Think an additional unit adds value to your property? Think again.
Read moreLow Money Down High Rate Trap
Beeeeeee Careful
October 20, 2023
You should not buy a house right now with low money down and > 7% rates without ample cash reserves.
Why is this? After all, the less you can put down on a house and the more you can finance, generally the better off you are. However, in today’s environment, this can backfire.
For example, let’s say you’ve saved up enough for 10% down. You put 10% down and take out a note at 7.5% and you can make the payments, albeit barely because you just doubled your monthly costs when compared to the house you were renting. But, it’s ok, you can refinance when rates drop everyone tells you.
Now, let’s assume rates drop and you want to refinance. Good idea. Except when it comes to a refinance, you’re looking at being able to borrow a max of 80% of your house value and typically it’s more like 70% to 75%. So, now it gets fun.
You bought your house for $1mm and borrowed $900,000. 3 years have passed but have values risen? Let’s say they have at a rate of 4% per year or 12% (non compounded) over that 3 year period. Your house will appraise for $1.12mm. If this is true and IF you can borrow 80% on a refinance, you take out a loan for $896,000. But, if you’re limited to 70%, you’re limited to $784,000 meaning you would likely need to put another $100,000 of cash in to get the refinance done.
Now, what happens if in the short run your house doesn’t appreciate and stays flat? Now, you’re looking at a max of $800,000 on the loan or even $700,000 meaning you may need as much as $200,000 of cash to get the refinance done.
You could very easily find yourself in a situation in which rates DO fall but you can’t refinance because you can’t put in enough cash to meet the loan to value requirements.
Now, let’s address the variable component. Typically, a variable rate note will price at a spread above WSJ prime or a specific treasury yield. However, the rate you start out with is often not priced at this metric but is priced lower. What this means is that when the fixed rate period is over and you go to the floating rate, the jump in rate may be larger than you expect. Moreover, these loans often have a rate floor meaning if rates fall, yours does not fall accordingly. So, in this scenario in which you have a relatively high floating rate loan, you could find yourself in a situation where market rates fall but your rate does not and you can’t refinance because you don’t have enough equity or cash to pay down the note.
The lesson here is a low downpayment note with a variable interest rate, particularly in a high rate environment is a risky gamble. It’s ok to take that risk but ideally you would maintain ample reserves to cover the risk should it go bad on you.
Now, all that said, if you can borrow 90% of your home’s purchase price, you should absolutely do it if the rate is reasonable in the current climate. Take the excess funds you’d have spent on a downpayment and invest it in higher return investments.
Residential Mortgage Asymmetry
Asymmetry in the Residential Mortgage Process
So, most of us have experienced getting a mortgage for a home at this point and most of us have used the mortgage platform that follows the governmental rules for residential mortgage qualification vs using a local bank making a portfolio loan. And, we are familiar with the headaches involved for that oh so cheap money.
But, what is really going on behind the scene there? Have you ever wondered what affects your qualification ability and how people with different scenarios have the same results?
Let’s start with the simple approach - Portfolio lending.
Portfolio Lending
With portfolio lending, a bank lends out its own money. They make their own rules and decide who qualifies and who doesn’t. The result is that this typically follows a formula based on equity in the project or house, income stream and ability to repay and net worth. It’s pretty simple and can be broken down like thus - The more wealth you have, the more willing they are to grant you a loan. While they concern themselves with ratios and such, basically it comes down to whether they think you can repay and if you don’t, how much other wealth do you have that they can come and get. The process is often very quick and rarely involves constant employment checks, credit checks, bank account checks, re checks, etc. etc. For this privilege though, you often pay a bit more in interest rate and the loan is often a variable rate loan. While this is common in commercial lending, most people don’t use a portfolio lender for their home loan as a first choice.
Government backed lending
This is a broad category and not all loans are government backed. But, in this sector, standard rules are followed regarding underwriting the loan in order for the loan to be sold in the secondary market. So, regardless of which bank or broker you go to, the process will largely look the same. This is where it gets fun and funny and I’m going to show you how.
The core goal is to have all your payments under 45% as a ratio to your monthly gross income. Payments include largely the following:
AlimonyChild supportPrincipal, interest, taxes and insurance on your personal and vacation homesCar paymentsMinimum credit card paymentsOther loan paymentsNet rental income/loss as calculated on any personally owned rental properties with individual mortgages. This is loosely calculated using your previous year rent and expenses excluding interest and depreciation and adding back in principal and interest on the note payment.
That seems all fairly logical, right with the goal of assessing payment capability? Well, not exactly. Let’s examine it more closely.
