— A Real Estate Investor Guide To Renting —
How To Make Money Renting
by Chris Brown, President, CB Investments
27 February 2017
An income property is an investment in which you attempt to derive an income from the asset prior to a distant future sale.
While any investment in real estate is speculation of one degree or another, an income property investment is a long term hold versus a fix-and-flip investment that is a quick turnaround. It is generally assumed that you will hold the property for at least a year or more, and the investment analysis that many lenders prefer is modeled at five years. So what makes the deal an investment is the project time line. A fix-and-flip speculator is attempting to cash in quickly and arbitrage the market to take advantage of the market mispricing an asset. An income property investor is attempting to generate an income that exceeds expenses and sell the asset later.
Choosing The Property
There are no guarantees of success in any investment. What you can do is reduce your risk by analyzing each deal and choosing the one with the least known risk. If nothing else, you will be able to eliminate many projects that were doomed from the start. Many major problems with property investment are made at the purchase due to a miscalculation of the future market. One could say there were unrealistic expectations, but in most cases those expectations were supported by the analysis of a property. While management of a property is very important, choosing the right property drastically improves your odds of success.
It’s a good idea to create an initial feasibility study that includes all the known variables of the project to play out scenarios.
Financing The Property
To finance the property you will need to put down a percentage of the purchase price known as equity. On top of your equity you will need to pay for inspections, fees, and anything else that may pop up. Even if you pull off a lease-option or option for the property, you will need cash to cover unforeseen expenses and most likely a fee to the property owner. In some form or another, you need access to cold hard cash. It is possible to get into a property with little or nothing down, but there are expenses that will need to covered so you will need something set aside. This will also allow you to lower your rents and still pay your expenses when the market is in decline.
Most real estate investors require financing to purchase their property. When you approach a lender as an investor, you will be considered a higher risk than a primary homeowner. The reason is because you can walk away from the deal leaving them with the bulk of the problems. The lender typically lends the majority of the funds needed to purchase the property. You on the other hand may only put in around 20% towards the purchase, and lenders do not want to hold onto a bad investment property.
When you start looking for financing you will notice there are many different lending programs. Some will have a higher equity requirement, but better terms as far as interest and amortization period. You will undoubtedly find lending programs with little or no equity required, but the terms are less favorable with higher interest and shorter amortization. Banks may require a 20% equity contribution from the investor toward the property purchase price. Furthermore, to compensate them for the higher risk, they will require a higher interest rate. The interest rate could be as high as a percent or more over what is quoted to primary home buyers. Your credit history could also affect your interest rate and whether the lender will consider you for a loan, and the amortization term may be shorter, 20 to 25 years for many banks.
All of these slight changes make large impacts on the finance payments — they get more expensive — and higher expenses make it more challenging to find a property that works. And to make it even more challenging, there is also another hurdle for your project to meet. Know as the debt service coverage ratio or DSCR for short, it is the ratio of the income to the debt payments. To calculate it, you simply take the projects income minus expenses (excluding debt) then divide it by the debt payments. Generally this is done on a yearly basis. The DSCR requirement is usually around 1.15 for smaller rental properties. “What does the 1.15 mean?” It means your income is 15% higher than needed to make the lenders payments. You can think of the DSCR as a built in safety cushion for the lender (it’s good for you too if you think about it).
Knowing your honest ability to cover the project equity and costs will determine the maximum project size you can pursue.
Hard Money Loans
With hard money loans, you can typically get financing on projects that lending institutions are unwilling to accept (or if your credit is pretty bad). To compensate the hard moneylender for the additional risk they charge very high interest rates – up to and over 16%. In addition, they may require fees up front to see if you qualify. At such high interest rates, who would use hard money? Hard money is just another tool in your financial toolbox. Every tool has a purpose, and if used properly can be helpful. The best use of hard money is as additional equity for the project. If you have a large project, the hard money loan can be equity in lieu of finding an additional investor. Why? An investor will want to share in the projects income, ownership, and profits that will cost far greater than the hard money loan. You just need to be certain that you can make the additional payments and pay the loan off when it becomes due. Hard money loans generally have short terms of one to three years. Developers usually anticipate the project will stabilize with cash flow by the end of the loan, and they will pay off the hard moneylender with new financing. Before you use creative financing like hard money, it is best to speak with a local mortgage broker that is reputable.
