In my last article, I discussed how lender recourse, prepayment penalties, a loan’s assumability, and fees and costs affect a real estate investor’s strategy. In this continuation, I will explore several other loan characteristics such that you can more successfully plan your next investment project.

Fixed Periods

Many commercial loan products offer fixed interest rates for some period of time before switching to an adjustable rate. The length of this time frame can vary based on several different factors. As a rule of thumb, the longer the fixed period, the lower the investor’s risk. Keep in mind, however, that a loan product with a long fixed period may be of little value when used to finance short-term projects. This can prove to be a determining factor when shopping around for the best loan product for your application; don’t pay a premium for a super long fixed period if you won’t need it.

Loan-to-Value Ratio (LTV)

The Loan-to-Value Ratio (LTV) is determined by dividing the loan amount by the sales price or appraised value, typically expressed as a percentage. Thus, a building purchased for $2,000,000 with a $1,600,000 loan has a LTV of 80%. Loan products may offer a maximum LTV from anywhere within the range of 70-85%. This ratio is extremely important to investors because the higher a loan product’s LTV, the less an investor’s capital outlay. Thus, the investor increases his leverage and his potential returns as the maximum LTV increases. Of course, when considering LTV, a limiting factor is often the…

Debt Service Coverage Ratio (DSCR)

Debt service coverage ratio (DSCR) is the ratio of Net Income to Annual Debt Service. Typically, the DSCR ranges between 1.15 and 1.25. The minimum DSCR is a loan-sizing factor just like LTV. For an investor looking to maximize his leverage, either DSCR or LTV will be his limiting factor.

Investors are best served looking for a loan product with a low DSCR. This is significant because it allows investors to acquire properties with less of their own equity capital and increase leverage and potential return.

Amortization Period

A loan’s amortization period is the length of time required to repay an entire mortgage. This period is typically between 15 and 30 years; however, loan products exist with amortization periods as long as 40 years. For a given loan amount, as the amortization period increases, the lower the required periodic payment. Thus, yearly debt service decreases and cash flow shoots up. Similarly, for a given DSCR, as the amortization period increases, an investor qualifies for more loan dollars. More loan dollars means more leverage and, potentially, greater returns! Consider long amortization periods as you search for the perfect loan.

Interest Rate

Finally, let’s explore interest rates. Surely, this is the most obvious loan characteristic that investors consider. What isn’t so obvious is how the interest rate ties all of the aforementioned variables together. For example, a lender may offer longer amortization periods, but it will surely cost you in terms of interest rate. In another example, a lender may offer a non-recourse loan, but that lender will almost certainly charge a slightly higher interest rate than for a similar, recourse loan. See where I’m going with this?

As a rule of thumb, tipping a loan characteristic in the favor of the borrower will have some negative impact on interest rate. With so many different loan variables, it can be difficult to determine which loan product is best suited for an investor’s project. While the search is tedious, it is certainly worth it. Happy investing!

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Loan Characteristics and Their Effect on Your Prospective Investment Project (Part 2)

This could be called a tale of two agents. In a recent article I discussed how I came to select a new agent to work with (article). Here I want to talk about a recent meeting with two mortgage professionals. One worked with a major lender while the other was with a smaller firm that acted as a broker dealing with many lenders.

You will always have the typical debate as to whether it is better to work directly with a lender or deal with a broker who can shop for the best deal. Working with a broker may mean incurring additional fees but that isn’t always the case since brokers often get wholesale prices on loans. Working directly with a lender may help cut through some of the red tape involved and might also get a better deal if that lender has what you want.

However this article is more about the professionals involved rather than the firms they represent. Both have sufficient experience and would be considered successful. The firms are reputable so there is no issue there. It is really a question of who is the best person to work with.

Behind Door #1

One thing that wasn’t even a matter for debate was that the broker knew his business. He proceeded to discuss what was available in the market and how he was the best at what he did. He spent so much time blowing his own horn and bragging about everything he could do and how he would get deals done. There’s nothing wrong with confidence but this bordered on narcissism.

The one thing I kept waiting for never happened. Not once did he ask what I wanted or needed. It wasn’t long before I realized that his primary goal in life was to hear himself talk. It was all about him and how he was the greatest mortgage broker since sliced bread. No matter how good he may be at his job, I could never envision using him or referring anyone to him.

