What we learned about lending for real estate – Part 2 of 3
This is part 2 out of 3 of a longer article, “What we learned about lending for real estate”. We explore some often used loan products for financing real estate purchases. For this part, we’ll talk about the different criteria in loan parameters in comparing loan products.
Loan parameters
I’m making a quick detour here to discuss the loan parameters that come to mind, since it is important to be aware of them to be able to handle portfolio loan negotiation. You will see that there are plenty of criteria, and all of them are crucial for the success of your loan shopping adventure and ultimately to your real estate purchase. They also make loan comparisons nontrivial.
Although people usually focus on the loan’s stated interest rate, there are quite a few loan parameters that should be taken into account when comparing loan products. When discussing lending options with lenders, you will do good for yourself if you ask about all of the parameters below.
What I have experienced way too many times is, the lender sales representative will try to sell you on their loan product by touting only the loan parameters that present their product in the favorable light. For example, they will show you a low interest rate relative to competition, but not tell you their upfront fees are sometimes much higher. They are banking on hooking you in with the favorable loan parameters. And once you start your loan process, you will be less likely to back out even if you find out that other terms are less than ideal. So they are incentivized to lie to you by omission to get you on the hook. If you make sure that you clarify all the points below, you will be in a much better position to decide between loan products, compared to if you don’t do this.
Determine the following loan parameters:
Whether the lender has open membership or not.
This might be the most important first question to ask if talking to lenders that are credit unions. Some credit unions require you to be a member to obtain a loan from them. But they may also limit who may become a member. For example, some credit unions are only open to active or former military personnel and their families. When talking to a credit union, ask this question first to avoid going through a lengthy application process only to learn, late in the process, that you are not eligible to be financed because you are not a member, and are not eligible to become a member because you are not the target demographic.
Whether the lender finances your type of project.
Not all lenders will finance every type of project. Some lenders will only finance single family homes. Or residentials. Some will not write long term debt. Some will not fund rehabs. Some can not close in the name of an LLC. Some (paradoxically) will not close in personal names. The criteria vary based on the lender’s business goals. Save yourself time by asking your lender early if your project is compatible with their lending criteria.
If you are an out-of-state investor, whether the lender will finance you.
Some lenders will only finance local borrowers. If you are an investor from across the country, you may be out of luck.
Whether the lender operates in the state your property is in.
If the lender is not in the state where your property is located, you must ensure that they are licensed to finance you where your property is.
If refinancing, how soon after the purchase may the refinance process start.
Some lenders require the property to be “seasoned”, and will not consider it for a refinance until 6 to 12 months pass since the property was bought.
Time to close.
This is worth asking early, too. Some banks may offer very favorable interest rates (below) or very cheap origination fees (below). But if their origination process is too long for your intended closing timeline, none of those other favorable terms matter: this lender is simply not compatible with your acquisition timeline. If, for example, your contract promises to close in 30 days, but your lender is only able to close in 60 days, you would be jeopardizing your purchase contract by going with this lender. They may take more time than the seller is willing to wait for you to line up your financing. Too bad. More often than not the time to close is one of the more important parameters you want to ask about, which is why it also appears very early in the list. And sadly, while big banks often offer the best loan rates, they have an abysmal record in the ability to close quickly. This becomes an important trade-off for an investor deal, where time is often of the essence.
Interest rate, or the annual percentage yield (APY).
This is the amount, expressed in annualized percentage of the total amount of debt, paid to the lender. What this figure means depends on whether the loan is straight or not.
- In a straight loan, the amount paid to the lender in interest is a fixed percentage of the remaining loan amount. For example, if you borrow $100,000 at 10% APY, you can expect to pay 10% of the remaining loan amount each year in interest. Thus, in the first year, you will pay $10,000 (10% of $100k) in interest.
- Otherwise, for an amortized loan, there is a period at which interest accrues. The period is usually a day. Which means that on an amount of $100,000 loaned at %10 APY, each day the loan is outstanding the amount of your debt will be increased by (10%/360). The 10% is the APY figure, and 360 is usually the number of days accounted for per year, for simplicity. Different lenders will have different, sometimes more precise standards.
Whether rate buy-down is possible or not.
Most lenders have this option. Lenders will allow you to bring the interest rate down by paying more in fees upfront. Usually you can pay a fraction of a loan point to bring the loan down by a certain fraction of a percentage point. This makes a trade off between up-front loan cost and the amount paid during the lifetime of the loan. Depending on your business plan, either the original or the bought-down interest rate may make sense to you. This depends on the “break even” point: honest lenders will let you know after how long does it pay more to use the “original” interest rate, vs. the bought-down interest rate.
