When you apply for a property loan, the lender must assess (or underwrite) your ability to repay it in order to decide whether to grant the loan, how much to offer and what terms to require. Depending on the type of lender, the underwriting process might evaluate:

• The value of the property (before or after rehabilitation)
• The net operating income (NOI) of the property
• The borrower’s financial condition
• The borrower’s financial history

Debt service coverage ratio (DSCR) is a measure of the borrower’s financial condition. It indicates whether a borrower has sufficient cash flow to repay current debt, including interest. DSCR is defined as NOI divided by the total current debt service (i.e., the amount of debt obligations due within one year, including principal, interest, and lease payments).

DSCR = NOI / Total Debt Service

A DSCR of 1.0 means the borrower’s NOI is just enough to service debt. Values below 1.0 indicates insufficient cash flow, while values just above 1.0 are problematic, because a small dip in cash flow might require the borrower to use other funds to service debt. If those other funds aren’t forthcoming, the borrower might default on payments and force the property into foreclosure. Naturally, lenders want to avoid this eventuality, as it is expensive and time-consuming to seize and sell the property, often at a loss. Therefore, lenders might set a minimum DSCR as part of their underwriting requirements and require the borrower to maintain at least the minimum DSCR during the life of the loan.

Hard-money lenders are typically not that interested in DSCR. The money they lend is based on the post-rehab value of a fix-and-flip property. Usually the loan amount is around 80 percent of the property value, and the borrower finances the remainder with equity. This arrangement creates great incentive for borrowers to meet their debt service obligations lest they lose their investment. Furthermore, a fix-and-flip property has a negative NOI, so DSCR is difficult to calculate. Hard money lenders are more interested in the value of the property, as it serves as collateral for the loan.

Also bear in mind that, unlike mortgages, hard-money loans are non-amortizing. That is, debt service is interest only, and the principal is repaid all at once at the end of the loan. This translates into smaller payments and a smaller DSCR requirement. The proceeds from the flip of the property are used to repay the principal. That’s why hard-money loan underwriting concentrates on property value rather than the borrower’s finances. If you live in the Washington DC region, contact Specialty Lending Group for terms and rates on hard-money loans.

 

Leverage, which in this context means buying properties by taking on debt, can be used to grow your wealth. The reason leverage is used is that it can boost your return on investment (ROI). The debt portion of a leveraged real-estate deal is funded with borrowed money.

Leverage makes flipping more profitable. Without it, a flipper would need to provide 100 percent of a property’s purchase price plus renovation costs. Suppose a flipper pays $200,000 in cash. The flipper might be able to quickly renovate the property, say over three months, for $30,000 and resell the property for $260,000. That’s a 13 percent ROI (($260,000 – $230,000) / $230,000).

That return is not a bad, but a flipper will do much better using leverage. The amount a flipper can borrow is determined by the lender’s loan-to-value(LTV) standards. A hard money lender will typically set an LTV ratio in the 70 to 80 percent range. This applies to the projected value of the property afterrenovation. In other words, if the lender puts up 80 percent of the $260,000 property, the loan amount would be $208,000. The flipper would be responsible for the remaining $52,000. If the flipper sells the property for $260,000, the ROI would be 400 percent (($260,000 – $52,000) / $52,000). That’s right, in this example you get a 4X return on your money by using leverage. That’s a lot better than 13 percent.

For the sake of simplicity, this example assumes a three-month turnover on the property, thereby minimizing interest costs on the borrowed money. But even if you factor in interest of $5,000, the return is (($260,000 – $57,000) / $57,000), or 356 percent. Don’t forget, the interest is deductible, which improves your return even more.

Finding the Right Private Lender

Rookie mistakes happen everywhere, including the rehab sector. Rate shopping is great, but a savvy developer is going to look beyond APRs. The most important feature a private lender can offer is expertise born of experience. For rehabbers, the best lenders have years of experience, because these lenders can help flippers navigate the obstacles bound to arise. A lender that has funded all kinds of project knows what to do and who to contact. That often spells the difference between success and failure.

Rehabbers should also look to a lender with a local presence. It’s important to have help with zoning laws, building codes, inspection customs and many other local issues.

One last point – a good private lender will offer creative ways to finance. For example, a project can be sectioned into two phases – purchase and rehab – with separate funding for each phase. Structuring loans in this way means a rehabber doesn’t have to pay unnecessary interest, but rather can wait on the second phase until permits are obtained and work is ready to begin. If you live in the Washington D.C. region and want more information about using leverage, contact Specialty Lending Group today!

