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 northwest 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 rehabilitation 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 out 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 bag, but it was far from planned.
It was after I was done with the first project that I started noticing the shady work on Arvada. There was unauthorized work everywhere. There was a small addition that was falling off the house, building material that didn’t belong, leaks that were plugged, and faulty wiring. The budget was spent before it even started, and it didn’t have the reserves to cover the extreme amount of overage. I didn’t know what to do, so I went cheap. 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 my lender hard money, 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 reached out to Joe Massey at Castle and Cooke, our preferred lender in Colorado, for help on the issues investors face today when trying to refinance their investment. Here is the list of traps 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 where it was listed below what could have been appraised. When I went for the refinance, the appraisal was at the latest list price and I was forced to bring cash to closing to close 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. Also, poor quality rehab is difficult for an appraiser to value, so it is common for poor quality rehabs to have no impact on the appraised value. However, poor quality rehabs have a big impact on the actual value. Once there is 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 coming in at or below the lowest list price.
Another hurdle with MLS exposure is time. This isn’t a big deal 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 delay in the process.
Credit: Credit requirements are a bit stricter 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 event that the loan is manually underwritten, your rentals credit must be 620 or higher until you hit your fifth rental, at which point you will need to have a 720 credit score.
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 you owned the property at ANY time with an entity. Most fix and flippers do business with an entity, so you can see how this can get you in trouble with a refinance. However, all hope is not lost! Because Joe is a direct lender to Fannie Mae, he can finance it as long as 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 your LLC or corporation, know that there are lenders like Joe who can.
DTI: You may hear that you can’t finance a rental because your debt-to-income ratio will be low, meaning 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 the income, which is always a loss in the first year you buy a new property and rehab it; thus, making it more difficult to qualify. If you receive this information, please call another lender. The guideline here is that you can use 75% of the gross rent 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’ve 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 lower your income, you damage your DTI, which makes 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 issues with your fix and switch, it’s all too common to burn through your reserves to save the deal. This is understandable, but could create a problem. You must have reserves to qualify for a conventional loan, so it is very important that you have this reserved before you apply for your refinance. The guideline is a bit confusing and is based on how many 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 the mortgage on your main home 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 retirement money to meet this requirement, and they can tell you what funds need to be there at the time of application. If you start to run out of 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 complete anything you need to complete that will consume your reserves.
Changes in your situation: Several things can create problems here. If you’re in the middle of refinancing, you’re probably better off not getting any additional credit or even having 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.