10 Best Practices in 1-4 Unit Investing for Agency/Conv. Financing
1) Maintaining 720 or more fico is essential since mortgages number 5-10 require it to keep your source of conventional money available
2) Maintaining as a rule of thumb 6 months reserves for all properties in the form of PITIA (principal, interest, taxes, insurance, assessments). This is not required for mortgages numbers 1-4 but the habit of having these is helpful especially when you get the the higher ranges of residential mortgages. The reserves also serves as a "compensating factor," when the credit decision of your loan is on the chopping block and it also helps in the "real world," when weathering repair and rehab storms. Reserves can be in the form of cash/CD's/money market instruments or cash value life insurance/Annuities/surrender value or other for 100% count in the reserve equation. They can also be in the form of less liquid sources like IRA's/defined Benefit plans/401k's and other qualified plans but these values generally will be counted for 60% of their face value due to withdrawal penalties and ordinary income taxes and such in the event you had to use them. The last is portfolio/stocks/bonds/mutual funds get counted for 70% of their value generally.
3) You can gross up non taxable income up to 125% so the portion of your social security that is non taxable, child support usually, Municipal bonds are usually fed tax free and can be grossed up, and other. As an example if you have 1000 dollars of monthly gross income that was non taxable it would count as 1250.
4) Rental properties can eventually alleviate you from having a day job completely if there is a sufficient amount of rental income. I encountered a client who had enough rental units earning her over 120,000 in net cash flow annually. So its important to plan how banks will interpret how you file or how you report your cash flow/income so that you can obtain the desired result when this source of money is needed most or when you plan to not work your day job any longer.
5) Down Payments can get 5% higher when you're in the 5-10 financed properties game. This does not count commercial real estate or business liabilities or mortgages and the residential mortgage only counts against you if you either have your name obligated on the mortgage or your name on the title or both. General down payments are 20% min for 1 unit and from 20-25% down for 2-4 units for 1-4 financed properties but, when you get up to 5-10 its 25% down for 1 unit and up to 30-35% down for 2-4 units.
6) Structuring non cash losses over actual cash losses when designing income. Since non cash losses like depreciation/amortization/depletion are only losses on paper/accounting side of things and do not count in the lending equation as these losses are added back to income. Banks are looking for the actual cash flow and income net to your pocket when we calculate your qualification. Depending on your financial plan you may want to speed up your depreciation which allows you to show less income on your taxes and therefore have a lower tax liability in the earlier years of the rental property. This allows more income to be recooped in the earlier stages of the investment and also increase your present value or effective return on your investment. I would recommend a lender who is familiar with these financial aspects so a balanced plan can be worked out between you and your tax strategist as there are pros and cons to be discussed.
7) Actively, and I mean Actively, Actively manage your debt to income! Debt to income is the ratio of your min payments per month relative to your average qualifying income. Example, 150 credit cards, 500 student loan per month, 500 car payment, and 2500 mortgage payment from your primary home = $ 3650 in monthly obligation divided by 10,000 gross income = 36.50% debt to income ratio. This is the total obligations ratio or back end Debt to income ratio.
Usually the front ratio is expressed as just the mortgage of 2500 divided by the income of 10,000 for a front DTI of 25%.
(expressed as 25% front ratio / 41.50% backend ratio)
When you open new cards ask what the min payment they will report to the credit bureaus will be, if you get a home equity line of credit or even unsecured line of credit ask what percentage of the balance will be reported as a min payment, chose longer pay periods for car payments and mortgages if possible.
Obviously longer payment periods have higher interest but in reality if you're serious and capable about REI you can make leaps and bounds above the rates charged by banks so is you're planning to save interest by going with the 1.99% intro rate car dealer loan for 36 months loan instead of the 3.99% 7 year loan or save .75% difference between the 15 year and 30 year mortgage it may best be characterized by "pennywise and pound foolish," to do so with respect to planning your income. This is because the higher payments may make it harder for you to access financing as your debt to income ratio will be very high and put your rentals in a negative cash flow position (high 15 year payment or high payment due to short payoff period on a car).
Im not saying to obtain the highest rate possible and spread out the loans forever however, I am saying to do so prudently while capitilizing on much more productive opportunities (disclaimer).
Its a Strategic balance for each individual and it can vary depending on your goals.
