Denise L. Evans' Real Estate Advice
New Mortgage Clauses Re: End of World; Death
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I belong to a listserv that covers real estate issues. There are some pretty lively discussions, but many of the topics are technical and dry. This morning there was some fun waiting in my “inbox” and I wanted to share it with you.
The writer said he found the following mortgage clauses in a PBI coursebook. I’m willing to be bet if we read our Bank of America or Regions Bank mortgages all the way to the end, we might find similar language:
“35. Death. Upon the death of any individual Borrower, the lien of this Instrument will extend to, and include, any cemetery plot, crypt, or other place of final interment of such deceased Borrower, together with any and all rents, issues, incomes and profits arising therefrom, and any and all renewals, replacements, accessions, improvements, and substitutions thereof and therefor, and a prior perfected security interest in and to any and all effects, articles of personal adornment, gold fillings and caps, and other things of value severed or capable of severance without material injury or desecration to the corpse of the deceased Borrower. The foregoing lien and security interest may be enforced and realized upon by any lawful procedure and will continue until the first to occur of the following: (i) full payment of the Indebtedness, or (ii) Lender is furnished with substitute collateral of equal or better class, quality, usefulness and value of the deceased Borrower.
36. End of the World. Upon the occurrence of the end of the world before full and final payment of the Indebtedness, at Lender’s option, the unpaid principal balance of the Indebtedness and all accrued and unpaid interest, fees, and prepayment or yield maintenance charges thereon shall become immediately due and payable in full, and the obligation to repay the same, with or without demand my be enforced by Lender by any available procedure. For such remedial purposes, Lender will be deemed aligned with the forces of light, and Borrower with the forces of darkness, regardless of the parties’ actual ultimate destinations, unless and until Lender elects otherwise in writing. Notwithstanding anything contained herein to the contrary, Borrower shall have a period not to exceed seven (7) days in which to effectuate a cure; provided however, that Borrower shall perform no servile work on either the first (1st) or seventh (7th) day of such period, as Borrower shall in good faith elect.”
Maybe you blog readers interested in Seller Financing issues might want to add these clauses to your mortgages 
No, don’t take me seriously!!
How to Finance Investments: Part Three
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You can still obtain financing based on future appraised value rather than current appraised value. Part Three of “How to Finance Investments” will focus on creating an accurate estimate of the current and future value of the real estate. As a result, you will be able to determine if you are paying a fair price, how the lender will evaluate your purchase price, and estimate the probability of obtaining a loan.
For income producing real estate, valuation is often tied to the Net Operating Income (NOI) and the Capitalization Rate (cap rate).
NOI is always calculated on an annual basis rather than a monthly basis. It gives people a more accurate picture of fluctuating revenues and expenses, and expenses like insurance and taxes that might come up only once a year.
Net Operating Income might be based on past performance or on future performance. If based on future performance, it is called “Pro Forma NOI.” The Net Operating Income is the bottom line after you take all operating revenues (rents, laundry fees, forfeited security deposits, late fees, etc.) and subtract all operating expenses (taxes, insurance, utilities, maintenance and repair, management fee, collection costs, etc.)
Some things are not considered expenses for purposes of the NOI calculation. Neither the principal, nor the interest, on a mortgage are NOI expenses. Yes, the interest is an expense for income tax purposes, but nothing about the mortgage payment is an expense for NOI purposes. Marketing and advertising and leasing commissions are not considered NOI expenses. The salary you pay yourself or your relatives is not an NOI expense unless you would have to pay a third party to do what you do. In addition, only the portion that you would have to pay a third party is a legitimate NOI expense.
Why are those points important? Many times people buy income producing property from unsophisticated sellers. The seller will often base their asking price on the “income” from the property. On several occasions in the past, I represented buyers in such situations. The seller included his own salary, his wife’s leased car, his own health insurance, and his mortgage interest, as NOI expenses. It meant that his “expenses” were much higher than they should have been for NOI purposes, and therefore his “income” was much lower than it should have been.
Many times, pro forma NOI paints a more accurate picture of the property. If the property has been vacant, or leased at below-market rates, your revenue is going to be more than the former owner’s revenue. Any lender will be repaid from the revenue YOU generate, not the revenue the former owner generated.
Don’t be afraid of pro forma NOI. Many people think “pro forma” means “I wish upon a star…” That’s not true. If you make reasonable projections about future revenue and expenses, you will be considered a sophisticated and respectable investor rather than an amateur.
