​LLCs, Mortgages, and covering your ASSets

The Answer: If you can't close in an LLC, it can't go in an LLC

NOTE: I AM NOT A LAWYER OR FINANCIAL ADVISOR, just a fellow real estate investor.

LLCing my new ASSet - (skip to WTF for the legal, financial bits)

I am a new real estate investor, but an old(ish) guy. I've been investing in stocks for decades, in business myself for more than 15 years, so it is important for me to do things right.

Like many of you, I started out reading a lot of real estate investing books, joining BiggerPockets, listening to podcasts (good stuff!), and reading more books and articles.

Protecting your Assets

A lot of investing books suggest putting your investment properties in an LLC (or LP) for asset protection.

Sounds good, right?

It sounded good to me too, so when I put an offer in on my first property (a single family home) as a buy and hold rental, that was my plan too.

So, I get pre-qualified for a mortgage, find a property, etc., etc., etc.

And, just as we are getting ready for closing I double check everthing....

I want to close into an LLC.

Nope, says my bank.

"What?" says I.

(Actually, more colorful language, but not to my bank)

Won't do it, says my bank.

Darn, says I (OK, things were really colorful now).

Off to find another lender.

This time, I'm really, really, really, clear. I want to put the property into an LLC.

Several folks say "No" of the bat.

I post a forum question about this here.

Several alternative financing people (and people who've) worked with alternative financing people offer to help.

(Thank you again, by the way)

The alternative financing would kind-of-sort-of work. But..... OUCH!

I had planned my property to cash flow, but, WOW, this was going to make things lean.

I considered cancelling the deal.

A third party mortgage lender said he could do it.

The numbers looked pretty good.

Off to another mortgage application.

If you can't close in an LLC, it can't go in an LLC

So, the mortgage guys told me I'd have to close in my name then transfer the property into an LLC.

Sounds kind-of-sort-of plausible... but, I'm getting paranoid and check with my attorney.

He says "They'll be able to call the loan".

So, I ask the mortgage guy to show me the note (the actual mortgage agreement) that I'll be signing. (I've worked with contracts for many years... so, it only matters what the contract says, not the verbals from anyone)

The contract says "Nope" (more details below)... unless you get a waiver.

I tell the mortgage broker this... and he says his VP says it will be fine.

I say, "GREAT"... can you send me a draft copy of the waiver.

(SILENCE)

... after much back and forth, the answer was... "No waiver".

Dead deal.

But wait....

As a "belt and suspenders" guy, I had kept other options open. I looked really hard at some alternate financing options, but my realtor openned the door to a local bank for a commercial loan.

We've got a deal.

After some back and forth, the local bank gave me a commercial loan (25% down instead of the 20% I would have gotten for a traditional mortgage) with 20 year terms and a 5 year ARM at 4.5 percent. Pretty good numbers, but definitely not what I had thought when I'd started with the traditional mortgage.

Done and done.

The math still worked (about $150 more a month mortgage and I'll have to plan to refinance in 5 years), not as sweet, but still a solid investment.

Thank goodness for a conservative financial model.

I closed Tuesday (3 weeks later than I'd planned). Now I just have to get the house rented.

(and thank you guys here for really focusing on getting that first deal done)

WTF - What's going on here?

AGAIN - I AM NOT A LAWYER..... so don't take this as any sort of legal advice or anything. And this is US only, your mileage may vary by jurisdiction.

Mortgages for 1 to 4 unit properties can be FHA insured and there is a vibrant secondary market for these mortgages. Even if a mortgage provider says that they are not planning on selling your mortgage, there is nothing in the note that prevents them from doing so and, more importantly, they all sign up for FHA insurance to cover their behinds.

Here are the notes that you are likely to see if you buy a 1 to 4 unit property:

https://www.fanniemae.com/singlefamily/notes

This is the standard fixed rate note:

https://www.fanniemae.com/content/legal_form/3200.pdf

The key clause is:

If all or any part of the Property or any Interest in the Property is sold or transferred (or if Borrower is not a natural person and a beneficial interest in Borrower is sold or transferred) without Lender’s prior written consent, Lender may require immediate payment in full of all sums secured by this Security Instrument. However, this option shall not be exercised by Lender if such exercise is prohibited by Applicable Law.

If Lender exercises this option, Lender shall give Borrower notice of acceleration. The notice shall provide a period of not less than 30 days from the date the notice is given in accordance with Section 15 within which Borrower must pay all sums secured by this Security Instrument. If Borrower fails to pay these sums prior to the expiration of this period, Lender may invoke any remedies permitted by this Security Instrument without further notice or demand on Borrower.