Alimony - All contemplations of marriage should really start with an examination of alimony, right? I’ll save that for another time though. Two people are married and one person makes all the money. They make $200,000 a year and have $40,000 in annual payments for the items above. That’s a 20% ratio. Now, they get divorced. The man is ordered to pay his ex wife $30,000 a year. Doesn’t matter for how long. In this world, that payment is in perpetuity if it exists. So, if he retains the same payments of $40,000 and adds on the $30,000, his ratio jumps 15 points to 35%. However, the reality is he was likely already paying this and more. It’s possible that he even limited his losses by getting divorced and accepting the alimony albatross. Yet, in the eyes of the mortgage system his attractiveness just dropped. A lot.
Child support - Same scenario as above. The man gets tagged for child support, and, let’s be honest, even if income is nearly identical the man gets tagged for child support. If he has to pay $30,000 a year for his two kids, that bumps his ratios up 15 points. The ironic piece here is two fold. One, this makes it that much harder for him to buy a house in which to keep the kids on his every other weekend schedule. Two, when he was married, he was very likely paying the same amount. But, when you’re married, what you pay to take care of your kids doesn’t factor into any equation. Moreover, how many kids you have isn’t even considered.
Marinate on that a bit. You have a couple making $200,000 a year combined with $80,000 a year in payments. 40% ratio. Couple A has 4 kids. Couple B has no kids. Which one has more free cash flow with which to repay debt? It doesn’t take rocket science to figure this out. Any parent will tell you it’s the couple with no kids. Normally, kids don’t get cheaper as you add them and normally they don’t contribute income. Yet, in mortgage world, these two couples are the same risk.
PITI on your personal and vacation residences. Well, this makes sense. Something had to.
Car payments - Don’t purchase a car and finance it until after you get a mortgage. Car payments calculate as though they go on forever. Have 10 months left on that $500 a month payment. That calculation acts as though you will have it for all 30 years of the mortgage. And, of course, you might - with a different car. But, own the car outright and it acts as though you will never have a payment. Ever. See the problem here? Most people have recurring transportation needs yet you can manipulate the system a bit by placing those costs in place after you get a mortgage.Minimum credit card payments - That’s right. Owing $10,000 is the same as owing $40,000 except for the small difference in that minimum payment. What kind of tortured financial analysis is that? Everyone knows that owing more credit card debt is exponentially worse.
Net Rental Income - Now this gets really fun. If you are working this system to gain loans for rental real estate, pay close attention. A 15 year loan is better than a 30 year in a pure financial sense. The interest rate is typically lower, resulting in lower costs. But, in mortgage world, this penalizes you because it produces a greater cash expense.
For example, you have a mortgage payment of $2,000 a month on a 30 year note. That same mortgage on a 15 year note would be $2,600 (for discussion sake…). The calculation in mortgage world would add a $600 increase to your monthly payments and would adjust your ratio by 3.6 points. So, if you have three of those, you’ve just taken 10 points of your ratio and probably prohibited yourself from any more borrowing. While it is correct to look at cash flow, this alone does not tell the entire story for a lender. All it does is tell them what is happening right at this moment and doesn’t even tell that very clearly.
However, what if you had a rental property that didn’t affect the payments positively or negatively? WHAT???? It’s true.
Let’s say you form a legal entity that buys a duplex. The legal entity takes out a loan with a local bank and it is guaranteed by you. Now, let’s say that duplex generates no taxable profit or loss but produces negative cash flow of $20,000 a year due to principal reduction on the note of $20,000. In mortgage world, this flows through into top line income and has no effect (zero net income) and doesn’t affect the payment ratio. However, had you purchased this individually with a mortgage in your name, you would be hit with a $20,000 annual payment amount on your ratio calculation. With $200,000 in income, that would cost you 10 points on the ratio. Exact same economic effect. However, in the legal entity scenario, you remain attractive for a mortgage on that new house you want. In the second, you are much less attractive.
So what lessons have we learned here?
In mortgage world, payments are everything. Don’t have them if you want to qualify for as much mortgage debt as you can handle. Don’t buy a new car. Know where you are vis a vis the amount of mortgage you will need and plan accordingly.
If you have a lot of kids and think you may get divorced (or, IPO equivalent if you’re the one cashing out), secure any house purchases before divorce because child support and alimony could eat your ratios up such that you no longer qualify.
Alimony is a bitch. Why would you ever put yourself in this position? Think first.