Whether cash flow reserves or liquidity is required.
Some lenders will lend to you only if you show that you have enough liquidity to cover debt payments for a certain length of time (typically 6 to 12 months). They may require you to have a certain minimum net worth, relative to the size of your loan.
What the required maximum debt-to-income (DTI) ratio is.
This check ensures that you are not too much in debt so as to be a high risk for default. Conventional loans typically have DTI limits on a monthly basis. Your monthly gross income needs to be a certain amount larger than your debt service. Lenders will compute both the front-end (before the loan) and the back-end (after the loan) DTIs to qualify you. Lenders will differ in their method of calculating the DTI. Some will, for example, disregard your passive income. Others will weigh it with a less-than-100% weight, depending on the source. Others will count it at its 100% face amount.
Whether there is a debt service coverage ratio (DSCR) limit.
Some lenders typically require that the property brings in more in net operating income than the amount of yearly debt service.
Loan cost.
Expressed in “points”, i.e. percent of the total loan amount paid as a fee to the loan originator, upfront. This is what you pay your lender for the convenience of getting a lump sum of money from them.
3rd party fees.
These are fees paid to third parties involved in making the loan happen, such as appraisers and surveyors. These fees are usually fixed dollar amounts.
Annual percentage rate, APR.
This is the cost of the loan to you, expressed as a percentage of the full loan amount during the first year of the loan. This is a convenient figure to compare two loans against each other. For example, let us suppose that you are quoted a $100,000 loan at a 5% APY, with 1 point and $1000 in fixed 3rd party fees. In the first year of the lifetime of the loan you will be paying 10% x $100,000, or $10,000 in interest. You will also have paid 1% of $100,000, which is $1000 in loan origination. You will also be paying $1000 in fixed fees. The total amount paid over the first year of the loan is $10,000+$1000+$1000=$12,000. As this equals to 12% of the original loan amount, we say that the APR of this loan is 12%. This figure allows you to compare two loan offerings quickly, taking into account all the money that will leave your pocket for repaying that loan over the 1st year of the loan’s lifetime. Of course, the APR is just a quick comparison, and sometimes it will be more favorable to you to front-load the loan cost, and sometimes it is more favorable to you to spread the cost around.
Whether the loan has an interest-only period.
Some lenders will allow you to pay only the interest on the loan. Other loans will require you to pay the interest, plus some amount of the principal, with the intention that over time your debt goes down.
Whether property taxes and insurance amounts are escrowed.
This means, whether you are required to pay a 1/12th of each year’s amount of property taxes and insurance to an escrow account from where it is then paid out to the tax authorities and insurers.
What the loan term and maturity are.
These are usually expressed in months. The term is a period of time over which payments of the loan are calculated. Conventional loans are usually fully amortized, with the loan term and maturity matching.
You would take out a 30 year loan, with a 30 year maturity for example – this means that your payments are divided into 30 x 12 monthly payments, all equal. There exist other loan products for example, a 30 year loan with a 10 year maturity – this means that while there are 10 x 12 monthly payments to be made to the lender, the amount of those monthly payments are computed as if there would be 30 x 12 such payments. This in turn means that after 10 years, the full loan amount is not repaid. A lump sum or a balloon payment is due to the lender for the remaining amount of the loan.
Whether the loan is fully amortized, or has a balloon payment.
A fully amortized loan is expected to be fully repaid once its term and maturity expire. If a loan has a balloon payment, it means that once the loan reaches maturity, a certain lump sum of money is expected to be paid to the lender.
Whether the loan has a prepayment penalty or not.
Some lenders will charge you an additional fee if you decide to pay the loan off early. This is a way for the lenders to ensure that they achieve a set amount of profit on lending the money to you. Some loan programs are not allowed to have prepayment penalties, such as FHA loans. Other loans have a prepayment penalty based on the net present value of the amount of interest that was projected to be received from you over the remainder of the lifetime of the loan. Others have fixed percentages of prepayment penalty depending on the timeline of loan repayment. For example, “3-2-1” prepayment penalty requires 3% of prepayment penalty if repaid during year 1, 2% if repaid in year 2, 1% if repaid in year 3, and 0% thereafter.
The main goal for the lender here is to ensure that the projected profit on the loan is collected from you. As the loan math works out, most of the interest on a loan, even a very long term one, is collected in the first years of the lifetime of the loan. This is why repaying the loan in the early years is usually seen as a big deal from the lender’s end, since that reduces the profit that the lender expected to get.
Whether you can close the loan in the name of an LLC or not.
