Rental Property #4: Part II The Closing Process

As I previously wrote, I closed on rental property #4 in November 2017. This is part two of a three post series.  You can catch up by reading part I here.

Part I covered:

• Finding the deal
• Analyzing the deal
• Why being patient in real estate pays off
• The offer to buy the property

Part II covers:

• The inspection contingency
• The appraisal contingency
• The financing contingency & bank underwriting
• How I got the money for rental property #4
• The renovation budget

Part III will cover:

• The renovation (before & after pictures)
• Managing the rehab
• The curve-ball
• Leasing the property
• Reviewing my rental property business plan & analysis vs. actual returns

Rental Property #4: Part II

 

I swallowed my pride and accepted the seller’s proposal.

I was thrilled to have rental property #4 under contract. Worries of overpaying quickly faded. Excitement, joy, and stress took over. The DC real estate market is very competitive which allows little room for error during the closing process. Most closings happen in less than a month.

My contract for rental property #4 had a 7-day inspection contingency. There was also a 14-day appraisal contingency and a 21-day financing contingency.

Inspection Contingency

There are two types of inspection contingencies. A traditional inspection contingency allows the buyer to inspect the property. Based on the inspector’s findings, the buyer may choose to negotiate the price with the seller. A traditional inspection contingency also allows the buyer to also walk away from the deal if they do not like the findings.

There is also an inspection contingency for informational purposes. This type of contingency still allows the buyer to inspect the property. The findings are for informational purposes only. The buyer cannot use the information to negotiate the sales price; this inspection is strictly for information. You could call this the ‘FYI inspection contingency’. The buyer still has the right to walk away from the deal if they do not like the findings.

Both options allow the buyer to keep their earnest money deposit if the buyer elects to walk away from the deal.

My contract gave me seven days to inspect the property. I also opted for an ‘FYI inspection.’ This made my offer more attractive to the seller.

In some markets, a traditional inspection contingency is less competitive. A friend of mine who lives in Seattle told me people are buying homes without inspections. Don’t do that.

Opting for the “FYI inspection’ meant I could not negotiate the sales price after the inspection. I would either need to be comfortable with the current condition of the property or walk from the deal.

Given my experience, I had a general idea of the rental property’s condition before the inspection. I worked with Habitat for Humanity for several years. I’ve also renovated several properties and am not afraid of work. In fact, I like ugly houses; they usually offer better deals.

I also like investing money in my properties. I especially like investing money up front when properties are vacant. Wisely spending money now will save on headaches later. The renovation process is easier when the building is vacant.

I would pull my offer if I was not comfortable with the condition of the property. This route may be riskier and may not be necessary for some real estate markets. Consult with your real estate agent when submitting your offer.

It’s ok if you are not an expert in inspecting or renovating a property. Your inspector will find any potential problems. A quality home inspector provides a very detailed report of the property’s condition.

As expected, the report came back clean. The property’s structure was sound. Some may say rental property #4 has good bones. This was $975 well spent. Please note that single-family home inspections cost much less.

The property required some cosmetic work and a few minor repairs. A couple of windows and appliances needed to be replaced. Nothing in the report scared me away from closing on rental property #4. More on repairs and renovations later.

When you have a home inspection, you’ll receive a report with dozens of pages of information. Do not be alarmed by the information overload. Find time where you can sit down and go through all the material. Talk with your real estate agent and the inspector. Both of them will serve as great resources if you have questions about the report.

Making sure the property is structurally sound and the systems like electrical, plumbing, and HVAC are in reasonable condition should be your top priority. Otherwise, more often than not, a majority of the ‘problems’ listed in a home inspection report can be solved with a couple bucks and a trip to Home Depot.

I would also like to reiterate that you should never buy a property without a home inspection. When I was searching for my first property, I had a house under contract. I thought it would be a great place to call home and house hack with some friends.

Thankfully, I had a home inspection. The attic was infested with mold. The beams holding up the roof were rotted out. The beams and the roof needed to be replaced. I pulled my contract and avoided this pitfall that would have cost at least $20,000.