Once you establish an NOI, the next step is the cap rate. In its most simplistic terms, a cap rate the “interest rate” you would like to earn on the purchase price for the property. For purposes of this analysis, you assume that you will pay all cash for the property.
If the purchase price is $100,000 and the NOI is (or will be) $9,000, then you divide the NOI by the purchase price ($9,000/$100,000 = 0.09) to arrive at the “cap rate.” In our example, the cap rate of “0.09″ is a 9% cap rate. Using the “interest rate” comparison, if you invested $100,000 in a CD and earned $9,000 in the first year, your interest rate would be 9%.
When deciding whether to purchase a property or not, ask lenders and other investors what the current cap rates are for similar properties. Cap rates are not published anyplace. They are not set by anyone. It’s just what things work out to be in the market place based on what people are paying to buy property, and what that property’s NOI is.
Different types of properties might have different cap rates. A shabby run down rental house in a bad school district might have a cap rate of 12%. In other words, before anyone will buy that property, they will want to make sure they make a really good 12% return on their money if you assumed a cash purchase. A modest brick three-bedroom, two- bathroom house within walking distance of a great elementary school might have a cap rate of only 9%. In other words, an investor might pay a higher price for that property, compared to its NOI, because he or she would know that the property will be low maintenance and probably have very low tenant turnover. When the investor decides to sell, it will always be able to sell to another investor OR a homeowner. The shabby property might have only another investor as a potential buyer, so there would not be as much competition to drive the sales price upward.
Once you understand all of this, you can ask any potential lender about another underwriting requirement. Technically, this one is related to the appraised value of the property, which is legally supposed to be out of the hands of the lender. But, lenders look at a lot of appraisals, and have a good sense of prevailing cap rates for different types of properties.
Suppose the lender says, “We’re seeing cap rates of 9% for 3BR, 2-BA brick rental houses with little or no deferred maintenance (repairs that need to be made).” Warning: Buyers might be buying such properties on an 8% cap rate, but bank appraisers might be appraising based on a 9% cap rate. At least, that’s been my experience.
♦ In case this is starting to get mysterious to you, a lower cap rate means a higher value. Let’s suppose the NOI on two different properties is $9,000. Property One is shabby and run down and has a high cap rate of 12%. In other words, whatever the purchase price on that property, $9,000 must be 12% of the purchase price. When you do the math, it works out to $75,000. If you buy the property for $75,000 and have $9,000 of NOI, then your cap rate will be 12%. But, the other property is the brick home in the good school district. That cap rate might be 9%. The NOI of $9,000 will be 9% of the purchase price. Based on that, the purchase price will be $100,000. If two properties have the same NOI, the one with the lower cap rate will appraise for the higher value.
Once you understand these concepts, you can greatly improve the odds of getting financing for your purchase. You can look for properties that will appraise high (but can be purchased low) or you can control the pro forma NOI to increase the likelihood of financing. In other words:
- By examining the seller’s financial information and “recasting” it into the NOI format, you might be able to exclude expenses that the seller is listing for income tax purposes, not realizing those expense depress the market price.
- By knowing the current cap rates for similar properties, and the NOI, you can evaluate right away whether the lender will appraise the property for a value high enough to support your loan request.
- In your pro forma NOI, you can increase revenues by raising rents, or decrease expenses in some areas, and increase the NOI. That automatically increases the value.
- In your loan request, you can include expenditures that will not only increase rental revenues through higher rents, but will also decrease the cap rate because the property will be in a different “category.” In other words, the appraiser might use a well-maintained property cap rate instead of a shabby run down property cap rate.
I know this is a lot of information for many of you. But, once someone explains it and you understand the importance of these things, you are no longer gambling when you make a loan request. You pretty much know if the property will appraise high enough to support your loan request. Also, once you understand the basic NOI and cap rate concepts, they stay lodged in your brain forever. A little bit of learning now pays off huge dividends in the future!
Further, you should now understand the importance of creating a pro forma NOI spreadsheet and providing it to any lender. To repeat, it can support a higher appraised value, AND it signals you are no amateur! In lending, as in most of life, perception is the same as reality. If you are perceived as a sophisticated investor, you will be treated like a sophisticated investor. Only good things will come from that!
How to Finance Investments: Part Two
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Much of lending makes sense if you think about your relationship with your teenage children. Suppose your 16-year old wants you to buy a car for him. It will cost $2,000. He will pay you back at the rate of $150 a month, using money generated from his lawn care business. It’s May, and business is good. You are motivated to make the loan because it is a learning experience for him, and because you are REALLY tired of ferrying him and his equipment.