Some loans, such as conventional loans, must be closed in the names of natural persons. Other loans require the borrower to be a company. This is important for example in case of 1031 exchanges, where you may be required to close in a very particular name or set of names to uphold 1031 exchange rules.
For example, if your company is doing the 1031 exchange, it is of paramount importance that the loan you take out be in the name of the company. Conventional loans are therefore not an option for financing your 1031 replacement property purchase. While the FNMA selling guide only allows natural persons to be on the property title, 1031 rules require your company to be on the title, making the conventional loan incompatible with 1031 company-bound exchanges.
Whether the loan requires personal guarantees or not.
Most loans for real estate require some form of a personal guarantee. This is a promise, from the borrower, to the lender, that if the borrower is unable to repay the loan, they will liquidate their personal property to repay the loan. It is of course required that the guarantor pledges some of their personal assets to this end. States usually regulate to what extent the lender can go after the guarantor’s personal possessions, so while personal guarantees seem like a big deal, they aren’t as much as it initially seems.
Whether the loan is recourse or non-recourse.
Non-recourse loans allow the lender to repossess the property collateral in case the borrower is unable to repay the loan, but may not go after the guarantor’s personal assets if the liquidation of the property ends up not yielding enough money to cover the entire debt amount. Recourse loans allow the lenders to go after other assets in case of a deficiency (shortfall) after foreclosure, but the extent to which this is possible is regulated by each state. Some states are recourse states, allowing the lenders to go after personal assets. Others, like California are single recourse states, which means the lender needs to choose a single asset to go after in case of a deficiency. California also affords some protection for primary residences, sheltering up to $150,000 of primary residence from foreclosure. Finally there are non-recourse states, where this sort of recourse is not allowed at all.
Whether the loan is assumable or not.
i.e. whether the loan can be transferred to a different person or entity, other than the one that originally borrowed the money. Some loans, such as conventional loans are not assumable by definition. Other loans may be assumable, with or without defeasance, which is the amount payable to the lender for the privilege of assuming the loan.
Maximum loan-to-value.
Which is the percent of the purchase amount that the lender is willing to finance. For example, LTV of 60% means that the lender is willing to finance 60% of the purchase price.
Whether renovation cost can be financed.
i.e. added on top of the purchase price. Such loans are usually about loan-to-cost or LTC (rather than loan-to-value or LTV), which is the percentage of the total project cost (purchase plus renovation) that will be financed with a loan. These loan products are geared towards rehabbers, allowing them to renovate the property mostly on lender’s dime. This sort of a loan assumes that the total project cost is a relatively small fraction (up to say 70%) of the property’s after repair value (ARV), so it isn’t suitable for a turnkey property or one that is very nearly so. The lender will use past experience to evaluate the borrower’s ability to pull the renovation off. As you may expect, this means that more experienced rehabbers get better loan terms. Don’t forget that rehab loans are usually completely separate loan products – this is not typically an add-on to a different loan program.
What are borrower credit score limits.
Lenders will most of the time set credit score limits for borrowers or guarantors. Better credit scores get better loan terms. This is done on the assumption that credit scores are good predictors of the likelihood of loan default for a given borrower. While that assumption–sadly–has not received enough scrutiny to be regarded as scientific, it is the reality of the USA lending landscape today, and we as borrowers must wrestle with it.
Reserve requirements.
Some loans will require that you have a certain liquid reserve (cash or cash equivalents) before, and after taking out a loan. Typically larger loan amounts will require liquidity in the amount of 6 to 12 months of the amount of debt service, and a net worth of about the full amount of the loan.
Is the loan compatible with your entity structure?
Some lenders will not lend to LLCs, or LLCs owned by other companies, or LLCs ultimately owned by trusts, and other common asset-protection arrangements. Make sure to know the lender’s position on this early of time to avoid closing delays or fall-throughs. Where this comes back to bite you if you don’t check for it, is when the lender starts inquiring about the ownership structure of the entity that will hold the title to property. This is a normal part of the lender’s loan underwriting process and can’t be skipped. However, since the underwriting can take a long time, you can save yourself a lot of work upfront and save a lot of precious closing time if you ensure that your deal structure is compatible with the intended loan.
Other limits.
My colleague Bo notes that lenders limit the amount of credit that a seller may give to the buyer in a transaction, say to 2% of the loan amount. We speculated that this is to prevent a situation where a loan becomes effectively a cash gift to the buyer, at lender’s expense. While this is an interesting limitation to ponder, it was never a factor in any of our transactions.
Check out the other parts of this series in our blog:
