I was young and inexperienced, but I was convinced that I was unstoppable. He had a lot of energy and motivation. The house was in Arvada, a northwestern suburb of Denver, and I bought it for an incredible price. It was part of a package with another house that he planned to keep as a rental. This one didn’t have great rental numbers, but it looked fantastic as a flip, so I bought both houses. I started the rehab on both properties, with a focus on the planned rental; that would be a much easier and faster rehabilitation. That house turned out well. I rehabbed it, rented it and refinanced it. Because I used a hard money loan, I had no money and was producing positive cash flow within six weeks. The Arvada house was a different story. That one also ended up in my rental portfolio, but it was far from planned.
It was after I was done with the first project that I started noticing the shady work in Arvada. There was illegal work everywhere. There was a small addition that was falling out of the house, material used to build that did not belong, leaks that were plugged, and faulty wiring. The budget was spent before it even started, and it did not have the reserves to cover the extreme amount of surplus. I didn’t know what to do, so I went cheap. I did a lipstick job, put the house on the market and crossed my fingers.
I lowered the price and then lowered it again. It got to the point where I couldn’t pay off my loan and pay a real estate agent, so I decided to keep it. To do that, I had to pay off my hard money lender, which means I had to refinance the loan.
This painful experience taught me many important lessons; don’t skimp on finishes, what to look for in a budget, and the pitfalls of refinancing. Lending has changed since then, so I contacted Joe Massey at Castle and Cooke, our preferred lender in Colorado, for help with the issues investors face today when trying to refinance their investment. Here is the list of cheats we discussed:
Worth: It is almost impossible to get an appraisal higher than the last list price. In my case, I kept lowering the price, to the point that it was listed below what it could have been priced for. When I went for the refinance, the appraisal hit the last list price and I was forced to bring cash at closing to seal the deal. Refinance appraisals are based solely on comparable sales (comps) in the area, as there is no other market indication for the appraiser to reference. Additionally, low-quality rehabs are difficult for an appraiser to value, so it is common for low-quality rehabs to have no impact on the appraised value. However, low-quality rehabs have a huge impact on real value. Once there’s exposure to the MLS, which means everyone looking for a home can see it, the appraiser has real market information that they can use to get a more accurate value. Think about it, how can the appraiser justify a higher value than what is listed on the MLS? You better count on the value to hit the lowest list price, or even below.
Another hurdle with MLS exposure is time. This isn’t a huge problem for most, but it’s worth mentioning. The property must be off the MLS for at least one day before you can apply for the loan. Again, not a big deal, but this will create a day or two of delay in the process.
Credit: Credit requirements are a bit more stringent with rental property loans compared to owner-occupied loans. Almost all loans are approved or denied by a computer system, so scores may vary. For example, if you have less than perfect credit but a higher down payment, the computer might approve the loan. In the rare case that the loan is manually underwritten, the rentals credit must be 620 or higher until you reach your fifth rental, at which time you must have a credit score of 720.
Entities: Conventional lenders will not lend to an LLC or corporation; you will need to own the home in your personal name to qualify. Many lenders will not lend you money if at ANY time you owned the property in an entity. Most fix and flippers do business in one entity, so you can see how this can cause you a problem with a refinance. However, all hope is not lost! Because Joe is a direct lender to Fannie Mae, you can finance it while his property is in his entity, but it will require you to move it into his personal name. If you hear a lender tell you that they can’t help you because you own your investment in their LLC or corporation, know that there are lenders like Joe who can.
ITD: You may hear that you can’t finance a rental because your debt-to-income ratio will be low, which means you don’t make enough money to support all your debts. The issue here is often the amount of rent on the new property, and whether you can use it to offset the new mortgage payment. Some lenders will want to see the property on your tax returns to give you credit for income, which is always a loss in the first year you buy a new property and rehab it; therefore making it more difficult to qualify. If you receive this information, call another lender. The guideline here is that you can use 75% of the gross rental amount as income if you have a lease and can show at least one month’s rent collected and the security deposit.
Another problem with DTI is self-employed borrowers. I have written entire articles on this subject, because many self-employed people take as many deductions as possible. When you take a deduction, you reduce your taxable income, so you save on taxes. The problem is that when you reduce your income, you hurt your DTI, making it harder to qualify for loans. It’s not the fact that you’re self-employed that prevents you from getting a loan, it’s the income you report. The guideline here is that you can get a loan when you are self-employed if your income supports the debt. Income is documented with two years of tax returns, unless you’ve been in business for at least five years and have a credit score of 740 or higher, in which case you’ll only need one year of tax returns.
Bookings: As you start to go over budget or have problems with your fix and change, it’s all too common to burn through your reserves to save the deal. This is understandable, but it could create a problem. You must have reserves to qualify for a conventional loan, so it is very important that you have this in place before applying for your refinance. The guideline is a bit confusing and is based on the number of properties you own. The reservation requirement is:
6 Months of mortgage payments on the property in question (PITI) plus…
- 2% of unpaid loan balances on your other rental property loans for 1-4 financed properties
- 4% of unpaid loan balances on your other rental property loans for 5-6 financed properties
- 6% of unpaid loan balances on your other rental property loans for 7-10 financed properties
You do not count the balance of your primary home mortgage in these calculations.
You can use some of your retirement money to meet this requirement, but you’ll also need money in the bank. Check with your lender if you plan to use your retirement money to meet this requirement, and they can tell you what funds should be there at the time of application. If you start to run low on reserves, do what you can to make the house acceptable for an appraisal and then get the loan. Once the loan is in place, go back and fill out anything you need to fill out that will eat up your reserves.
Changes in your situation: Several things can create problems here. If you’re in the middle of the refinancing process, it’s probably best if you don’t get any additional credit or even have your credit taken away. You also don’t want to quit your job, which seems obvious, but I feel the need to mention it.
I wish I had this information when I was working on that house in Arvada, and I wish I had known someone like Joe to help me through the process.