You know that with his own car he’ll be able to take on more customers, and will make more money. You are confident he’ll make enough money to pay you each month, save some for college, and have some spending money. Everybody is happy. Then you say,
“How will you make your payments in November, when no one cuts their grass, everyone is spending their money getting ready for Thanksgiving and Christmas, and money is tight all the way around?”
Your son says, “Don’t worry, I’ll get my customers to pay me to put up their Christmas decorations and then take them down.”
You say, “Good thinking. What about February?”
Your son says, “Something will come up. Don’t worry. It will be okay.”
You say, “Wrong answer!”
That exchange pretty much describes the issue in Part Two.
Besides Debt Service Coverage Ratio (DSCR, described in prior post), lenders want to know how you will make the mortgage payments if the property is vacant for several months. It would be nice if someone just came out and asked you this question, but they often don’t. No, someone in underwriting will review your paperwork, feed the numbers into their computer model, and read the answer that pops out. Even when a real live human being makes the decision to loan you money or not, that real live human being is a bean counter in underwriting.
My husband can count the beans in a 40-acre field, so I’m not trashing the breed. BUT, many of them have no communication skills and no contact with the public. The following conversation almost never takes place:
BC (Bean Counter): According to the Borrower’s financial statement, she has liquid assets consisting of a CD of $5,000. That’s enough money to pay the mortgage payment if the property were vacant for five months. We require six months worth of mortgage payment coverage payments in liquid assets. I’m sorry, we’re turning down this loan.”
LO (Loan Officer): “What if the Borrower agreed to buy another CD for $1,000, giving her $6,000 in liquid assets and the ability to cover the mortgage for six months if the property were vacant?”
BC: “That won’t work, because we need to see that they’ve had those liquid assets for at least six months. That indicates it’s truly a “savings account” for emergencies. If the money has been set aside for just a short period of time, it’s more likely the borrower will have it today, spend it tomorrow, and then we don’t have a vacancy cushion any more.”
LO: “What if the Borrower had a total of $6,000 in CDs AND she gave us a security interest in the CDs? That would make it impossible for her to spend the money without our permission, and we’d be protected. Would that work?”
BC: “Sure! Why didn’t she just offer to do that at the beginning?”
LO: “Because neither one of us knew your rules, that’s why! You just say, ‘Approved’ or ‘Denied’ and you never tell us the reason.”
The point of this comment is: Ask any loan officer about the underwriting requirements for the ability to make mortgage payments even if a rental property is vacant. They all have different rules. One lender might approve your loan and another one might turn you down. Minor differences in your financial statement could make a difference in whether you get approved or not.
Some lenders evaluating a small investor will view total family income when deciding if the potential borrower can make mortgage payments even when a property is un-rented. Do you have “day job” that covers all your normal living expenses plus a certain percentage more for investment cash flow problems? (What percentage? Every lender is different.)
- Knowing this, you might be much more careful when completing the income and expense form on a loan application. Don’t estimate numbers, get REAL numbers. Minor changes in your monthly expenses could make the difference between loan approval or a turn-down.
Sometimes, if your DSCR is large enough, that’s sufficient.
Sometimes, you need liquid assets, and the lender might want to hold some or all of your liquid assets as additional collateral. If they do have such a requirement, ask if the security interest can be released after a certain period of time. For example, “If I make every mortgage payment on time for 24 months, will you release my additional collateral?” “Yes, we can agree to that.” “Thank you. Please include that in the ‘Additional Provisions’ section of my promissory note and the security agreement.”
How much of a “cushion” will you need? As usual, every lender is different, and the answer could change depending on the type and size of loan. You must ask questions when interviewing potential lenders. If the loan officer does not know, ask them to inquire of the people in underwriting.
Remember, obtaining a loan is a two-way conversation. Obtain as much information as possible ahead of time, and engage in possibility thinking if your loan is turned down. A “no” from underwriting doesn’t mean you are a bad person. It means you don’t meet one or more of the underwriting requirements. Ask what those requirements are, and see if you can meet them with a little extra work.
How to Finance Investments: Part 1
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There’s a lot to say on this subject. I’ll break it down into little pieces and separate Posts.
For this post, I’ll cover one of the first things lenders look at—Debt Coverage Ratio, also called DCR. Some lenders call it the DSCR—Debt Service Coverage Ratio. It is a comparison between the anticipated mortgage payments and some of the cash flows from the investment. Usually a lender wants a DCR of 120% to 125%
You should interview potential lenders before making a loan request. Ask about their underwriting requirements. The DCR is an underwriting requirement. Each lender has specific rules about their requirements for the type of property you want to buy and finance.
