How to Make Hard Money Financing Work- for Landlords

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I love buying foreclosures with cash. Nothing beats the flexibility and certainty.  But financing can also be an incredible leverage tool.

With flipping, borrowing usually works well.  Buy, fix and flip quickly, and you earn easy profits, even with the high costs of a hard money loan.

But what about the buy-and-hold investor?  The landlord looking for steady income?  Should leverage ever be a part of the equation?

I used to think that it was a really bad idea to borrow for buy-and-hold.  But I’ve changed my mind.

When you run the numbers…actually do the math… financing makes a lot of sense for income producing property.  The leverage REALLY helps the returns.

Now… where do you get a loan?  Credit today is tighter than hipster jeans.  And even if you qualify for investor financing, Fannie Mae caps the number of properties you can finance as an investor.

So, for most investors, the only real financing option is hard money or private financing.

That’s usually 12% money (or higher).  So how can you possibly make money on a rental if you are paying loan-shark rates?

Well… the math is actually pretty simple. Hard money works.

It turns out you can STILL make money on your buy-and-hold properties, even if you are borrowing 12% money…actually, you make MORE money than if you paid all cash.

SIDE NOTE: This is GREAT for people with Self Directed IRAs.  You can buy rental properties with leverage.  While banks won’t give you the “non-recourse” loan the IRS requires, a hard money lender is usually happy to lend based on the value of the property– with a large down payment.  And again, the math gives you a much better return on investment.

Now, first you have to accept the difference between Return on Investment (ROI) and Cash Flow.

Because with hard money, you are really going to dent your monthly Cash Flow… but you are going to increase your overall ROI.   This just means you have to look at the long term, not the short term.  Of course, since most buy-and-hold strategies are designed to look at the long term anyway….

In Florida, I can readily find hard money at 12% interest.  Usually, that’s a 50% LTV Hard Money(Loan to Value)… I have to make a 50% down payment, and can borrow the other half.  The hard money lender wants a short amortization schedule… full repayment of all principal and interest in 100 months.  (Or they want a short term balloon, which requires a refinance in a couple years… not a great long term plan.)

Again, 12% sounds like an exorbitant rate and results in a really high monthly payment, right?

So… how can the hard money loan POSSIBLY be better than all cash?

Here’s the simple math:

EXAMPLE:
$100,000 Property
$1,200 Monthly Rent

  • Assume 4-months of rent to pay property manager, taxes, insurance, vacancy and other expenses. (Conservative, but simple). 
  • Ignore depreciation, cost allocation, and other tools that actually make financing even more attractive.
  • Ignore the possibility that rent and property values should go up over time- that’s common to both calculations.

Cash Return on $100k property rented at $1,200/month:
$1,200/month x 8-months = $9,600 / $100,000 invested = 9.6%

Cash Return using 100 month / 12% interest / 50% down payment:
$50,000 Loan: 100-month amortization=$793.29 per month ($9,520 per year)
$1,200/month x 8-mos. = $9,600 – $9,520 loan = $80.00 / $50,000.00 = .0016% 

Ugh… which would you prefer?  A 9.6% return… or a tenth of a percent?

Hold on a minute. 

So far, we just calculated your cash flow as a percentage of the amount invested.  It’s not an accurate picture of your overall ROI.

Because every month, your tenant is helping you pay off the hard money lender. 

On a 100 month amortization, a huge chunk of the monthly payment is reducing the loan principal.  And that reduction is adding to your equity value (independent of any appreciation in rents or the property value).  Here’s what your $50k loan looks like over time:

For the mathematically challenged, this looks like a bunch of gobbledygook.

What it shows is the investor who borrowed hard money (even at an outrageous 12%) makes a little less ROI in the first three years than his “all cash” counterpart.

But then in the 4th year, the return for the leveraged investor passes the All Cash investor… and it steadily gets better.

Over the course of 8 years, all other factors being equal, the Investor with a hard money loan made an average of 11.72%, while the cash investor made a steady 9.6% return.

That means the leveraged investor had a 22% better ROI than his all cash counterpart.

BUT…

The REAL difference is what happens at the end of the loan.

Because the leveraged investor could afford TWO houses with his 100k (two $50k loans with $50 down payments).

So after 8 years, the leveraged investor has two houses, both paying rent, both with fully paid off loans.

And the ROI for the leveraged investor is thereafter DOUBLE that of the cash investor.