Leverage in real estate is the ability to use a small amount of cash to do a larger project. You put in 10 to 20 percent of the funds required, and the lender puts in the rest. The bank lets you know how much leverage they are giving with the loan to value (LTV) percentage. An LTV of 80% means you will need to provide 20% equity (cash). So utilizing leverage, you can buy a property many times worth your initial cash investment.
To illustrate, suppose you had a property that you purchased for $100,000 with a LTV of 80%. This means that in order to buy the property the bank required you to put up 20% of the funds, $20,000. The remaining $80,000 is provided in a mortgage by the lender. Suppose that after we sold the property we made $5,000 in profits. Had we invested 100% cash in the deal we would only realized a 5% return — not very good. However, using leverage our returns are actually the profits divided by our equity contribution of $20,000 — a very impressive 25%.
There is a dark side too — negative leverage. Primarily an issue for income properties, negative leverage occurs when the real estate income cannot cover the cost (payments) of the financing and expenses. There are an unlimited number of reasons why this could happen, and this is precisely why the banks only lend a certain loan to value (LTV) and a debt service coverage ratio (DSCR).
It’s a good idea to get prequalified for financing so that when you’re ready to make an offer you don’t have to wait and risk it.
Making The Offer
Here is where it is important to have a good realtor. Without a realtor it may become frustrating why a property owner is not accepting your offer and you may end up squabbling about trivial matters. A good realtor acts as an ambassador who conveys your concerns and demands in a professional manner and keeps the deal a business transaction. With a property selected, bring your realtor, and a contractor who can spot issues, and do a preliminary walk through. If the contractor does spot issues, ask them for an estimate of the repair and renovation costs and revise and update your pro forma. Auctioned properties can generally not be visited or inspected (buyer beware), but they do have reports of issues with the home.
To pull off your deal, you are going to need financing. So put together a professional finance package that includes the following:
- Title page
- Table of Contents
- Investor Background
- Property Information
- Local Market Information
- Project Pro forma
To get your hands on financing you need to demonstrate the project and yourself are acceptable risks to the lender. And by the way, if your credit score is low you need to find a partner with a good one.
With your financing in place and pro forma guiding the investment decisions, you now make an offer and wait for a response. How you make the offer varies from state to state. Some states have standardized contracts that are widely used and accepted as industry standards. In the offering, which may be a sales contract, everything needs to be spelled out; sale price, due diligence period, reasons to kill the deal during due diligence, how long the seller has to vacate, etc. If it is not spelled out in the contract it is not legally enforceable, or at least as enforceable. Make sure to thoroughly read the contract and understand the provisions. Once executed, the agreement is a legal document which must be followed. If you default from the agreement you can be personally liable for damages to the seller.
Once your offer is submitted to the seller you wait to hear back from your real estate agent if the offer was accepted. But chances are it will not be in the first round; you will most likely get a counter offer, higher than you were willing to pay. So be prepared, and as a defense tactic, always offer 10% less than what you are willing to pay. Then the seller can feel they did their best by pounding the last ten percent out of you.
Once an offer is accepted, you are in your due diligence period. Now you have the right to have the property inspected by a licensed inspector and any other professionals needed. If anything you find during the due diligence period is serious, you have the right to renegotiate the price or walk away. This is also the point where money starts being spent – the inspector is not free. If everything is acceptable you proceed to closing on the property. All you need to know is that no matter what they promise, something generally goes wrong with the paperwork at closing. But as long as you and the lender transfer the money, you will get the property.
As the new owner and landlord of a rental property with tenants, you will need to enforce rules, so be the “property manager.”
Congratulations, you have done a lot of work to purchase the best possible investment property. Now you just need to do whatever repairs and remodeling work so you can get a tenant in there to cover those expenses and generate income. Time to get the required utilities such as water, sewer, garbage, and electricity switched on. Since the house is vacant, you can leave off the telephone and cable plus anything else not essential. Your contractor can hopefully jump on the project to complete it as soon as possible. Be aware, he may not be able to start for two to three weeks until they have the required permits. You can advertise the space as ready in a few weeks to see if you can get somebody lined up to rent. Then there’s the management, but that’s a whole new discussion.