, and finding a good tenant and property manager all involve risk. Many of the turn-key companies, especially the ones in the business for a long time, have already vetted the property locations, construction crews, and property managers. This makes it all much easier for you to get in the game and at this point in the market cycle just getting in the game is a great thing to do in my opinion.

Vacancy rate estimation

Vacancy is equivalent to an expense because it subtracts from your potential maximum income. There are several ways to estimate the vacancy rate when calculating your return on investment. I ask my property manager what her experience is for the area that the unit is in. I also look up vacancy rates on websites such as the Redfin community information page mentioned in a previous post. I have begun to learn that the vacancy rate generally goes up for more expensive properties. A higher rent produces higher income, but it also takes longer to rent.

The Real Estate Guys Radio Show

I highly recommend The Real Estate Guys Radio Show. It's a great way to start learning about the industry. They cover a huge variety of topics that's useful to investors of all levels. It's the most downloaded iTunes podcast for real estate. Their website is also full of useful info.

Give 6 to 8 weeks for closing

Mortgage rules are tighter now than in the past and it takes longer to close on a property than before. My rule of thumb is 6 to 8 weeks to close on a foreclosure property. This gives enough time for the mortgage and title companies to order and review the appraisal, survey, pest inspection, credit and financial account checks, and all personal documents from the borrower. Sometimes the loan underwriters require repairs to be done prior to loan approval, or request required documents at the last minute. These types of things all add up to a significant amount of additional time so it's better to set your expectations properly from the start. This also means you shouldn't lock your mortgage rate in too early or you will end up having to pay additional fees to extend the rate lock time period.