8) A great book for credit scoring and general credit care with regards to personal credit would be " Best Credit - How to win the Credit Game," by Dana Neal. If you're looking to maintain and build those scores
9) Keep an organized file so that your loan can be a slam dunk file that processors and underwriters flock to when they want to hit their monthly numbers not the file that they keep till the end of the day to work on. Some tips:
- each mortgage/loan on each property whether on the credit report or not, preferably on the credit report so its seamless but if its a private note, subject to, land contract we'll need to obtain the loan note or contract for this and 12 months of cancelled checks to document payment for this obligation otherwise it could stall your loan
- all sources of employment in the last 2 years whether employed or self employed (employers names, addresses, tenure working at the company, HR's contact info, and more)
- all sources of assets must be seasoned (60-90 days in your account) or documented, and cannot be cash under the mattress or cash on "hand." Make sure to not move money between accounts too much during or before a transaction. If you're not sure ask your lender
- Insurance declaration pages are needed for all properties, recommended to keep a folder on your computer for parts of a loan file and to update it regularly
- mortgage statements for all properties
- lease agreements all pages for all properties (usually only the subject property is needed unless if the property is not on the tax return then this will be needed for sure to document income)
- and more
10) File Taxes and prepare them closely with your tax advisor and your mortgage professional as financing typically goes off tax returns and profit and loss statements year to date when working with real estate and self employment/business income. So having quick books routinely updated and your books up to date really makes the process a breeze even for massive portfolios and borrowers with complex tax returns/multiple business/entities/holding/family limited partnerships/etc
Comments (3)
great post
James Wise, over 10 years ago
These are great topics Tiffany. I can break it down into two areas 1) capital expense write offs versus operational expense write offs and how they affect commercial/multifamily lending and residential and 2) "days put into service" a tax view into how income should be calculated from tax returns 1) The first applies to commercial and multi family. I have people who have recently acquired properties and have spent money on rehabs but those rehab costs were shown as repair or "operational" expenses. Its not so much as placement but, rather documentation, or verification from a credible third party source that those were in fact capital expenses when it comes to being able to add them back. Commercial underwriters are better at this because most of their files involve using the income approach so they are generally more well versed on this and can search through the balance sheets and realize that some of the rehab/repair was allocated to basis which shows it was a capital expense to be depreciated over time and not a yearly operating figure, but residential UW's for the most part will not go into depth like that to uncover repairs vs capital expenditures the burden of proof will be on your mortgage professional or you as the borrower to uncover. Generally these can added back or at least the portion that can be shown to be capital expenses like a stairwell, a stove, carpets, drywall, roof, etc. On the commercial multifamily end they may only hit you for your fraction of the useful life of the capital expense. For example, lets say you had 10,000 in capital expenses and the accounting useful life is 10 years they would hit you for 1,000 of that 10,000 and add back 9000 to income to figure out your cap rate average based on appraisal adjustments. On the residential end we can usually add back the entire capital expenses for 1-4 unit rentals if its documented to as "not likely to reoccur year after year," so your income may look substantially better. 2) The issue of your income showing up incorrectly is a separate topic as well and its an ultra important topic that is a great segway for why the mortgage professional and your tax advisor should be intimately involved in your real estate portfolio, purchases, distributions, and reportings. The days shown on the tax return are the days that the underwriter "should," be using to calculate your income, however this is not always the case as you've experienced personally. For example if you netted 10,000 rental income but acquired the property Oct 1st 2013, the UW should divided the 10,000 net income by 90 days not 365 and this is sometimes an issue in determining correct rental income on a rental/income property. A mortgage professional who invests themselves or is experienced in working with real estate investors should be able to pick these up during the initial consultation of your file. This is also going to help streamline your loan process and reduce the need for a hair pulling and teeth grinding experience =D.
Albert Bui, over 10 years ago
Albert, this is a great post! For complicated borrowers (aka real estate investors) it's often difficult to find all of this information spelled out in one place. Well done! One complication that we've run into (a mistake we will not make again) is when we had 1 time renovation expenses (6k-15k when purchasing a new hold property with cash) we didn't document the invoice and payment well enough or get a "paid in full" receipt from the contractor. Additionally, our tax person put these under some place on the tax return that indicated to the underwriter they were regular expenses when in reality they were the purchase rehabs and not ongoing. Subsequent to that our fair market rental days were calculated as 365 on the tax return when we had only owned the properties and had them occupied for a portion of that year. I'm not quite sure the reasoning behind this. It was probably just for ease so we didn't have to go through a bunch of emails and paperwork to try to determine exact dates. The actual income we claimed was accurate to days rented, however. These factors really messed up our debt to income because it looked like our expenses were out of control and like our rents were extremely low. So a few questions for you: Where could those 1x rehab costs be placed on the tax return so as not to hurt us in the expense department? One idea was to show them as an increase to asset value. It seems like there's a balance here because you may also need the write-offs. But, I understand the underwriters can be very particular about what line of the tax returns these show on. Perhaps they could be a general business expense but not on the schedule of real estate? Might I request a future blog topic emphasizing how a self-employed person can prepare to be able to get financing (whether that's creating an entity and needing a number or time frame of showing some type of income, w-2 or other)? Thank You!
Tiffany H., over 10 years ago