Time to simplify things a bit.

I’ve been talking all about corporations, rentals, businesses, etc. etc.

How about those of you who would just like to purchase your first home?

I was playing Cashflow 101 the other week and one of the players couldn’t decide if buying a property was a good idea. That made me sit and wonder for a moment. How many people are thinking the same thing in real life?

Certainly in the game the key to doing anything worthwhile must involve owning real estate. There is some that give you a little cashflow or passive income, but ultimately turn into a significant capital gain when the market goes up. And what do you do when you have more capital? Buy more real estate and generate more passive income.

But if you don’t get started on the cycle of buying real estate and just hope and pray that some day you’ll finally have enough saved to buy a property, you may be waiting a long time.
There’s an old quote, I don’t remember who has said it and I’m sure many have, “You can’t save your way to wealth.” At some point you need to invest it or leverage it to make it work for you. Those that do save their way, tend to just keep on doing just that. They save and save and no one knows (except maybe their bank) that they have any cash, as they never buy anything significant as they are too busy saving.

On the flip side, real estate is a get rich slow method of building wealth. Anyone who says otherwise is either selling you something or there’s a significant risk they’re not telling you about. Yes, there are no money down deals. It is possible to do flips and make significant amount of capital, however there are also significant risks you take on, in many cases without even knowing it. If you don’t have the background or experience, you’d better have your assets protected. See previous post.

Should you own your own home? Most definitely and as soon as you are financially able. The world doesn’t owe you a home, nor does it owe you a downpayment. Get over it. Owning one is a major responsibility. People that think they can own a home an not do any maintenance are in for a rude awakening when they try to sell.
There is a reason why banks or CMHC limit the amount of debt you can carry to 32% of your income. You absolutely need the rest to… well eating is a high priority… maintain the house.

You’ve decided to buy a house. Great. What can you afford? Well the maximum you are typically allowed to spend is 32% (GDS) of your gross income. There are lots of mortgage calculators out there that will help you determine what that value is, including this site, look under the mortgage tools button above.

Now you have a price target, right? Well, maybe. You also have to consider what other expenses you might have, like credit card debt or a car loan, student loan, etc. Your total debt load, which includes all your monthly payments plus your mortgage payment cannot exceed 40% (TDS) (generally, higher in certain situations, different lenders, or credit rating).

So if you decided that you just had to have that new Cadillac Escapade at a fleece, err I mean, lease of say $900/mo. Then this is going to impact your total monthly debt load and significantly lower your GDS or buying price.

OK, you are smarter than the average Joe and you pay cash for your cars (concept for many I know). You have a couple credit cards and you pay them monthly.

Credit. There’s a whole topic unto itself. Search this site for at least 3 previous posts on credit, how to mange it and how to fix your score.
Let’s just say, you’ve been following the rules and you have a score of at least 650 or better. You can buy a home with 10% down. But you heard that you could buy a house with only 5% down. Yes, if you credit score is above 680. If your credit is above 700, they you may also qualify for what the lenders call a cashback mortgage. I try to avoid putting clients into cashback mortgages, but the option is available and in certain situations makes sense.

You’ve got good credit (which you can check for free from equifax, except they don’t give a number for free). You’ve calculated what size of mortgage you can afford (32%). You’ve managed to save 5% for the downpayment (or you have a gift from your parents).

Next item you need to be aware of is the lenders also want to know you have enough cash to cover the closing costs. I could list all the items, but the lenders have done calculations and they estimate that you need 1.5% of the purchase price in order to close. The BIGGEST chunk of that is for the land transfer tax. Yes, when property changes hands the government has to get their grubby little hands on it.

Those are the basics for folks who are employed with a salaried income. Good credit, good income, buying within your limits, not carrying too much debt, can and have saved at least 5% for a downpayment and have a little more on top of that for closing costs.

Next time I will look at the options for self employed people (like me, although I like to refer to myself as self-unemployed. I like to fire and re-hire myself from time to time), folks who have an income but it fluctuates from year to year or their income is contained within a business.

This week turned out to be an interesting week.