Candidate #2
The second mortgage professional runs the local office of a national lender. While his firm offers a wide array of products and has the ability to offer FHA loans, there are things they he may not be able to do. On the other hand, he has direct access to the underwriters and decision-makers at his company that can allow him to solve problems quickly and efficiently.

What really makes him stand out, however, is that the first thing he did was to ask about me, my business, and what my needs were. The kicker is that not only does he readily tell you he can’t do something, he refers you to someone who can. That is so refreshing in a time when it seems that everyone will claim they can do the impossible just so they don’t lose your business.

The Bottom Line

Everyone that you work with has a right to earn a living and to be compensated for the services they provide. That doesn’t mean that they should put their needs before yours. I walked away from the meeting with the first lender with the impression that he would always do what was best for him even if it wasn’t good for me.

The second individual clearly demonstrated through his actions that he puts the client first. In the long run he is much better off. I have referred numerous people to him in the short time that I’ve known him because I know he can be trusted. I’ve often received thanks from people I’ve sent his way and had them tell me they’ve never worked with anyone like that. In reality shouldn’t everyone be that way?

Trust has to be earned, and should come only after the passage of time. – Arthur Ashe

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Finding Mortgage Professionals Who ‘Get It’

On October 1, new federal lending rules took effect under HOEPA–the Home Ownership and Equity Protection Act.  One that will benefit consumers most is a restriction on prepayment penalties for higher-priced loans (those with an interest rate 1.5% above prime).  No longer will borrowers need to worry about an excessive penalty for paying off their loan early. Great, right? Well, believe it or not, this good deed on the part of the federal government could have led to a bit of a fiasco if sound logic hadn’t reigned supreme. 

You see, lenders were worried that the rule would apply to higher-priced FHA loans, which require borrowers to pay the entire month’s interest when they pay off their loan, regardless of which day of the month the pay-off takes place. 

Their position was that depending on how it’s viewed, the extra interest payment could be considered a prepayment penalty, and they would rather stop making those higher-priced loans altogether than risk violating HOEPA for charging it. That would have been most unfortunate for consumers, since those loans account for 20% of the FHA market. 

Luckily, though, the president of the National Association of Realtors (who, by the way, have also been lobbying the FHA to change their extra interest payment policy for quite some time)–Charles McMillan–brought the issue to the attention of the Federal Reserve and FHA Commissioner David Stevens. Stevens then took the issue up with the Fed as well, who promptly replied and explained that it had no intention of designating the FHA interest fee as a prepayment penalty. 

So, thankfully, it looks like a new rule that could have ended up being a blessing for some borrowers and a curse for others will instead be good for everyone. And, all thanks to a little sound judgment on the part of the federal government–who would have thought?

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

New Federal Restriction on Prepayment Penalties Won’t Apply to FHA Interest Charge

Most real estate investors acquire income properties by obtaining a loan. As you are probably aware, maximizing loan funds (or OPM—Other People’s Money) maximizes leverage and, thus, maximizes returns. The right loan product can easily make or break a real estate investment deal. As such, exploring various loan characteristics is more than warranted.

Lender Recourse

Regarding lender recourse, loans fall under one of two broad categories: “recourse” or “non-recourse.” The former refers to loan products that require the borrower to accept personal liability for the repayment of a loan. The latter, however, is a loan for which the borrower is not personally liable; if the borrower defaults, the lender’s only “recourse” is to seize the collateral—the property in the case of real estate.

This is important because not every investor will qualify for a recourse loan. Likewise, an investor might only qualify for a limited amount of loan dollars that may prevent him from obtaining the money necessary for a particular property. This investor may be able to secure a non-recourse loan and the coveted property in the process. Keep in mind, however, that non-recourse loans are not only much rarer than recourse loans, they also take much longer to secure since the lender thoroughly inspects (read: qualifies) the subject property.

Prepayment Penalty

A pre-payment penalty is a fee that must be paid to the lender if the borrower prepays a loan within a certain time frame. Lenders do this to guarantee some specific yield on the loan they are making. Prepayment penalties can be “soft” or “hard”. A lender offering a “soft” prepayment penalty allows the loan to be paid off without penalty if the property changes ownership, but applies the penalty if the loan is refinanced. A “hard” prepayment penalty will kick in regardless of the source of repayment.

It is crucial for the real estate investor to understand the specific terms of the prepayment penalty because it directly affects the investor’s exit strategy and return. Be sure to take the prepayment penalty into account when performing your analysis.