Appraisal Contingency

Buying a rental property with a mortgage will require an appraisal. Appraisals are designed to protect buyers and ensures a property is worth at least the value of the purchase price. Thanks, banking regulations! (sarcasm; free market capitalism is sexy)

An appraisal costs a few hundred dollars. The report contains a few dozens of pages of information about the property, market data, and analysis.

The appraisal for rental property #4 cost $600. This appraisal cost more than most because there are three units. A single-family home appraisal costs less.

Personally, I think most appraisals are overly optimistic. In my experience, all of my rental properties have appraised for more than the purchase price. Sometimes the appraisal has been $10,000-$20,000 more than the purchase price.

The appraisal contingency protects a buyer if the property appraises for less than the purchase price. A number of options are available when an appraisal is less than the purchase price.

First, the buyer may ask the seller to lower the price to reflect the appraised value.

Second, the buyer may elect to make a larger down payment to keep the bank happy.

Alternatively, if the buyer cannot get the seller to lower the sales price and the buyer is unwilling to pay a larger down payment, the buyer can walk away from the deal and keep their earnest money deposit. 

Rental Property #4’s contract had a 14-day appraisal contingency. The appraised value was slightly above the purchase price. I waived my appraisal contingency for rental property #4 and continued to march towards closing.

Financing Contingency

The financing contingency or mortgage contingency allows the buyer time to qualify for a loan. This contingency also allows the buyer to walk away from the deal if they cannot get a loan. The financing contingency also allows the buyer to keep their earnest money deposit if they back out of the deal.

Rental property #4’s contract had a 21-day financing contingency. This means I had 21 days to qualify for a loan. Thankfully, I have an experienced mortgage broker and we’ve closed several loans together. Your banker/mortgage broker is the most important member of your real estate team.

In order for your loan to be approved, the lender must underwrite the loan and the borrower (aka you). The lender will require the following information:

• Last two years of personal tax returns
• Last two pay stubs
• Last two statements for all checking and savings accounts
• Last two statements for all investment accounts (401ks, IRAs, brokerage etc.)
• If you already own real estate, you will need to provide a copy of mortgage statement(s), proof of insurance, proof property taxes have been paid, and lease(s) if applicable.

Debt to Income Ratio – DTI

Underwriting metrics ebb and flow with market conditions. One of the most important metrics is the debt to income ratio or DTI. Generally speaking, you can qualify for a conventional loan provided that your debt to income ratio is no greater than 43%. FHA loans allow your debt to income ratio to be as high as 50%.

Calculating your debt to income ratio is not hard. In fact, figuring out your DTI only requires simple addition and division.

Simply put, you take all of your monthly debt obligations and add them up. Think student loans, car payments, mortgage payments, credit card payments etc. This number will be your numerator (top number of the division).

Next, take your annual pre-tax income and divided it by 12. This will be the denominator (bottom number of the division). Now divide your monthly debt payments by your monthly pre-tax income. This will give you your DTI ratio.

For a real-life example. Let’s say you have a car payment that is $200/month and your student loans are $250/month. Your total monthly debt payments are $450/month.

Let’s assume your salary is $50,000. Your monthly pre-tax income is $4,166.67 ($50,000 / 12 = $4,166.67). In this scenario, your DTI is 10.79%. We got this number by dividing your monthly debt payments by your monthly pre-tax income ($450 / $4,1666.67 = 10.79%).

When a bank underwrites your loan they will factor in your future mortgage payment or PITI (principal, interest, tax, and insurance). Including your new monthly mortgage payment, your DTI cannot exceed the required ratios.

Ernest Money Deposit and title company

After your offer is accepted, you will need to deposit your earnest money deposit (EMD) with the title company. As the buyer, you usually have the power to choose the title company.

The title company will hold your EMD in an escrow account. Additionally, the title company will provide title insurance and check for existing liens on the property. The title company can also provide a survey of the property.

The title company will also prepare all the documents for the buyer and seller to sigh. be prepared to sign dozens of pages if you are buying a property with a loan.

Only one signature is needed if you are buying a property with cash.

How I got the money for rental property #4

When I made the offer for rental property #4, I had enough cash to cover the down payment. However, I would not have any cash left over.

This would leave me with no cash to fix up the new property. I would no longer have an emergency fund or any way to cover a major repair at my other three properties. Sounds pretty scary, right?