I have a client, let’s call her Mary, who is in the process of doing a refinance of one of her rental properties. From my perspective, we have someone with a large portfolio (say 16 doors), high equity position on most of the rentals, high networth as a result and above average income. Properties are all well managed and maintained. She runs it like a business. The DCR (debt coverage ratio) as calculated by the lenders works out to 1.3. Well above the minimum 1.1 requirement.

This should be a no-brainer. Right?

So I thought until I discovered that those silly lenders decided to apply the new CMHC rule to her entire portfolio. Which rule is that? The rule that says for any variable mortgage you are requesting, the borrower must qualify at the MQR (new acronym -mortgage qualifying rate). My understanding was when you have a portfolio, you examine the current DCR and if all is well we focus on the property at hand. Much to my surprise (and dismay) the lender applied the MQR to ALL her rental portfolio. All her variables jumped from 2% or less to 5.99% and if that wasn’t bad enough, they also randomly decided to shorten all the amortizations to 25 years.
What I had expected was they would simply reduce the rental income from 80% to 50%. Well, they did that too.

Guess what? The lovely cashflow that she enjoys, well according to CMHC she barely breaks even. I couldn’t believe it when I saw the DCR calculation.

At this point, we had to explore different options.
Accept the measly increase the lender offered. Look for a way to treat the refinance as a commercial deal. Find another lender who will not apply the MQR to the portfolio and accept the fact that she has been running this as a business for the last 5 years and has paid down significant equity in that time. High networth, etc. etc.
The last option is a restructuring of her assets into corporations.

What’s the point of putting real estate into corporations? There are several reasons. The main one I’m going to cover here is a form of asset protection.
Right now when the lenders ask about what Mary owns, she must list everything where her name appears on title. Trust me the lenders do searches on their own to verify.
Let’s say Mary moves all of her rentals into 1 or 2 corporations (holding companies – see Real Estate By Numbered post for more details)
The title is now in the number corporation name and Mary is the guarantor for the mortgage.
Big deal, right? All just semantics.
Except when it comes to the question of what real estate does Mary own? She can now list just her personal home. If the lenders search, they wont find her name on title any more, except her personal home.

Now she qualifies for the new property using her income and the rental income. The portfolio is now excluded. Again she becomes the guarantor for this new mortgage and places it in a new company or into an existing HoldCo.

Naturally this takes time to set things up and there is an expense to transfer existing holdings to a corporation, etc. I’m not an accountant, nor do I play one on the Internet, but I do know an accountant just loves to talk about how to do this and explain all the other advantages to structuring your portfolio this way. He’ll even set things up and explain the reasons why things must be done in certain ways.
I’d call him “creative” however the term “creative accountant” has a few negative connotations. Let’s say he fully understand the real estate investment game and ensures you pay the least amount of tax.

Along the same lines, we had a speaker at the OREIO meeting www.oreio.org that spoke on the importance of asset protection. He along with several other successful investors all start with the same piece of advice. Put your primary residence in your spouses name. That way if something happens and you have to declare bankruptcy, you wont lose your house along with everything else.
The other tidbit the speaker left us with was eventually your corporations grow to a point where you no longer personally guarantee the mortgages. Your corporation stands as an entity on its own.

Post #1 for this week. #2 is on it’s way.

I tried looking up the last time I did an article on commercial deals. I thought I had summarized somewhere as I seem to find I’m repeating myself lately in emails. 2008 seems to be a bit of a long stretch for an update or re-familiarization with commercial so here goes. I’m also finding I’m repeating myself lately (and forgetting certain items) and want a nearly complete reference for people.

I’m coming from the perspective of those who have purchased at least one investment property through a mortgage agent and are now thinking of stepping up to the commercial world.

Let me begin by saying that in the commercial world, the rules are just different enough that you should first consult with someone who has done a commercial deal (be that a fellow investor or a mortgage agent who has done a commercial deal).

The assumption in the commercial space is that the purchaser has access to funds, whether it is your own funds or OPM (other peoples money) doesn’t concern them much. The expectation is you will be paying upfront for most items and as it is commercial, most of these items wont be cheap (think double or triple most costs).