I’m going to explain how you can calculate the DCR yourself to see if you will meet a potential lender’s requirements. Remember, just because one lender won’t finance you doesn’t mean NO lender will finance you. They all have different rules. Also, once you know how things work, you can “tweak” your numbers to fit into a lender’s guidelines. There is nothing illegal or unethical about this. I explain how you do it, at the end of this Post.
To find the DCR, you start by taking the gross rents you would collect from the property for a year if it were rented 100% of the time at market rents. Let’s suppose that’s $800 a month for 12 months, or $9,600 “gross scheduled rent.”
Then you subtract 5% to 10% of that number (depending on the lender) for a vacancy and concessions factor. Concessions means renting the property for less than full market rent, because that’s what you had to do to get a tenant in. Maybe it’s cheaper rent, maybe it’s two weeks free, etc. Let’s use 10%. That gets us down to $8,640. When interviewing potential lenders, ask them what they use as a percentage for vacancy and concessions on your type of property. They know the percentage, they just don’t volunteer it in a conversation.
Next subtract all the anticipated operating expenses for the property. That will include real estate taxes and insurance. It could include lawn care and maintenance. A larger property might have office staff, maintenance people, etc. Even if you maintain your own rental properties, you’ll need to buy supplies and parts, and some work might require a third party. Some lenders require you to include a property management fee as an expense, even if you self-manage.
♦ When shopping for a lender, ask them about whether they impute a property management fee even if you self-manage. It might be harder to obtain a loan from a lender that says they will evaluate your numbers using higher expenses than you will really have.
After subtracting all those expenses, the number that is left is called Net Operating Income, or NOI.
Technically, advertising expenses and leasing commissions are not subtracted out to reach the number that commercial real estate brokers call NOI. But, some lenders subtract those numbers anyway. This is something else to ask a potential lender.
Some lenders will also require you to include an expense called “replacement reserves.” That is money set aside each year so you can save up enough money for big expenses like a new roof or replacing the appliances. This, also, is an underwriting requirement. Some lenders require it in the financial analysis, some do not. Find out which is which!
The NOI is what is left over that you can use to make your mortgage payments. Hopefully some of that will be money you get to keep, also. Let’s suppose in our example that all those expenses add up to another $1,500 per year. That leaves us $7,140 in NOI.
|
All numbers are calculated using annual basis |
|
| Annual Rent ($800/month) |
9,600 |
| Less Vacancy & Concession of 10% |
(760) |
| Equals Gross Effective Rent |
8,640 |
| Less Operating Expenses |
(1,500) |
| Equals Net Operating Income |
7,140 |
The lender will want to see that $7,140 per year is 120% or 125% of the annual mortgage payments, depending on their underwriting requirements. In other words, they want your Net Operating Income to be 20% or even 25% more than your annual mortgage payments.
Let’s suppose our lender has a required DCR of 120% If that’s the case, then you can have annual mortgage payments of up to $5,950, or $495.83 per month. In other words, if your NOI is $7,140, and your mortgage payments are $5,950, then your NOI is 20% more than you need to pay the mortgage.
|
All numbers are calculated using annual basis |
|
| Annual Rent ($800/month) |
9,600 |
| Less Vacancy & Concession of 10% |
(760) |
| Equals Gross Effective Rent |
8,640 |
| Less Operating Expenses |
(1,500) |
| Equals Net Operating Income |
7,140 |
| Lender’s Required DCR |
120% |
| Convert DCR to a decimal |
1.2 |
| Divide NOI by DCR |
7,140 / 1.2 = 5,950 |
| The answer is the maximum annual mortgage payment you can have–$5,950 | |
That leaves you a cushion of $1,190 per year.
♦ By the way, if your property will support mortgage payments of $5,950 a year, then that’s a mortgage of around $76,000 if the interest rate is 6% and the term is 25 years.
Now that you understand how this works, you can use it to get loans approved. Suppose a particular lender requires a DCR of 120% but you need to borrow $85,000 rather than just $76,000. This is how you analyze the loan requirements:
| Loan Needed |
85,000 |
| Annual pmts with 6% interest and 25 yr term |
6,572 |
| Required DCR |
120% |
| 6,572 / 1.2 = Required NOI |
7,886 |
| Actual NOI in example |
7,140 |
| NOI must increase to support the loan |
746 |
| How can we reduce the annual mortgage payments, and/or increase rent and/or reduce expenses to fit within the lender’s requirements? | |
In other words, play with your numbers after you find out the underwriting requirements and before you make a loan application. You’ll find a lot more of your deals getting approved.