 

Tax Benefit of Opportunity Zones

OK, you’ve flipped a property for a nice profit, but now you are faced with a tax bill on the gain. The 2017 Tax Cuts and Jobs Act gives you a new way to shelter that profit from the IRS. The Act created Opportunity Zones, which are designated economically-distressed communities where investments can earn a preferred tax treatment. A Qualified Opportunity Fund (QOF) is a pool of eligible properties located in Opportunity Zones, and these funds unlock the tax benefits to investors. Check out this map to see what’s available in your area.

This is how it works. If you score a gain from the sale of a property (which we’ll call the original investment), you can invest the gain in a QOF within 180 days to defer the tax on the gain. The period of deferral is the earlier of the sale of your QOF investment and December 31, 2026. If you hold your QOF investment long enough, you are forgiven some taxes on the gain you earned from the sale of the original investment, as well as possible tax forgiveness on profits you earn on your QOF investment.

The amount of tax benefit is tied to the holding period of your QOF investment. You receive a tax deferral but no tax reduction during the first five years. However, if you hold the QOF investment five years or longer, you get the following tax reductions:

 

QOF Holding Period	Benefit
Less than five years	Deferral of tax on original capital gain
Five to less than seven years	10% reduction of original investment’s taxable gain
Seven or more years	15% reduction of original investment’s taxable gain
More than 10 years	100% forgiveness of QOF profit

In other words, if you hold your QOF investment for more than 10 years, your cost basis in the fund is stepped up at the time of sale such that you owe no capital gains tax on any QOF profitearned afterQOF investment. A QOF holding period of between five and less than seven years reduces by 10% the taxable amount from the original investment’s capital gain, and you save 15% for holding periods of at least seven years.

House flipping can be quite lucrative when you know what you’re doing. Investing some of your gains in an Opportunity Fund is a good way to defer your current taxes and reduce your future taxes.

 

 

In the land of unicorns and pink rainbows, you can devote all your time and effort to finding run-down houses, bringing them back to like-new condition, and selling them for triple your investment.

Then there is the real world. In the real world, you already have a job, yet somehow money worries are never far from mind. For many of our clients, doing real estate part time is a rational solution to the desire for increased wealth despite the time constraints of the real world.

Benefits of Part-Time Real Estate Investing

You don’t have to be a full-time house flipper to reap the benefits of buying, renovating and selling home within a 12-month period. Doing it part-time simply means that you flip fewer properties per year and each flip takes longer. Notwithstanding those constraints, you still participate in the benefits of home flipping:

1. Potential for strong ROI: RealtyTrac reports a sharp uptick in ROI in the first half of 2016, with an average return of 49 percent, compared to only 27 percent in 2006.
2. Potential for quick returns: Even at a part-time pace, you can realize investment returns much more quickly through home flipping than you can through stock market investing. And those returns are within your control, not subject to the vagaries of the stock market.
3. Lifestyle choice: Many rehabbers simply enjoy the process of bringing a property back from the dead. The physical work and design challenges afforded by a part-time fix-and-flip project are often a welcome counterpoint to the slow pace and routine of desk jobs.
4. Availability of financing: Hard money lenders like Walnut Street Finance have freed rehabbers from the whims of the banking industry. We lend money based on the property, not on your credit score. Our short term loans are affordable and flexible, and best of all, obtainable.

Using a System to Pick the Right Property

All flippers, whether full- or part-time, do best when they follow a consistent system for identifying target properties, estimating the cost and time of repair, arranging financing, completing the work and selling the property. One of the best tools for evaluating potential investments is a property repair estimate sheet, in which you quickly document the all major repair items and their approximate costs. We’re talking about significant items, such as the roof, kitchen, flooring, structural repairs, appliances, paint, etc.

As you gain experience, you learn that you don’t need an exhaustively precise estimate when preparing a repair estimate sheet. Its main purpose is to save you time and to give you confidence to go forward with the deal. As a part-timer, you don’t need to waste time measuring every room and documenting every defect, especially since there is no guarantee you’ll buy the property. Better to limit your initial inspection to 30 minutes, and save the more detailed work for when you have a strong candidate.

Working a reliable system for each and every rehab project is your best defense against costly mistakes. Using a reliable funding resource like Specialty Lending Group can easily fit into your system and provide the financial stability you need to see the project through to completion.