Loan Assumability

If a loan agreement includes a “due on sale” clause, the associated loan is referred to as a “non-assumable” loan. An “assumable” loan, on the other hand, does not carry a “due on sale” clause. Once again, the assumabilty of a loan affects the investor’s exit strategy. After all, a low-interest, assumable loan is much more attractive to potential buyers than a property with existing financing that must be paid off upon the property’s sale.

Fees and Costs

This one is fairly obvious, but don’t forget to take it into account since it directly impacts your initial investment. These also vary greatly from lender to lender and loan product to loan product. As a rule of thumb: the more unique the loan, the higher it’s associated fees and costs.

Stay tuned because next week we’ll explore some other loan characteristics. Until then, happy investing!

Updated 11/9/09: PART 2 – Other Loan Characteristics is now live on the site.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Loan Characteristics and Their Effect on Your Prospective Investment Project (Part 1)

What if you had a home modification law that everyone ignored? In its 2009 legislative session the State of Nevada passed a law requiring loan modification companies to be licensed. The law, which recently took effect, not only required a license but the companies were also required to post a $75,000 surety bond. It seemed like a good idea at the time. (article)

At the top of the foreclosure rankings for practically the entire housing crisis, it made perfect sense that it would be a hotbed for loan modification companies. Unfortunately that also lured the scammers. According to the Nevada Attorney General’s office, loan modification scams account for 88% of all housing related fraud cases in the state (article). It was a statistic that ensured that the legislature would act.

The Best Laid Plans

It seems that a funny thing happened on the way to regulation. As usual, the legislature didn’t foresee what might happen when it wrote the law. It’s no surprise that the scam artists would ignore the law as they continued to operate. The new regulations give the government a way to shut these predators down and protect homeowners desperate to save their homes. There’s certainly nothing wrong with that.

But what about legitimate companies that are trying to comply with the law but are finding it difficult to do so? As the licensing deadline approached the state’s mortgage division was processing about 50 applications for loan modification licenses. However, none had posted the required surety bond which means the licenses won’t be approved. Does that mean the end of loan modification companies? Not likely.

What Went Wrong?

To invoke a line from Cool Hand Luke, What we have here is a failure to communicate. It seems that many feel the government did a poor job in relating the new requirements to the industry. The loan modification bond requirements went into effect along with another law that required mortgage brokers to post a similar bond. Many operators of loan modification companies are also mortgage brokers and made the assumption than one bond would be good for both, it isn’t. Many consumer credit counselors are also doing loan modifications and assumed that bonds required for that industry also covered loan modifications, they were wrong as well.

Most small and start-up companies, even if legitimate, are not in a position to put up $75,000 just to do business. That means that they need to purchase a bond from a surety company. Problem number one is finding a company willing to post a bond for a high-risk industry. Problem number two is affording it if they can find one. A surety bond can easily cost 10% or more of the face amount. A lot of companies simply don’t have the money. Many of them will continue to operate and risk running afoul of the law.

It will be interesting to see how the mortgage division handles the issue. For sure there will be some sort of grace period since the regulations weren’t as clear as they could have been. Beyond that it remains to be seen whether they go after all companies who haven’t complied or just those that receive complaints.

Laws are like sausages, it is better not to see them being made. – Otto Von Bismark

Photo Credit: Nevada Tumbleweed

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Nevada’s Home Loan Modification Law Ignored

Commercial real estate owners who are considering hiring an attorney to handle their commercial loan modification should investigate the background and experience of the person they hiring so that they know in advance what to expect.

In my experience as a commercial loan modification specialist I have found that many attorneys who advertise themselves as commercial loan modification attorneys actually have very little experience performing successful loan workouts. Unfortunately, as many people know, there is an over supply of attorneys in the United States. This forces many lawyers to follow the latest and hottest trends in order to get new business and survive. You may see the same people who used to do accident and injury work now advertising their services as loss mitigation specialists because it has become such a needed service. For this reason the commercial real estate owner should definitely do their homework and research the actual experience of the person they are hiring.

