Financing Fundamentals

Property management may or may not involve real estate ownership. If your goal is to be an investor of income properties then you will want to know about financing. Financing allows you to acquire an investment using leverage. Leverage is a tool used by investors where a buyer purchases a property by paying a portion of the selling price and financing the balance with a loan or other commitment to be paid back over time. By financing a significant amount of the price, the investor can obtain control of a property whose value is much higher than the initial contribution (called the down payment). The lender benefits by charging interest based on the type of loan and payoff timetable. The amount borrowed for the purchase is called the principal.

Most conventional lenders expect a borrower to contribute the down payment as a gesture of commitment to a property. This does not mean that a buyer needs to use their own money to acquire an income property; there are financing companies that will loan 100 percent of the property's value, and others who will provide funds to cover the gap between the selling price and the amount to be financed. However, the risk of loss to the lender increases the more the purchase is leveraged with outside funds, so it may be challenging, especially in tough economic times, to find financing for the complete purchase price.

Lenders use a formula called the loan-to-value ratio (LTV) that indicates how much it will lend based upon the appraised value of the property. An appraisal is an independent, professional estimate of the fair market value (the asking price it might sell at) when compared to similar properties. The lender takes the requested loan amount and divides it by the market value. Most commercial lenders will lend up to 75 percent LTV on income properties.

When approached with an investment property, a financer will analyze several aspects of the property and borrower. Lenders have two objectives in mind, 1) to make money on the loan or investment and, 2) to keep the risk of financial loss as low as possible. Figure 11-1 shows that both must meet certain criteria before it will extend funding.

Figure 11-1. Criteria for Financing.

Loan Types

Fixed rate mortgages require an equal monthly payment that includes payback of the principal amount borrowed plus a steady rate of interest that is added to the principal over the life of the loan repayment (called the amortization period). The interest makes up the largest portion of early payment and decreases over time, whereas little of the principal amount is included in the installments early but increases later. Adjustable rate mortgages offer an interest rate that can change during the amortization period. The percentage is generally linked to a cost-of-funds index that banks and other institutions use to loan each other. Usually the initial (or teaser) rate is guaranteed to be lower than market rates for a short period (for instance, one year), then it rises to match current average rates.

Creative Financing

There are non-traditional ways to finance a purchase. Though there have been many real estate gurus that recommend strategies that are either risky or controversial, some techniques exist that have been generally accepted by financial institutions over time. A few examples include the following.

1. Purchase Money Loan (Soft Money). The seller holds a junior (or subordinate) mortgage to bridge the gap between the limit of the primary financing method (the first mortgage) and the purchase price. This loan is typically a shorter term and likely at a higher interest rate than the primary note. The property is pledged as collateral for nonpayment, as it is with the first mortgage loan, but the first mortgage must be paid by the seller in order to recover the property.

2. Wraparound Mortgage. This involves a seller continuing to pay an existing mortgage while extending a soft money loan to a buyer for the total purchase price. The buyer would make payments to the seller who would then make his payments on the original loan. This may be challenging to do because most mortgage contracts contain provisions that discourage a change of owners while the loan is being paid off. Transfer of ownership usually triggers an acceleration clause, called a due on sale clause, giving the lender the right and authority to force the original borrower to pay the entire mortgage balance immediately.

The wraparound financing technique can be beneficial to both a seller and a buyer. The seller typically charges interest, at or higher than current bank rates, in exchange for extending the financing. Some advisors recommend a 2 percent increase over prevailing rates. This has a three-fold effect, 1) the seller can earn income in addition to the sale price; 2) the seller may achieve better returns than other investment options; and 3) the seller can deduct the original mortgage interest against income. This technique requires good record keeping because the tenant (and the IRS) can ask for payment records.

