Real Estate Loans

Once in a while, I like to touch on the basics. But if this is obvious stuff, skip to the next post. Here are the questions I’ll be answering:

  1. What is a real estate loan?
  2. What loan programs are available today?
  3. How do I qualify?
  4. What are the hidden costs and benefits of a loan?

1. What is a real estate loan?

A real estate loan allows you to buy a property whose purchase price (or, value) is a lot more than you have in cash. Banks and mortgage companies will lend you large sums of money so that they earn loan origination fees, plus fees for selling your mortgage to a third party, who then collects interest on your loan.

2. What loan programs are available today (as of 4/21/2016)?

For a single family home as your primary residence, you can put anywhere between 3.5% to 25% cash down, or more. If you put down less than 10% of the purchase price, you will likely have to pay hefty mortgage insurance up to 1.75% of the total loan up front, plus 1% annually. These loans are usually 30-year fixed loan (your interest rate doesn’t change for the life of the loan) and government regulated.

For a duplex the same rules apply, except you’ll pay mortgage insurance if you put down less than 20%.

For 3-4 units as your primary residence, the same rules apply, except you’ll pay mortgage insurance if you put down less than 25%.

If any of the above are investment properties only and not primary residences, you have to put down 25% minimum.

For any residential income properties with 5 or more units, you must likely put down around 50% in order to qualify for a loan, based on today’s market. For five or more units you must get a “commercial loan” which is based on the gross annual rental income, and therefore varies by how much your property currently cash flows. These loans are usually amortized over 30 years, but the interest rate is fixed for a shorter time period (usually around 7 years).

3. For 1-4 units, you qualify partially based on the rent, but mostly based on your average annual income over the past two years (the rent counts toward your income). Banks use a standard formula to determine if your annual income is enough to secure the loan, despite these loans usually being non-recourse.

By contrast, for 5 or more units, your personal income is not a factor because the loan is based on gross annual rent from the subject property. This makes these properties better for investors who can’t show regular income on their tax returns.

4. The hidden cost of your loan is obvious: all the interest and mortgage insurance you pay during the life of your loan adds up.

The hidden benefit of your loan is twofold: if your rental income is covering your mortgage and expenses, that 75% LTV (loan to value) that the bank gave you is turning into money in your pocket over the course of the loan. In other words, if your interest rate is less than the your annual return on your loan, you are making money off the loan.

Make sense? If not, feel free to ask any questions you may have at: davidlbrundige@gmail.com

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Cash vs. Loan on Income Property

Many clients who read this blog shop for investment properties with the understanding that they will need a loan. The idea of a loan is pretty simple (for a brush up read here), but what you may not know is the actual implications on the real estate transaction, and why on earth there is so much power granted to cash buyers.

The main issues lie in

(1) time,
(2) hassle, and
(3) the value of going through only one escrow.

Off the bat, a cash transaction requires no more than a 21-day escrow, whereas a loan requires between 30-45 days or more. No deal is done until escrow is closed, so those extra weeks cause not only expediency problems, but psychological ones, as well. That’s 2-3 extra weeks that everyone has to worry about closing the deal.

The hassle is real but manageable. Here are the extra steps for closing a loan deal from the Seller’s point of view:

a) pre-approval process to determine the buyer’s ability to close
b) initial appraisal of property by bank
c) loan and appraisal contingency periods
d) fixing physical issues that the bank finds objectionable (this could be anything from exposed studs to unstrapped water heaters to chipped paint — yes, chipped paint)
e) re-inspection by appraiser to confirm those fixes are completed
f) field review by second appraiser to confirm value (this is a new one)

For example, yesterday and today I went to two different properties my clients have in escrow and personally fixed two last-minute physical issues that the Sellers weren’t willing to fix and for which my Buyers couldn’t get a handyman in time. That wouldn’t happen with a cash deal.

There are only two reasons why a loan is more likely to fall out of escrow than a cash deal. The first is that the Buyer may not qualify for the loan. The second is that the property does not qualify for the loan if those physical issues above cannot be fixed. If a deal falls out of escrow, the property may lose value because (a) its market momentum slows, (b) it’s tinged with the question of “what’s wrong with it,” or (c) the backup buyer finds another deal in the meantime.

So what is the real consequence of needing a loan? If there are enough buyers interested in the property, one or two of them are likely to be cash and they have an advantage if your offers come in around $10,000 of each other. That’s why, as a buyer using a loan, you have to be slightly more creative than cash buyers in the types of properties you buy, the terms you elect on your deal, and our approach with the listing agent.

All that said, 83% of my closed deals have used one kind of loan or another. Don’t count yourself out; just know what you’re up against.

