Buying Investment Property - An Example of the Issues

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My aunt is going to move to a new condo and wants to sell her old one. I would like to buy her old condo as an investment and rent it out (as I am already a home-owner). This whole investment/rental buying is all new to me.

She has lived there about 5 years and the value has increased more than double. Obviously I would love to be able to keep her tax base. I am thinking about getting an interest only loan to help me get into this. Can I get a loan for 100% of value? My aunt will need the entire amount to purchase her new place. What suggestions do you have to make the loan process easier and pay the least amount in fees?

It is worth between 360,000 to 390,000 (we haven't yet got an appraisal, this is from comps in area). My wife and I currently have a house in (City) with a value of 650,000 and a mortgage of 400,000. We both work and have some extra income, maybe 400 a month that we could supplement against a renter. I think we could qualify for the loan, but then we would have to refinance our house to cover a down payment and closing costs. We don't have any savings to pull from. My wife hopes to retire in 2 years and I will in about 8 years.

Investment property is a different item from a personal residence, in several particulars. First off, even if it's residential, the loan is a riskier one to the lender. A loan on investment property is going to carry a surcharge of 1.5 to 2 discount points (one discount point is one percent of the final loan amount), over and above any other charges for the rate you choose. Furthermore, despite a lot of research, I don't know a single lender that will currently do a loan on investment property for more than 80 percent of the value of the property (When I originally wrote this, it was 90-95 percent, but there has never been such a thing as a zero down investment property loan). So you need a down payment of at least twenty percent.

The good news is that whereas you do not have savings to pay it, you do have a considerable amount of home equity. Depending upon your exact situation, either a "cash out" refinance or just taking out a HELOC (Home Equity Line Of Credit) might be in your best interest. It depends upon your current mortgage and your credit, and I cannot make a recommendation one way or another without looking at the market you're in for current comparables, running your credit, and seeing what can be done. If you've got good credit and income, and have had the good credit and income for some time, it's more likely to be in your best interest to simply take out the HELOC. I have some without prepayment penalties and are zero cost. If your credit or income has improved of late, it may be in your best interest to refinance, or if you've got an ARM that's about to adjust anyway. Assuming you're "A" paper, you may now be a conforming loan where you would not have been when you took it out, although taking the cash out could cause you to exceed, once again, the conforming limit. Therefore, the acknowledgment that a HELOC is likely to be the way to go.

Cash flow is also an issue with investment properties. If you don't have a tenant, you get zero credit for the rent at initial purchase from A paper. If you do have a potential tenant, with a signed lease for at least one year, the lender will give you a credit of seventy-five percent of the proposed rent towards your cost of owning the home (principal, interest, taxes and insurance). Some subprime lenders will credit you with ninety percent, but their rates are typically higher in compensation. With the vacancy rate in urban California being about four percent, even ninety percent is a bit low, but the standards are what they are. I know many people who are making money hand over fist on rentals where the bank thinks they are paupers.

There is no such thing as an easy documentation investment property. Indeed, for any loan, for all real property you have to show the full breakdown for each property you own. When I first wrote this, you could state your overall income in most cases, and most folks with investment property had to do stated income due to the cash flow computations being so restrictive, but with the disappearance of stated income loans this option no longer exists. Most folks are probably going to have to incorporate and apply for cross-collateralized commercial loans - requiring higher interest rates and still more equity - in order get loans for investment property.

In urban California, however, prices had gotten so high that I did not remember (when I originally wrote this) the last time I saw a single family residence being purchased for rental purposes that "penciled out" with a positive cash flow. As I said in my article Cold Hard Numbers, this is one of the things that convinced me California real estate was overvalued. The penciling out part has now changed. Rents are up and prices are down, and due to all of the pressures placed on landlords by the changing loan rules for investment property, expect rents to continue to climb. I'm in escrow with some folks buying a better house than they're renting right now, and their monthly cash flow requirement is still going to go down, even before the effects of income taxes and all those lovely deductions for mortgage interest and property taxes.

(Got some spare cash lying around? Condominiums are wonderful investments at current price levels in my neck of the woods)

Now, as long as you have the cash flow to last until rents catch up, this is fine. But you need to be very certain that you do have that cash flow. When I originally wrote this, if you were buying for $360,000, that was a first loan at about 6.75 percent right now of $288,000, which gives a payment of $1868 (rates are lower now). Additionally, there's going to be Homeowner's Association dues of probably about $200, and taxes (assuming no Mello Roos) are about $375 per month, or about $200 if you can keep your aunt's tax basis. That sums to $2443 or $2268 if you can keep her tax basis. Now ask yourself how much similar units are renting for? If it's less than $2050 (or $1875 if you can keep the tax basis), your $400 per month isn't going to make up the difference. You might consider a negative amortization loan in this circumstance, but be advised that you're eating up your investment every month, the real interest rate is actually higher than the 6.75 percent, and prices may go down and not recover for several years, leaving you holding the bag for a big loss. It's a risk some folks are willing to take, others are not. I'm willing to do them for people in this situation, but only after I explain all the pitfalls (Option ARM and Pick a Pay - Negative Amortization Loansand Negative Amortization Loans - More Unfortunate Details cover most of them). Usually people who have been informed of the pitfalls decide that these loans are not for them, which is one of the reasons why I question whether the risks have been adequately explained to the forty percent of all local purchases being financed by these. (At this update: Anyone still have any doubts on that?)

Indeed, given the fact that you're going to have to make payments on the Home Equity Line of Credit as well, it's difficult to see how your $400 per month of extra cash flow is going to stretch to cover. If your credit is decent, I could have gotten you into the property, but that's not exactly doing you a favor if you find it impossible to make the payments.

Caveat Emptor

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2 Comments

Kyle Hoak said:

Hi-
Thanks for posting this, nicely written. As a newer agent my thirst for informative content like this is pretty high.

One question, if a prospective investment property decided to place their newly purchased property on a vacation rental pool in a resort area, might they receive a credit for that from a lender?

Best Regards,

Kyle

Dan Melson Author Profile Page said:

If the pool can document a certain level of occupancy, they'll like get some credit for it. Most resort areas have a "season" where they are popular, and they sit unused for the balance of the year.

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About this Entry

This page contains a single entry by Dan Melson published on December 4, 2019 7:00 AM.

Second Trust Deeds: Home Equity Loans and Home Equity Lines of Credit was the previous entry in this blog.

If The Underwriter Makes A Mistake is the next entry in this blog.

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