Rental properties. Think through where you are going with a rental portfolio and set yourself up in the best way to allow continued access to debt. Debt is your lifeblood with real estate. Keep your amortization period long. Put any big cash flow drains into an entity and have the entity take out the loan. This is particularly key for development properties where there is high negative cash flow in the short run followed by a sale. If you structure this wrong, you could cut off your lifeblood during the project which could affect your timing on future projects.
CAP RATE - A BRIEF INTRODUCTION
Cap Rate and Desired Returns in Real Estate
One of the key measures in a real estate investment is the cap rate or capitalization rate. What exactly is this and what does it mean? And, what does it mean to you?
The cap rate is simply the return being generated by a property based on a 100% equity scenario. For example, if a property is being marketed for $500,000 with a cap rate of 7% based on existing rents and expenses, it will yield $35,000 in profits annually. Cap rate is profits (exclusive of depreciation) / value of the property.
Knowing this number allows you to compare a particular investment with other investment returns from a mutual fund to a dividend yielding investment to other private investments.
But, really, what does it mean?
The cap rate will vary based on the tenant risk of property, location risk, seller’s delusionality and any number of other factors. Generally speaking, the higher the cap rate, the higher the risk and the lower the cap rate the lower the risk. That risk may be long-term impairment, tenant vacancy risk, repurposing cost risk if a tenant leaves, etc.
Let’s say you have two single tenant buildings both marketed for $1mm. One building has a Starbucks with a 20-year lease (18 years remaining) guaranteed by the Starbucks corporation (yes, THAT one). Its cap rate is 6%. The other has a local tenant with a 3-year lease and 1 year remaining. Its cap rate is 10%.
Now, the local tenant may turn out to be a great long-term tenant. Only your knowledge and research will help unearth that. But, the seller is implicitly stating with the higher cap rate that they believe there is tenant risk of default or vacating that is some level greater than the Starbucks building. Otherwise, if they were as confident as the Starbuck’s landlord, they’d price their building and income stream at a 6% cap rate, too. We know Starbuck’s is successful and the corporate entity can support the lease if they close the location. But, with the local group, we can’t be as sure.
So, the cap rate can help show you the inherent risk of a property.
But, what if your desired return is 20% on your equity? A 7.5% cap rate isn’t going to cut it. But, searching for a real estate investment with a 20% cap rate might well be a foolish and risky endeavor to your financial well being.
However, you can get there through leverage. Next week……
MEMORIAL DAY BBQ AND RENTAL PROFITS
Have you ever been at a neighborhood gathering and your neighbor regales you with tales of his passive investment property making $2,000 per month?
Sure you have. We all have. But, really now, what does “making” really mean anyway? Have you asked your boastful neighbor that question? To an accountant, it seems simple. However, as I often say, four out of three people can’t do fractions and I’m here to correct that.
Let’s take the above $2000 profit per month example. Definitionally, this is calculated as follows:
Rent less (Interest, Insurance, Repairs, Taxes, Management fees and other expenses) equals PROFIT.
Notice that nowhere in the above do you see the phrase mortgage payment or principal payment. There is a good reason for that. Those are not expense items but rather balance sheet items. Principal is important but it is an element of cash flow, not of profitability and is a function of the debt level, note length, and interest rate. All are important but that is a financing transaction. Notice also that nowhere above do you see return. Not all $2,000 per month profits are created equal.
In determining whether to be impressed with a rental or passive income stream, there are several key factors to look at.
Is profit being calculated correctly?
What are the equity and debt levels?
What is the cost basis of the property or investment?
Now, let’s look at this further. Let’s say your friend calculated this correctly (they almost never do - typically the banknote is treated as an expense). What does this mean? $2000 in profit means nothing without context. If I have a $1mm building, no debt and I netted $2000 that qualifies as a pretty poor performance. If I have a $100,000 building with $80,000 in debt and I netted $2000, that qualifies as an outstanding performance.
The key here is the level of equity and debt. To determine whether $2000 is good, you need to know the level of equity (essentially the cash invested) in the project. This allows you to calculate the return on equity. After all, the returns are what you’re after, right? To calculate this, you divide the annualized profit ($2000 * 12) / Equity. The answer is stated in terms of a percent.
In the above example, $2000 in monthly profits on a property with $1mm of equity yields a return of 2.4%. In the other, $2000 in monthly profits on $20,000 in equity yields a return of 120%.
This isn’t golf. Highest score wins.
So, the next time the neighbor talks, ask how he calculates profit and what his equity level is and then decide if the neighbor is a wizard or just a guy wearing a funny hat.