For the buyer, this technique can allow him to obtain control of a larger property or escape the normal qualification process and upfront fees required by most conventional lenders. He also may realize better cash flow than if he was to split financing between a first and second mortgage. There are two risks to the buyer, however, 1) If the seller does not make payments on the original mortgage, the property could be foreclosed upon and the buyer may be forced to pay the balance or lose the property (though the buyer might be able to claim fraud) and, 2) the due-on-sale clause in the original mortgage could be triggered and the entire amount could be demanded. Make sure to obtain written permission from the lender prior to agreeing to a deal. All parties should keep their payment records.

3. Sharing Appreciation Loan. A lender can either offer a lower interest rate loan or provide the down payment, allowing a buyer or occupant to purchase the property with little or no money down. In exchange, the lender has an ownership interest in the property for a period (the holding period). At the end of the holding period, the property either is sold or is retained by the buyer or occupant, who must refinance the original mortgage. The appreciation (increase in value) that has occurred during the holding period is split between the two parties.

Properties that can show a significant increase in value are primary targets for this type of financing. Poor rental performance and properties selling below market value (undervalued) make attractive SAM (Shared Appreciation Mortgage) financing projects. It is critical from the lender's view for the property to go up in value; this is how it receives a return on its investment. A manager should look to improve the performance of the property for two reasons, to realize part of the appreciation during the holding period and, possibly to retain a more valuable property in the future.

4. Option, Lease Option, or Lease Purchase. You can arrange a delayed purchase by placing an option on the property or agreeing to lease, and then buy at a prearranged price. An option involves making an upfront payment for the right to purchase the property in the future. You can make the option payment (which can be sizable) either with or without occupying the building. The lease option gives the buyer the right to occupy during the lease term, which is usually one to three years, and the choice whether to purchase or not at the end of that period. The lease purchase gives the buyer the right to occupy during the lease term and commits to a purchase following that period.

During a lease or option period, the property may not be sold to another party. Rent payments during a lease period can include a portion that goes towards the down payment due at the time of purchase. Option money is generally nonrefundable and is not credited towards the purchase price. If a buyer with an option or a lease option chooses not buy the property, the option payment is kept by the seller as compensation for withholding the property from being sold during the lease or option period.

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Do You Need a Broker?

Are you better off selling your income property yourself or hiring a realtor to handle it? That depends on your ability to commit the time and energy and your marketing capabilities. If you can reach buyers efficiently and effectively then you can save thousands on commissions. Because income property sales, especially commercial sites, include so many facets, it is generally recommended by experts that you find a good broker to assist you. However, if you have been an active property owner, selling your own property can have two advantages, 1) you can clearly explain the history of the property and, 2) you can speed up the process by not having an intermediary. Figure 14-1 shows a comparison between a for-sale-by-owner strategy and using a broker.

Figure 14-1. Comparison of Sales Strategies

Selling Approach

Your approach to selling the property will depend upon your goals. Do you need to sell quickly? Do you want to get top dollar? Will you sell the property in an 'as is' condition? Before you begin marketing your offer, you should examine the deal from an investor's perspective. Write down the pros and cons of the deal you are offering as if you were an interested buyer. Discuss with your broker what investors will look for (see below). You will have an easier time selling your property if you know why another investor will buy.

List Advantages

How do you make your investment appeal to another investor? There will likely be other options available for a real estate buyer, so discussing the financial figures will be important. Equally important is positioning the benefits of the property. Some of these benefits may provide an advantage for a buyer over another investment choice. Your selling strategy should include listing, and really selling, the advantages to owning your property. For example, if the buildings are in good condition and the exterior is kept clean and maintained, a landlord can expect higher rental income (and lower repair costs) than for a rundown property. On the other hand, if the property for sale is not kept up, the buyer has the advantage of increasing income by raising rents following proper maintenance.

Investigating similar properties for sale can help you position yours by looking for comparisons that are favorable for you. For instance, if there is a similar property without off street parking spaces selling for less, let the buyer know that your property provides renters peace of mind by providing worry free parking. Even if your property has no apparent special characteristics, find qualities that can be compared favorably to other available properties. The more you can explain why the buyer should purchase your property and not another one, the better your chances are for a sale.