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Real Estate Agent Payment Structure

Real estate agents, whether I’m representing the buyer or the seller, get paid a percentage (%) of the sale. This % is determined in a contract between the listing agent and the seller, and paid out of the seller’s proceeds once escrow closes. What are the ramifications of this payment structure?

Ideally nothing. An agent should represent his or her client to the best of his or her ability. But you have to wonder what motivation a buyer’s agent has in getting his client the best deal on a property if he’s losing 3% of $10,000 or $300 by negotiating his client a discount.

Conversely, what motivation does an agent have in getting his client $100,000 over asking on a sale if he’s only making $3,000 extra for being good at his job? After all, a relatively competent agent could sell a million-dollar house for a million dollars and make $30,000 commission. So is being a great agent really worth the extra couple grand?

From a financial perspective, the only reward for being the best agent possible is referrals. I average selling my listings for over $100k or 6.9% over asking price, for which my reward is approximately $3,000 per listing. I guarantee you that extra bit is not my main motivation. My financial motivation is to tell you, my new client, that I sell my listings at an average of over $100k or 6.9% over asking so that you will trust me with your next listing. My reputation is my most important financial resource and getting my buyers and sellers the best deal possible is always the means to that end.

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Sold! $110,000 above asking and that’s not the full story…

Closing my recent listing, the Glendale fourplex (1414 Dixon), at $1,305,000 this week answers the age-old question of “why sell.”

Not only did we negotiate $110,000 above asking, but the property also went into escrow like lightning speed. We had strong interest from several buyers, but ultimately the Seller favored the Buyer with the best financials and was most likely to close. The property went into contract 7 days after it went on the market, and closed in a 47-day escrow.

The hidden story behind this fourplex is that the Seller bought it with me in late 2014 for $860,000 and made $445,000 difference on the sale in less than 18 months time, minus closing costs and improvements on the property. Now we’re targeting two more properties that he can buy with these proceeds in a 1031 exchange (tax free), and hopefully do the same thing again next year.

There was no reason to sell 1414 Dixon, except that the landlord knew that he had maximized the property with the resources he had, and could do the same to a different, under-utilized one with new resources from the sale. If you have a property that you are curious about selling, please get in touch.

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Applying SFR Lessons to Income Property

Today a listing agent on a hot fourplex said her Seller accepted my Buyer’s offer, which was $25k less than two other offers, because the Seller liked me at the open house. How did my likability become worth $25,000? It’s not my worn-out jeans.

As a seller, your greatest fear is someone tying up your property through escrow, canceling, and wasting not only your time, but the momentum your property builds when it goes to market. Therefore, any good buyer’s agent builds a reputation of doing what he says he’ll do, and following through on deals. Thankfully, that reputation not only precedes me most of the time, but when it doesn’t I know what’s important to the Seller and make sure she knows that.

What I learned from selling a $2.5M single family house is that income property agents often take for granted that the person on the other side of the transaction is just that–a person. Most landlords who have properties with 2-10 units often spend a great deal of personal effort caring for their properties and getting to know their tenants. That’s why it’s important not only to understand how income property numbers and laws work, but also how to treat the person on the other side of the transaction like a homeowner.

[Note: I originally intended to be more detailed in this post, but I realized that I’m not retiring yet, and so describing too much of how to transact as an agent doesn’t make much competitive sense.]

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Speaking of Single Family Homes

If anyone knows someone in the market for a mid-century modern classic in Brentwood, 1115 N. Norman Place is on the market for $2,450,000.

If you ask any Brentwood agents, this property will move fast. Check out 1115Norman.com for details.

Norman-Sign

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Single Family Home Agents versus Income Property Agents

I just closed a beautiful house for a friend on the Pasadena / Eagle Rock border.  One difference, among many, between working a single family home versus an income property is when I close a house, 14 alarm and security companies call me the next day hoping to earn a referral to my client.  I’m polite and then hang up.

But don’t start feeling sorry for house agents. The process of buying a house is five times simpler than buying an income property. When I dabble in the house world, it’s like the bowling lanes have bumpers. After working SFRs, I realized why so many agents are slow and fumble around during income property escrows. The nuances of tenants, leases, estoppels, rent control, and systems in an apartment building are understandably more complex than in a house.

So why don’t I start working exclusively in single family homes? When you have an expertise that is rare, even if the work is more difficult, it makes a lot of sense to offer buyers and sellers something special. Smart clients can tell the difference.

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Advice

Something has been happening lately that is both frustrating and encouraging. I’ve had several buyers email or call me recently and ask my opinion on a particular property. The only catch is, they are already in escrow on the property with another agent. First off, I’m grateful that these buyers in question have been forthright about their current agent status. And while it’s frustrating to hear them admit their regret not working with me, in each of these instances I encouraged the buyer to feel confident in their purchase. Why? Because in these particular cases, they were making smart decisions already and were simply looking for reassurance. It’s not my job to tell someone what I would do with my money – it’s important to understand the buyer’s needs, explain the potential pitfalls and opportunities, and let them make the decision that’s best for them.