Let’s Summarize your choices:

1.  An all cash purchase of a rental home.  Pay $100k, rent it for $1,200 a month, and make a steady 9.6% return on investment after paying all property management, taxes, insurance and maintenance bills.  (Plus the rents and property value hopefully go up over time)

OR

2. Borrow 50% hard money at 12%.  Buy two houses.  Enjoy an average of 22% higher ROI over the first 8 years…. then 100% higher ROI than under the cash option (and still enjoy appreciating rents or property values)

The Moral of the Story?

Even leverage at loan-shark rates can compound the returns for long term, buy-and-hold foreclosure investors!!

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Foreclosure Hazard Stories… #46 and #47

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It doesn’t seem to matter how long you do something… there is always something new to learn.

In the past week we’ve had two “learning experiences” I’d prefer to have skipped.

1. You Need Accurate Info at the Foreclosure Auction

Accurate information is a must.  Everybody knows that.  But we learned today  information can be “accurate” and “misleading” at the same time.

We have a spreadsheet listing every property for each day’s foreclosure auction.  Our list has all the information we think we need to make intelligent decisions… case number, names, address, size, year, type of construction, etc.  This way if the bank offers a deep discount on something we didn’t see, at least we have a fighting chance of deciding whether to bid.

Well, there wasn’t much of interest at this particular sale.  But there was one property where the bank’s maximum bid seemed really cheap.  We were generally familiar with the area, even though we had not seen the particular house.  It was a new house, on a little bit of land, in an area of farms. And it sounded like a great deal.

So we bid on it, won and paid the deposit.  $3k in cash.

Then we drove out to see our new house.  And then we realized our mistake.

Well… the mistake of the person who prepared our spreadsheet.

See, our list said this was a “2034SF/08” house.  That means it is just over two-thousand square feet of living space, built in 2008.  Or, at least, that’s what it is SUPPOSED to mean.

Turns out… this is a 1908 house.  Not a 2008 house.  Hundred years off.  Our spreadsheet was accurate… it was in fact an “08” house… just not “2008”.  That’s extremely accurate and incredibly misleading at the same time.

A 2008 house would have been a no-brainer… easy rehab and flip for top dollar. 

A 1908 was also a no-brainer…. forfeit the deposit.

Any way… lesson learned, right?

2. You Just Can’t Avoid Crazy People.

We bought a great house about a month ago.  The owners had done everything they could to keep the house… filing answers, counterclaims, motions and appeals.  They had even filed a separate federal lawsuit, alleging the foreclosing bank committed fraud.  ALL of this crap had been summarily dismissed.

We had to evict the owners, who still thought the federal lawsuit protected them (even though it was dismissed months earlier).  They were a little nasty about it… telling our agent that he needed to find a better job, wasn’t getting paid enough, and didn’t know what he was talking about.  However, once the Sheriff posted the writ, they moved all their things.  Surprisingly, they even left the house relatively clean.

So we rehabbed (tile, carpet, counters, paint, pool screen, etc) and put the house on the market.  Got a contract right away at our asking price.

Great.  Just the way it is supposed to work.  Everything is perfect.

Then right before closing, the old owners filed a “lis pendens” in the public records.

WTF?

Now, all a lis pendens does is warn people a property is involved in litigation.  This particular lis pendens is complete bullshit… it references the state foreclosure case and the federal case they filed… both of which have been dismissed and appeal times have run.  So the “pending” action it supposedly warns of is non-existent.  And it doesn’t even give the property address, so it doesn’t meet the definition of a lis pendens either.

There is absolutely no merit to their claim, and we will have it resolved within a week.  Luckily, we know exactly what to do, and can handle this inexpensively and quickly, since we don’t have to hire outside legal counsel.  More importantly, these owners filed their bullshit paperwork with enough lead time that it won’t screw up our closing.

But you can’t predict Crazy. 

And if this had happened to another investor… or happened a little closer to the closing… it could cost a LOT of money.  And it could cost the deal.  Obviously Crazy Owner has no money… so even if the court sanctions them for wasting everybody’s time, good luck collecting.

Just another risk of buying foreclosures at the auction.  Luckily this one wasn’t our fault and could never have been predicted….

What other risks have you seen at foreclosure sales?  What have Crazy People done to mess up your investments?

Please COMMENT below– Thanks!

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Short Sale vs Auction

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“What are the differences between short sales and auction properties?”

When a homeowner falls behind in their mortgage payment and doesn’t catch up, refinance or sell the property, the home is going to become a foreclosure property.

So which is the best stage of the foreclosure process for an investor to buy the distressed property? Before the foreclosure auction, at the auction, or after the auction?

Pre-Foreclosures and Short-Sales

What is a Short Sale?