The capitalization rate, or cap rate, is the required or expected rate of return on a property. It can be calculated as is a property’s annual net operating income (NOI) divided by its current value:

 

Cap Rate = NOI / Current Value

 

For a new or renovated property, it can be extrapolated from comparable properties in the same neighborhood, adjusted for unique features, such as the property’s façade or the quality of its tenants. Usually, the estimated cap rate is within a half percentage point of the average for local comparable properties.

The Gordon Modelis another way to estimate cap rate, where you subtract a constant growth rate, g, for NOI from an investor’s required rate of return, known as the discount rate d:

 

Cap Rate = d – g

 

For example, suppose you are evaluating a building with an NOI of $100K that is growing at a constant rate of 1 percent annually. If an investor has a required rate of return of 10 percent, the cap rate would equal (10% – 1%), or 9 percent. This only works when the growth rate is less than the discount rate.

Evaluating a Property

Whether you plan to use a property to generate rental income, operate your business out of it, or fix and flip it, knowing the appropriate amount to pay can make the difference between a winning and losing transaction.

The cap rate is used in the income approachto valuing a property, using the equation:

 

Current Value = NOI / Cap Rate

 

For example, suppose a rental property has a cap rate of 8 percent and an annual NOI of $700,000. The current value is ($700,000/.08), or $8.75 million.

It’s very useful to have a dispassionate estimate of a property’s value when it goes up for sale, as both buyers and sellers will have a good idea of how much to offer/ask. It’s also used by lenders when figuring how much to lend. Note that hard money lenders use the estimated value of a property as it would exist after rehabilitation to help calculate the amount they will lend.

The income approach can be adjusted for recent sales, but it doesn’t account for factors such as required repairs, collection loss and vacancy rate, which can lead to overstated value and NOI.

If a property has a complex, irregular income stream with significant variations in cash flow, the income approach can easily give an erroneous valuation. In that case, you can use different valuation methods, such as discounted cash flow analysis or the band of investment method.

 

Other Uses for Cap Rate

The cap rate can also be used to compare the returns on rental property investments. All other things being equal (which, in truth, they seldom are), you might prefer to invest in a property with a higher cap rate than an alternative with a lower cap rate. However, a high cap rate can mean a property is riskier, in that it might be more vulnerable to factors that can hurt its cap rate. Therefore, the cap rate should be tempered by factors such as:

• Property age
• Tenant diversity and creditworthiness
• Tenor of leases already in place
• Regional economic fundamentals, including demand and supply of similar properties.

Cap rate trends over a several-year period can give you a good idea where a market is headed. For example, compressing cap rates indicate a market that is heating up, because values are being bid higher.

 

When you decide to participate in a real-estate project, you will be faced with all sorts of figures and calculations. One important number to be aware of the is the origination fee on your loan, because it affects the calculation of your annual percentage rate (APR) and the amount of interest you ultimately will have to pay.

Some Definitions

An origination feeis charged by lenders for verifying your loan application and generally taking care of all the paperwork associated with a loan. It takes time and money for the lender’s employees to track down and maintain all the necessary information, and the origination fee compensates the lender for these costs. You might see the origination fee expressed as a flat amount or as a percentage of the loan amount. Typical origination fees can reach the 3 to 5 percent range. In many cases, the lender will roll the origination fee into the loan principle, meaning you don’t have to pay it separately, but will be paying interest on the fee. You can choose to pay it up front if you like, to avoid paying additional interest on it.

The APRof a loan is usually higher than the loan’s interest rate, because the APR includes any fees, such as the origination fee. The APR calculation includes inputs for the loan amount, the interest rate, the loan term and fees. But don’t worry about the calculation. First of all, there are numerous online calculators available that will compute the APR for you. Secondly, your lending agreement will explicitly state the loan’s APR, as a matter of law. The importance of APR is that it puts competing loans on an equal footing, so that you can compare them with each other. Two loans sharing the same principle amount and interest rate can have widely different APRs, depending upon the loan’s fees and term.

Examples

Let’s assume you take out a $100,000 real estate loan with a 10 percent interest rate. The APR will vary depending upon origination and other fees, as well as the loan term. If the origination fee is 2.5 percent or $2,500, a 12-month loan will have an APR of 12.492 percent. The same loan with a 5 percent origination fee will have an APR of 14.930 percent. The same loans made for a six-month period would have APRs of 13,293 percent and 16.506 percent, respectively. As you can see, all things being equal, a shorter loan term can translate into a higher APR.

Specialty Lending Group offers fast, flexible private loans for investors, renovators and developers in the Greater Washington D.C. area. Apply now!