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Los Angeles Vacancy Rate

I often get asked by clients whether my spreadsheets account for vacancy. If the tenants are paying below market rents, I don’t.

Let me back up. The recent census determined that L.A.’s vacancy rate is down to 2.8% from an already astoundingly low 3.7% last year, the fourth-lowest in the nation. Los Angeles has the highest percentage of renters in the U.S. at 52%, according to a Harvard Joint Center for Housing Studies study. What does this mean?

apartment vacancy 2015

It means there aren’t enough apartments. If you own apartments, they will be in demand. It’s that simple.

So why don’t I include 2.7% as a vacancy allowance in my spreadsheets if tenants are paying below market rents due to rent control? The reason is that if one of those tenants leaves, you should jump for joy because you will be able to re-rent that unit in no time and raise the rent while doing it.

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1031 Exchange Strategy

I’ve had some very active buyers and sellers lately and it feels like everyone is in a 1031 exchange. This is a very important tax strategy in real estate, and it’s important that you know how to operate with precision when trying to execute a 1031. First I’ll explain what it is, and if you don’t need a refresher, go ahead and skip to the Strategy.

What is a 1031 Exchange?

Simply put, a 1031 Exchange is when you sell an income property, buy a new income property to replace it, and skip paying taxes on your sale.

What are the rules?

  1. They have to be income properties – essentially that means that neither property can be your primary residence. I’ve heard of some people doing some tricks like putting title in an LLC and paying themselves rent, but I’m not a lawyer and that is certainly not advice.
  2. You have to name 3 options for your replacement properties (or “uplegs”) within 45 days of your sale property (or “downleg”) closing escrow.
  3. You have to complete the purchase of your upleg(s) within 180 days of the sale of your downleg.
  4. Both the equity (cash down) in your upleg(s) and the total value (purchase price) has to be equal or greater than that of your downleg(s).
  5. All has to be accomplished within the same taxable year and to the same person(s) on title.
  6. You have to own the property for one year before selling.

These are the most common and basic rules. There are more if you strive to be more creative.

The Strategy

By skipping capital gains tax, you could save hundreds of thousands of dollars. But why sell in the first place if you’re just going to buy something else?

I’ve written about this before, but the fastest way to substantially grow your wealth through real estate is by buying and selling again and again. I’ve been a party to this and I think my clients in question would admit that I masterminded this growth for them. (And yes, when writing a blog your humility sometimes falls by the wayside.) Staying ahead of gentrifying neighborhoods, good deals and unnoticed potential is key to unlocking a property’s value that you can cash in one year later (1031 Rule #6).

Why sell that unlocked value rather than hoard it? Once you have unlocked a property’s value, you have maxed it out. And unless you have unlimited capital, you can’t simply buy more and more properties; you have to use that unlocked value to unlock even more value, and so on.

That’s the abstract. Here’s an example:

Property A, a fourplex, is selling for $780,000 in an up-and-coming neighborhood.

After closing the deal with 25% down, you fix up a vacant unit and rent it for $700/month more than the seller predicted. Another tenant moves out, and you do the same. Not only did you raise two rents in the property, but those rents are so high that you proved what the other units can get. You may or may not have the cash to renovate the other units, but who cares. You’ve implied the value in the property that no one saw before; you’ve unlocked it. Now your property is worth $1,050,000 (if  your agent knows how to present that unlocked value as current value).

You spent $50,000 to fix it up, and $220,000 on the down payment. After a year, the mortgage pay down is near negligible. But you doubled your equity to $540,000 on a $1.05M value. The bank not only won’t value your property like a buyer will, but it also won’t let you cash out enough to do it again. So you sell to a smart, more fluid, and less hands-on buyer and do it twice more with the newest gentrifying neighborhood / great deal / unnoticed potential.

If that sounded tricky, buying Properties B and C is where things can get sticky.

Because you only have 45 days to name your next properties, being sharp and aggressive during this process is absolutely essential. You make strong bids, drive by dozens of properties, and always see the forest rather than the trees.

When I have a client in a 1031 exchange, that client usually gets my ideas in their inbox first because (a) the 1031 time sensitivity and (b) they reward me with selling their property, as well as their responsiveness and aggressiveness in getting the next amazing deal.

Do you want to make one of these deals happen? I’ll tell you how you can unlock the value in your property to get top price, and guide you towards doing it again.

 

IMPORTANT DISCLAIMER: I am a licensed real estate agent, not a CPA nor a tax attorney, and nowhere on this website am I offering you tax advice.

 

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