If you buy a home directly from the owner, but for an amount less than the mortgage owed, that’s a short-sale.  While it used to be common for creative investors to buy pre-foreclosures without paying off the mortgage (subject to deals, wrap mortgages, lease options, etc.), the lack of equity in the vast majority of today’s distressed homes makes those tactics MUCH less useful.  Instead, focus on getting the bank to take less than what is owed… a Short Sale.

Why a Short Sale?

Short sales are plentiful, and can be financially rewarding.  There is no shortage of underwater houses with desperate sellers.  A seller who can short sale his house STOPS the foreclosure process, protecting his credit and often eliminating any risk of a deficiency judgment.  So buying a short sale helps the seller, in a way that buying later in the process just can’t.  As an investor, you can find short sales at any price point, in any neighborhood, with a simple MLS search.

Making a Short Sale work

The major key is to work with a real estate agent experienced in short sale negotiations.   While most of the banks have streamlined their short sale approval process (especially in the past few months), the process still takes a long time and a great deal of patience. An agent who is actively involved in tracking and following your offer is invaluable.  You need an agent who anticipates the bank’s moves and knows how to successfully negotiate the playing field … especially since the bank is paying the commission.

What is needed?

Before a bank approves a short sale, the asset manager is going to require at least one BPO (Broker Professional Opinion) or CMA (Comparable Market Analysis), which is essentially a light appraisal based on comps in the area.  The bank also needs to see a variety of documents, (sometimes on their own forms) including:

  • A fully executed sales contract (with all signatures and initials)
  • An executed listing agreement (showing the property has been marketed)
  • A hardship letter from the seller (telling their story why a short sale is needed)
  • Seller’s bank statements, tax returns, W-2s, and payroll stubs
  • An Estimated HUD-1 (closing statement showing the net to the bank)

How to submit

Ten years ago, we would deliver short sale packages by FedEx because banks would always claim to lose the package or would accidentally shred the fax.  Now most banks have adopted online software to submit shortsales.  But some banks still prefer faxed documents.  You need to know before you submit.

Its always a good idea to submit your own CMA with the short sale package, to justify the sales price and help set the asset manager’s expectations.

ALWAYS submit an exhaustive list of all the repairs needed on the home, together with pictures and multiple bids for the repair estimates.  The more repairs, the lower the value, and the better the deal you can expect.

Getting the offer accepted

Remember that in most cases, nobody knows if a short sale offer will be accepted or rejected by the bank in advance.  A short sale listing simply means the seller and the listing agent HOPE the bank will take a reasonable short sale offer.  Banks turn down plenty of reasonable offers.  But most of the time, the bank rejects the short sale because:

  • Offer is too low (bank believes foreclosure will net more)
  • Short sale package is incomplete (or the bank “lost” documents)
  • Seller does not qualify (too much income/asset shown)
  • Bank sold the loan (often months ago… even though they were negotiating with you)

Short sales compared to auction properties

Short sales are a LOT less risky than auction properties. With Short sales:

  • You get lots of time for inspections, surveys, appraisals, title insurance and closing.
  • You can lock up the property with a minimum down payment.
  • You have many opportunities to back out of the deal.
  • You get to negotiate the best possible price.

On the other hand,

  • Auctions often sell at a steeper discount than short sales.
  • You don’t need much patience with auction properties.

*BIG SECRET for successful short sale offers

Until a bank has actually accepted a short sale offer, there is no way of knowing whether they will let a house go for a particular price.  And a bank will not accept an offer (or even hint at the bottom line price) until a complete short sale package has been submitted and reviewed.  Until that acceptance, the list price is just to gauge interest from the public.

Want to increase your short sale success dramatically?  Look for “preapproved” short sales, where the bank already accepted an offer and the buyer walked.  Properties marketed this way are much easier and quicker to close.  The bank already knows what the BPO or CMA will show, and has already determined the amount of loss they are willing to write off.  They just need a new buyer…

**HUGE SECRET for auction buyers

I can’t tell you the number of foreclosures we have bought at the auction, only to find out that agents were putting the final touches on a short sale closing.  The bank was telling everybody the short sale was approved and ready to close… but the bank didn’t tell their attorney to cancel the foreclosure sale

The interesting thing was that we bought these houses at the auction for significantly less than the bank would have made through a short sale.  The bank discounted MORE at the foreclosure auction than they would have had to discount the mortgage.  Once, we flipped the house the day we got title… to the short sale buyer…. for a huge profit.

So finally, we started submitting short sale offers on upcoming foreclosure auction properties, about a month ahead of time.  The banks would do the BPO, decide their bottom line number, and then… let it go to auction anyway.  But they would reliably discount the judgment and reduce their strike price at the sale.  And since we already knew the rehab and resale numbers, we could bid confidently at the sale.

–David

 

 

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