To be eligible for FHA insurance, the buyer needs to meet:

https://portal.hud.gov/hudportal/documents/huddoc?id=4155-1_4_secA.pdf

Which is as clear as mud.

The short version of this long document is that you have to be a person with a social security number or a living trust owned by such a person.

While, technically, you could get a mortgage (not FHA insured)... which is much harder to resell (and not FHA insured).

What about a non-FHA Loan?

(Back to my experience for a bit)

It is not easy to get a commercial loan on a single family home. Basically, the greater the number of units (and the existing rent roll), the easier a commercial loan will be to get. This is likely to be a recourse loan secured by you. You almost certainly WILL NOT be able to get a commercial loan from a national bank for this type of investment (your mileage may vary). I had an additional challenge in that I am investing out of state, so one of the banks that I contacted could not work with me.

Why the LLC again?

So, one of the comments that I've heard is that "just put it in your name and insure the **** out of the property".

This is a fair question. My plan is to invest in multiple properties, so I very much wanted to do this one as "right" as possible so that I could simply repeat the process for future investments.

Insurance is great, but insurers can sometimes decide that they don't want to cover you. The LLC is a "damage limitation" form of insurance. If you get zapped in one property, it won't spread to your other assets.

If the increased leverage provided by a conventional, conforming mortgage is worth the risk to you... that is between you and you. As you add more properties (or have other existing assets in your own name that you can't otherwise isolate), you are multiplying your risks.

I won't tell you what to do, but for me, I want the added insurance and asset protection that an LLC provides in addition to good insurance coverage.

What about moving a property to an LLC after the sale?

This actually seems to work in practice for a number of people. If you look at how mortgages work (thanks for all the great stuff on seller financing again, BiggerPockets!), you'll see that the lein is separate from the title, so changing the title on the property doesn't directly "touch" the lein held by the bank or other lender. They still have their hooks into the property. They won't see the title change unless they look for it (and the state of many government entities that actually manage titles doesn't make this easy). They may not even notice if you decide to refinance.

They may also not want to have to mark the loan as non-conforming as they may have to reclassify it on their books (and we all know how well banks like to keep their books clean).

... but, technically and legally, you are in violation of your loan agreement and it can be called which could be "exciting".

... and I am a boring guy who wants my investments to be boring most of the time.

So, what if I rent out my house after I've lived in it for a while?

Again, your mileage may vary, but you are in technical violation of your loan agreement (most likely). See above for more details.

What if I'm a flipper?

This is not my personal strategy, but I'd suspect that you are at less risk here as there is not a renter in the property and the most likely target for a lawsuit (say from an injured worker or random trespasser) would be the contractor.... but the property owner is always at risk. REMEMBER I'M NOT A LAWYER!

Random Thoughts and Options

Refinance after renting

One of the challenges I faced is that the property is not producing rents so the loan is being purely backed by my household income. Once the property has been rented for a while, you may want to pre-emptively refinance it into a commercial loan to reduce your potential risk of having the loan called.

Get HUD to change - Call your Congress-person

The law (regulation?) as written is pretty screwy. I'm not trying to defraud the system, skip out on my mortgage, or do anything goofy, I just want to protect myself. HUD could "easily" change the rules so that instead of the borrower being a "person with a social security number" to an "entity owned by a person with a social security number". FHA mortgages are clearly set up to support a modest level of investment (otherwise we'd only be allowed to have one), so why not let people protect themselves?

.... one can dream.

Skip to bigger properties

One of the main reasons I switched from a small multi-plex to a single family home was ... leverage. I could get an investment loan at a lower rate with only 20 percent down vs. 25 percent down for a 2 to 4 plex.

Without the leverage, why bother? Just go straight for a property that is easy and natural to finance with a commercial loan. I've had good discussions with a national bank for commercial deals on 5+ plex properties.... numbers are numbers, so why not?

Seller financing

Alternate and seller financing doesn't have to make a bank happy if it makes both of you happy. The FHA is involved. Yet another reason to investigate this option. NOTE: If you want to refinance out at some point, you are likely to face these same issues, but with a proven rental property, getting a commercial loan at a reasonable rate "should" be easier.

CAVEAT Borrower

I don't think anyone was trying to deceive me or steer me wrong when they suggested "just LLC it later". But, these people are business people, not lawyers and the only thing that matters is the contracts you sign. Ask for a copy of the draft agreement. Make your own risk decisions.