Financial Strategies For Investors To Consider: This Last But Definitely No Least
Welcome back, this is part 3 of the saga called, “Financial Strategies For Investors To Consider”. We have covered a lot of information thus far in part 1 and 2.
For those you that might have missed it, you are in luck.
You have to understand how underwriters evaluate investment properties. It really doesn’t matter how much equity you have. They only look at the cash flow impact of owning it.
And you can show that impact in one of two ways. You can show lease agreements on the properties but the underwriters will always take the monthly rental figure and mark it down by 25% to account for periodic vacancies.
It’s called the occupancy factor and most loan programs give you credit for 75% of the rental income listed on lease agreements. Incidentally, many Subprime programs will give you 90% or even 100% of such rental income – another example of easier Subprime guidelines.
Financial Strategies For Investors To Consider: The Schedule E On Your Tax Form
The other way to show the cash flow impact is with the Schedule E of your federal tax return. That schedule details the income you make from rental properties but you clearly have an incentive to reduce that income as much as possible to limit your tax liability.
Meanwhile, for underwriting, you want to show as much income as possible. So there’s a conflict there. Point is, there are disadvantages with both methods and you should usually look at both options to see which one will calculate the highest.
Financial Strategies For Investors To Consider: Debt To Income Ratio
Each time you have a property that’s got negative cash flow, you have to show more income to squeeze into the same debt-to-income limitations for the next loan. It makes sense.
If you’re subsidizing a property with your own income, it represents a monthly expense just like a car payment. So each time you add another property you have to subsidize, you have to show more income to qualify for the next loan.
Depending on how much you’re subsidizing, you will quickly be claiming more income than you actually earn and will eventually be considered unreasonable by underwriters.
Financial Strategies For Investors To Consider: Importance Of Positive Cash Flow
If a speculator wants to continue accumulating properties in hot markets, one of his or her top priorities is staying cash positive, or as close to it as possible.
That priority exists for long-term investors as well but so does the repayment of the mortgage balance. As a result, these investors tend to consider more factors than just annual real estate appreciation.
Appreciation is attractive but so is a healthy rental market, and the rental market depends on the types of jobs available in the local area and the health of the local economy.
There are plenty of companies that study this type of information and provide various reports and ratios to help identify healthy markets.
I’m sure you could go to Google and find a lot of such offerings. I recently read an article that chose Charleston SC, Jacksonville FL and Austin TX as particularly attractive markets for long-term real estate investments. All three cities have diversified economies, good wages and affordable housing.
Anyway, the motivation is clearly different then speculators or flippers. Long-term investors want a stable market where they can cover an amortizing loan payment – that’s principle AND interest – with the rental income from the property.
Financial Strategies For Investors To Consider: More Than One Way To Skin A Cat
Now, a well planned real estate investment strategy may involve more than one type of investment. For example, a long-term investor may buy a property in a hot market using a negative amortization loan and keep the property for only three or four years.
After realizing some appreciation, the investor may sell the property and use the profits to pay down a mortgage on a different property in a more stable market.
Perhaps the reduced mortgage balance will bring that property from a cash negative situation to a cash positive one. For the right investor, this strategy can work well even for flipped properties.
There are plenty of promoters encouraging people to take these profits and leverage them even further into more and more properties. Many of these promoters encourage negative amortization on all their properties.
That’s where I have to disagree. That would’ve been fine before the house bubble burst but I just don’t believe the real estate market will continue to appreciate the way it has in the years before it.
Given the current market conditions, I don’t believe it makes sense to expose yourself to that much risk. If real estate goes sideways, these loans erode your equity and add volatility to the market.
Financial Strategies For Investors To Consider: Final Thoughts
There’s always a balance. That balance will definitely be different for a sophisticated investor than it will be for an average homeowner but that doesn’t mean you have to stretch it to the absolute limit. At the end of the day, the ideal situation remains; owning properties free and clear and collecting monthly rent payments on each.
Thank you for joining me in the discussion of “Financial Strategies For Investors To Consider“. Also feel free to comment your thoughts on what you have read thus far.
Take Care And Have A Great Day
Dr. Gregory Stargell II
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