Thankfully, I had a home equity line of credit (HELOC) on rental property #2. My HELOC has a maximum of $85,000 but I did not want to draw the full amount – nor did I need that much.

My lender was running a promotional offer to fix any advances on my HELOC at 4.0% for the first 12 months. So, I borrowed about $70,000 from my HELOC. The funds went towards buying and renovating rental property #4.

Using my HELOC allowed me to keep a meaningful cash position. This also meant I could pay for an emergency in cash and avoid credit card debt.

Some of my cash went towards closing costs and renovating rental property #4. My plan is to repay the HELOC before the end of the 12 months, which will allow me to avoid higher interest payments.

I wanted to share the HELOC story with you for a few reasons. First, I always aim to be transparent with my readers.

Second, I wanted to show a common real estate strategy. Using a HELOC is a great alternative to a cash-out refinance. Rates are much higher today and I would lose my low-interest rate if I refinanced rental property #2. Refinancing is also more expensive than setting up a line of credit.

Third, I wanted to show one of the many benefits of real estate investing. Rental Property #2 has experienced strong appreciation over the past few years. There are two main reasons the property has appreciated.

First, I completely gut renovated the house. This is called ‘forced appreciation’. I forced the value to increase by improving the property. I took the property from ‘falling apart’ to ‘modern and luxurious’.

Second, the property experienced ‘market appreciation’ or ‘demand appreciation’. In general, the area has changed a lot since 2015. The neighborhood is more desirable, safer, and has more amenities. Most of the rundown buildings have been renovated. People want to live in this area.

The best part? The neighborhood is still trending upwards. Several developments are underway while others are being planned. Did I mention a Whole Foods is opening up down the road?

Lastly, it would be irresponsible of me to not mention the risks of a HELOC. Leverage is a beautiful thing, but too much leverage can make a grown man cry. By using my HELOC to buy rental property #4, I am using more debt than most would be comfortable with.

However, I am comfortable with this approach for several reasons.

Cash flow – my three rental properties all support themselves. In fact, I get paid to own all my properties. My rental property portfolio provides great cash flow. In fact, the cash flow from my rental properties covers the mortgage of rental property #4, the HELOC interest payments, and I still have some cash left over.

Low overhead – My lifestyle is very affordable since I’ve avoided lifestyle inflation. I have little personal expenses and overhead. I house hack and live for free. My student loan and car payment are my only non-mortgage debt. My student loans will be paid off in a few months (finally). My car payment is only $250/month. If needed, I could revert to spending less than $1,000/month on a personal level.

Income – I’m fortunate to have job security and a comfortable paycheck. The cash flow from my rental properties and my affordable lifestyle allow me to save most of the income from my job. This has not always been the case. However, as my rental property portfolio has grown, I’ve become less dependent on my paycheck. This is one of the many reasons I invest in real estate and am working toward FIRE. In a pinch, I could stop saving/investing temporarily to pay off the debt of the HELOC.

Assets/Investments – Part of offensively building wealth involves saving and investing regularly. I’ve regularly bought index-funds and dividend stocks in my brokerage accounts. I’ve always contributed to my 401k and have maxed it out the past two years. I also have a modest Roth IRA. If things do not work out, I could sell some of the stocks in my brokerage account. This would suck but at least I have something to fall back on.

To summarize why I am comfortable with such debt. One, my rental properties cover all the new debt an then some. Two, I have a low-cost lifestyle and few expenses. Three, I have job security and save most of my income. Four, I can sell stocks if things go poorly (never want to do this).

Rental Property #4’s Renovation Budget

Rental Property #4 was in decent shape but needed some cosmetic repairs. I like to call this ‘paint and powder’. Most importantly, rental property #4 had good bones and a structurally sound structure. None of the major systems needed to be replaced or repaired.

Unit #1 was decent shape but needed some in upgrades and repairs.

Unit #2 could be rented in its current condition. However,  a few cosmetic improvements would not hurt.

Unit #3…. well just walking into the unit was painful. The place was trashed. Thankfully, most of the damage is cosmetic as well.

The estimated budget to renovate and rent rental property #4 is $21,350. Below you will find the renovation budget for rental property #4.

Now a word from our sponsors. Stay tuned until next week to see how Drew’s personal HGTV show went…