Offer and Pricing

Income property sales are rarely a quick offer and acceptance process. To start, determine what price you should expect and what offers you will accept. The asking price will shape the market of buyers you attract. Affordability is usually the first screening factor a buyer uses when looking for properties. Compare prices using similar properties, and be prepared to justify a higher price than the market. If you are flexible on the conditions of the sale, such as payment terms, you may be able to receive a better price. Once you have set a price, think about the conditions you are willing to extend to get the deal done. Write down criteria like offering to replace signage that might sweeten your offer. If you can, maintain the criteria of your offer for sale (such as purchase terms or future property management options) for a defined period, such as six months. This will allow you to determine whether your offer is reasonable. If you are having problems selling the property, consider changing your strategy and be more flexible on your sale terms.

The condition of the property will be a critically important part of your offer. If the buildings need updating or repairs, consider performing the maintenance or include a provision in your offer that compensates the buyer for handling the work. You may choose to lower the price or offer special terms in exchange; keep in mind that you want the buyer to feel good about the purchase. If there are any deficiencies or defects make sure you disclose them in your offer or you may be violating disclosure laws. If rent charges are below market or expenses are high, find ways to adjust those elements before selling. You may also want to extend leases for good tenants to make the property more attractive to investors.

Attracting Buyers

Use a multistep approach when marketing your property. The more channels you use to advertise your offer, the faster you will receive interest. Provide as many contact options to reach you as possible as buyers may have different preferences. Your strategy should reach out to a wide audience of qualified investors, as opposed to narrowing your search when attracting renters. There are several methods to announce your property sale.

Ø Print ads. Newspaper and magazine classified advertisements (either with or without pictures) can be an effective way to reach a wide audience. Use the ad space wisely by listing price, net operating income (NOI), and number of units. Give enough information to generate interest then discuss more details when speaking with the prospective buyer.

Ø Brokers. Whether you hire a seller's agent or discuss your property with a buyer's agent, real estate brokers can get the word out. They can list your property with a multiple listing service or websites like www.realtor.com to attract interest. A broker will not only share the listing with interested parties but may also likely discuss your property with other brokers, increasing your reach.

Ø Associations. If you belong to an apartment owners' group or Building Owners and Managers Association or have other real estate affiliations, spread the word through members about your property. Some groups have national and international membership, and some publish listings that are exclusive to members.

Ø Word of mouth. Simply letting neighbors, friends and family know that you have a property for sale expands your reach. Share some details with others and hand out business cards that they can distribute. If a sale results, you could offer a small finder's fee to the person who provides a direct connection with the buyer.

What Buyers Look For

Investors are typically as interested in, as or more interested in, the financial aspects of a deal than the property itself. The physical appearance and structure are important, but if it cannot earn a good return then most experienced investors will hesitate to buy it from you. An appraisal will include physical dimensions, property description, neighborhood characteristics, the cost approach used to determine the current market value, and a group of comparable properties.

Three approaches can be used to determine the property's value, cost, comparable sales, and income.

§ Cost Approach. Calculate how much it would cost to build the same structure on the same type of land (called a lot) at current prices. Exact descriptions and dimensions are important to calculate the replacement cost. From the replacement cost depreciation is subtracted, which factors in wear and tear and normal deterioration costs. Then the price of acquiring a similar lot is added to that figure to arrive at the estimated cost value.

§ Comparable Sales Approach. Measure how the property compares to comp (similar) properties that have recently sold. Usually similar size, in square feet, is used to find comparable properties, as well as location and age of buildings. Adjustments are made for positive and negative features of each comp property, such as having a swimming pool or the previous sale date. The resulting value closely reflects current market value.

§ Income Approach. The income is used in a formula to determine the market value. Some use the gross rent multiplier (GRM) method, where the price is divided by the total monthly rent to generate a multiplier factor. That factor is compared against the prevailing factor for the area (which can be determined by using comparable properties or contacting a local appraiser). A capitalization rate (cap rate) method is another popular valuation method, accomplished by dividing the NOI by the prevailing cap rate for the area to generate a market value. Again, comparable property sales and income figures will generate a rate to use.