What You Should Expect from a Commercial Loan Modification Attorney:

1. A Money Back Guarantee: Is your attorney willing to give a complete refund if he or she is unable to successfully modify your commercial mortgage?  Very few commercial loan workout companies are offering a money back guarantee but it is will worth the research to find a company or attorney that is willing to offer a written money back guarantee if they are unable to modify your loan.
2. A Written Plan or Proposal:  Make sure that your commercial loan workout attorney gives you a very detailed written proposal of all of the services that he or she is going to perform on your behalf.  Commercial loan modification can be a complicated process that requires many hours of work and research.
3. Satisfied Clients. Ask your commercial loan modification attorney if they can give you the contact information for any clients that they have successfully helped to modify their commercial loans.  They may not be able to give you any references because of their privacy policy or because of attorney client privilege but it can’t hurt to ask.  An attorney who successfully modified the commercial loans of many clients surely must have one or two who would agree to attest to the experience and results that had with the attorney who helped them.
4. Who Does the Work? Find out if your commercial loan modification attorney will be doing the negotiating and processing him or her self.  Many attorneys are too busy to actually perform the important work themselves and they may be outsourcing your commercial loan modification to a third party.  You may be able to save money and time by cutting out the middleman and going directly to the company that performs the negotiation and works with the bank.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Attorneys for Commercial Loan Modification. What You Need to Know.

When it comes to finding great real estate deals, I am a firm believer that you can find deals in any market and any time.  But what is the probability that you can cherry pick from many home run deals have little competition and multiple exit strategies? 

To identify markets to invest it is recommended to have not 1 or 2 of the following, but all 4: 
Little chance of depreciation, lots of available deals, low competition, multiple exit strategies.

Probability of depreciation

If you haven’t heard of PMI, Private Mortgage Insurance, let me introduce you.  PMI provides insurance to lenders to protect them from buyers who default.  PMI also applies leading research, analytics, and pricing principles to manage risk concentration, and releases a monthly market review and quarterly Market Risk Index report. 

The PMI U.S. Market Risk Index score translates to a percentage that predicts the probability that house prices will be lower in two years.  Based on this report many of the hot areas during the boom such as CA, Vegas, FL, etc have a High probability of lower home values in 2 years.  However, many areas of OH, TX and the Midwest have Minimal risk rank.

Lots of available deals

It is safe to say that the US economy has impacted every market in the country.  Foreclosures have hit all time highs and many areas have an oversupply of opportunity.  Some areas have more deals then others, but there are plenty of distressed properties out there.

Competition

Have you ever been in a bidding war?  5-10 offers and the seller counters or asks for best and final?  I have experienced this many times and almost always, the property sells for much more than I am willing to pay.  Competition drives up prices.  A perfect example is the way prices soared in hot areas like CA, Vegas and Florida.  Homes would be put on the market for 15% higher than the comparables justify and still multiple offers as much as 20K over asking price. 

Investors are in the best situation where they are the only offer and thus have much more leverage in negotiations.  My experience is that there is a lot of competition in the desirable areas that were very hot during the boom such as CA, Vegas, Florida, TX etc.  Other less desirable areas have less speculation and competition which often results in lower purchase prices for distressed properties.  Many smaller cities and areas of the Midwest such as OH have much less competition. 

Multiple Exit Strategies

I have written about this topic in the past articles.  Having multiple exit strategies is often crucial to avoiding loses.  If you are unsuccessful flipping a property you may be able to rent, lease option and even get a lower payment or take cash out with a refinance.  Or, if you cannot find good property management or good tenants then you can flip or wholesale the property because you have plenty of equity. 

Multiple exit strategies give investors backup plans if your 1^st exit is unsuccessful.  Simply put, multiple exit strategies will lower risk, not to mention, let you sleep at night.  Many high priced areas are difficult to cash flow and have multiple exit strategies.  Again, many smaller cities and areas of the Midwest such as OH have an oversupply of deals with tremendous equity, tremendous cash flow and multiple exit strategies.

Summary

It is strongly recommended to identify areas with all four traits.  High priced areas that were hot during the boom have a high probability of depreciation based on PMI’s research, there is a lot of Competition and Multiple Exit Strategies is difficult to achieve.  While there are many foreclosures in CA, Vegas, Florida, etc, they are not areas that are recommended.  Many people will do well on deals, but many deals will also tank.  TX is an interesting market as it is very stable.  You can achieve multiple exit strategies, but there is a lot of competition fighting over the available properties.  Many smaller cities, areas in the Midwest and OH however hit on all 4.  Minimal chance of home values decreasing, tons of available deals, low competition and ability to find deals with tremendous equity and tremendous cash flow. 

The success of a deal is still dependant only on that specific property and not the market as a whole, but the Midwest and OH are the areas strongly recommended as areas to invest at this time.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Where to Invest in Real Estate?