Next Post: What lenders want to see as far as your ability to make mortgage payments even if the property is vacant. The lender views the DCR cushion as money available for unforeseen expenses. Unless you have a very large DCR (140% or more), the cushion is not viewed as money available to pay the mortgage even if the property is vacant.
You tell me. Did you already know this, or is this new information and you want more of the same kinds of stuff?
Tags: DCR, DSCR, financing real estate, NOI, real estate investing
Title Insurance for “Subject To” Transactions
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There’s been a lot of comment activity for my prior post about buying a property “subject to” a mortgage. One recurring issue involves clear title. I just checked with Dwight Blair, of Blair and Parsons in Pell City. They write a lot of title insurance. I’ve known Dwight and his law partner, Elizabeth Parsons, for a long time, and trust their opinions.
Dwight said that as a general matter, his firm would not have any problems writing title insurance on a “subject to” transaction. He did warn that specifics of a particular deal might cause a problem, though. He couldn’t think of any examples, off-hand, but he said it is difficult to make a general rule that applies to everything when you are talking about title insurance.
Dwight suggested that if you are considering buying property “subject to” a mortgage, please contact a title company in your county before signing any contracts. Discuss your plans with the attorney in the office, not with one of the regular closing people. That’s because “subject to” transactions are still unusual, and probably outside the training and experience of the typical closing person. If you talked to one of the regular closing people, they’d just have to take good notes, talk to the attorney, and then get back with you. I think it’s best to cut out the middle man (or woman) don’t you?
You want to talk to the attorney to make sure they will be able to write title insurance for you, and to discover any concerns that might need to be handled in the contract itself. If a particular title company says they can’t write title insurance for any “subject to” transactions, then try another title company.
As always, thank you everyone for your thought-provoking comments, and for sharing your knowledge and experiences.
Buy Property “Subject To” Mortgage
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Here’s the best-kept secret of the last thirty years: You CAN buy investment real estate with no money down and no credit. The secret comes from understanding WHY mortgages contain “due on sale” clauses and WHEN lenders won’t enforce them.
Before 1980 or so, it was common for people to sell their property, and the new owner would just take over the mortgage payments. The seller either received cash for their equity, or took back part of the financing with something called a “wrap around mortgage.” Everything was fine until the federal government de-regulated the maximum interest rates that could be paid on savings accounts and CDs.
Typically, savings and loans originated mortgages and kept them until paid in full. S&Ls received interest income from the loans, and they paid interest on savings accounts. If competition forced them to pay 12% interest on savings, they’d get killed if assumable mortgages continued to earn only 6%. To solve the problem, lenders added due on sale clauses to mortgages. With such a clause, lenders were able to demand payment in full whenever a property was sold. It became virtually impossible to buy a property “subject to” an existing mortgage.
Fast forward to today. In this environment, do lenders WANT to “call” a mortgage loan and force default, foreclosure, write-offs? Of course not. If a property owner could not make his or her payments, would you be a HERO if you bought the property and started making the payments? Of course you would!
The due on sale clause is not usually automatic. The lender has the right to call the note. They don’t have to, if they don’t want to.
You should target properties advertised as “possible short sale” or similar words. Sign a purchase contract that includes a contingency for lender forbearance from exercising the due on sale clause AND an agreement to tack past due payments onto the end of the mortgage term.
Explain to the seller that this will be “subject to” and not “assumption.” With an assumption, the lender typically releases the seller from liability on the promissory note, but adds the buyer. With “subject to,” the seller still remains liable on the note and the buyer’s name is not added. In other words, with a “subject to” sale, timely payments by the buyer show up on the seller’s credit report. Past due payments by the buyer will hurt the seller’s credit. If the buyer defaults, the foreclosure will show up on the seller’s credit report. If the lender sues for a deficiency after a foreclosure, it will sue the seller, not the buyer.
In a “subject to” transaction, the buyer is invisible as far as the loan is concerned. Selling property subject to a mortgage requires a great deal of faith and trust, or a great deal of desperation. I think many sellers today are desperate for a chance to preserve their credit, for an opportunity to avoid the humiliation of foreclosure, and for freedom from lender’s collection calls. I think many lenders are desperate to keep performing loans on their books but can’t allow true assumptions because of outdated regulations. It is the perfect time to invest with no money down and no credit.
One last piece of advice: Don’t try to hide this from the lender. Be up front and honest. You both want the same thing: a performing loan. Good luck, and good investing!
