Refinance the Pitfalls with a Fix and a Change – Keeping Ownership When Your Change Fails
He was young and inexperienced, but he was convinced that he was unstoppable. He had a lot of energy and motivation. The house was in Arvada, a northwest Denver suburb, and I bought it for an incredible price. It was part of a package with another house that he planned to keep for rent. This one didn’t have a large number of rentals, but it looked fantastic as a hitch so I bought both houses. I started the rehabilitation in both properties, with the focus on the planned rental; that would be a much easier and faster rehabilitation. That house went off without a hitch. I rehabbed it, rented it, and will refinance it. Because I used a hard money loan, I had no money and was producing positive cash flow in six weeks. The Arvada house was a different story. That one also ended up in my rental wallet, but it was far from planned.
It was after I finished with the first project that I began to notice the murky work at Arvada. There was work not allowed everywhere. There was a small addition that was falling out of the house, used building material that didn’t belong, leaks that were plugged, and faulty wiring. The budget was ruined even before it 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 applied a lipstick, 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 the money back to my lender, which means I had to refinance the loan.
This painful experience taught me many important lessons; Don’t go cheap on finishes, what to look for on a budget, and the pitfalls of refinancing. Loans have changed since then, so I reached out to Joe Massey at Castle and Cooke Mortgage, our preferred lender in Colorado, for help on the problems investors face today when trying to refinance their investment. Here is the list of cheats we discussed:
Value: It’s almost impossible to get a higher appraisal than the latest list price. In my case, I kept lowering the price, to the point where it was below what I could have priced. When I went for the refinance, the appraisal hit the last list price and I was forced to bring cash at 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. Additionally, low-quality rehab is difficult for an appraiser to value, so it is common for low-quality rehab to have no impact on the appraised value. However, low-quality restorations have a large impact on real value. Once there is MLS exposure, which means anyone looking for a home can see it, the appraiser has real market information to get a more accurate value. Think about it, how can the appraiser justify a higher value than what is listed in the MLS? It is best if you have the value that enters the lower list price, or even below it.
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, it’s not a big deal, but this will create a one or two day delay in the process.
Credit: Credit requirements are a bit stringent with rental property loans compared to owner-occupied loans. Almost all loans are approved or rejected by a computer system, so scores can vary. For example, if you have less than perfect credit but a larger down payment, the computer might approve the loan. In the rare event that the loan is manually underwritten, your rental credit should be 620 or higher until you reach your fifth rental, at which point you should have a credit score of 720.
Entities: Conventional lenders will not make loans to an LLC or corporation; You must own the home in your personal name to qualify. Many lenders will not loan you money if at ANY time you owned property in an entity. Most of the arrangements and flippers do business with an 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, he can finance it while your property is in his entity, but it will require you to transfer it to his personal name. If you hear a lender tell you that they can’t help you because you owned your business in your LLC or corporation, know that there are lenders like Joe who can.
DTI: You may hear that you cannot finance a rental because your debt-to-income ratio will decrease, which means that you are not making enough money to cover all of 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 rehabilitate it; therefore, it is more difficult to qualify. If you get these comments, 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’ve written full articles on this topic, because many self-employed people take the most deductions possible. When you take a deduction, you reduce your taxable income, thereby saving on taxes. The problem is that when you lower your income, it hurts your DTI, making it harder to qualify for loans. It is not the fact that you are self-employed that prevents you from obtaining a loan, it is 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 have been in business for at least five years and have a credit score of 740 or higher, in which case you will only need one year of tax returns.
Bookings: As you start to go over budget or have trouble with your fix and change, it is very common to burn your reserves to save the deal. This is understandable but could create a problem. You need to have reserves to qualify for conventional loans, so it is very important that you have them in reserve before applying 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 the unpaid loan balances of 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
The principal balance on your home mortgage does not count in these calculations.
You can use some retirement money to meet this requirement, but you will also need money in the bank. Check with your lender if you plan to use retirement money to meet this requirement, and they can guide you through which funds should be where when you apply. 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 the refinancing process, it’s probably best if you don’t take out any additional credit or even have it taken out. You don’t want to quit your job either, which seems obvious, but I feel the need to bring it up.
I wish I had this information when I was working at that house in Arvada, and I wish I met someone like Joe to help me through the process.