Why are things more expensive in the commercial realm? The thinking or philosophy is that any expense incurred in the commercial space will in turn be used as a tax deduction against your business. Expenses related to the acquisition of the property can be deducted (disclaimer, I’m not an accountant, seek professional advice) against the revenue of the property. If I understand this correctly, you can deduct up to 50% of the expense, thus the doubling effect?

Let’s start with the lender. On the commercial side they outline that they want to see 3% of the purchase price available in some liquid form in order to close. For those who have read a normal residential mortgage commitment recently, you’ll recall that typically they require 1.5% available to close.

The lenders themselves also want to see some kind of commitment upfront, which is non-refundable by the way, so that they know if they are going to put the work in there is at least some cash in the deal. What lenders charge varies, but typically it is between 1-2%. They don’t need the full amount upfront but typically 10% of the 1-2% is required for them to continue to work on your file. Some quick numbers $1M mortgage will require $10K fee at close (which can be added or capitalized into the mortgage) and they will want to see $1000 (non-refundable) at the time of the letter of intent.

Here is the first significant difference from the residential world. In residential, we start with a purchase and sale and provide income verification. The lender then looks at the deal and declines it or provides a commitment. We meet the conditions of the commitment and the deal closes. In commercial, we gather the income and expenses for the building for 2 years, purchase and sale agreement and your personal networth statement (PNW). We submit that to the lender and they review with a committee. The result, if they agree, is a letter of intent (LOI). Within the LOI there are several conditions that must be met, but this is in no way a commitment from the lender. That only comes when we get to the letter of offer stage.

In the residential world, when you get a commitment, your rate is locked in at that point. On the commercial side, your rate is not set until 2 days before the closing date. Why? The source of funds for commercial is completely different from that of “bulk” buying on the residential side. The lenders only source the funds 2 days before they know they have a done deal as they know anything can happen (and regularly does) in the commercial space to nix the deal.

Timelines. Assuming we have collected the documentation upfront, once submitted to the lender, it can take from 48 hours to 5 business days to get a letter of intent (LOI). The LOI will normally require an appraisal and these days more commonly a phase 1 environmental report. There will be a proviso that CMHC may require an inspection, but that is up to CMHCs discretion and you should allow time in your planning for that.
The appraisal. Here’s where the fun begins. First the price. This will vary depending upon the size/type/location of the building, but start at a base of $2500 and go up from there with a minimum charge per door. This type of appraisal typically takes longer to do, both on the inspection side and the research side finding comparables that have sold within a reasonable time frame. The reports are longer, contain more information, etc. etc. If you managed to schedule an appraisal in less than a week you are off to a good start. Once the appraiser has been to the site, expect at least 2 weeks before you’ll see the report (larger buildings 3-4 weeks or if it’s a busy season).
Environmental report. Similar timelines/cost to the appraisal. You hope the report shows nothing out of the ordinary otherwise you move onto phase 2 (the removal of underground oil tanks say) and hope that when they resample the soil nothing is found otherwise the current owner now has a rather large headache to fix.
The appraisal and enviro phase 1 can be done at the same time if you have confidence in both. If you think the value might not be there and may adversely affect the financing you may want to get the results of one before starting the other. Keep in mind the lenders will only lend based on the purchase price OR appraisal value, which ever is LOWER.

The appraisal comes back at or below the purchase price. Phase 1 finds nothing. You’ve provided the deposit. Your deal now goes for review. Again 2 to 5 business days later you get a letter of offer, which might quote a rate based upon today’s bond yields, but offer no guarantees. From there, the lenders are willing to close within 5 to 10 business days.

I’ve mentioned lender fees, let’s not forget broker fees. These deals are a heck of a lot of work for me as well. I can’t just simply submit the deal electronically as I do with residential deals. I have to contact various lenders and explain the situation and negotiate on my clients behalf. Then there’s the pile of documentation. I’ve only known one investor to purchase commercial as his first deal. Everyone else builds up to this level and has several rental properties and I have to collect the income/expense for the complete set. T1 generals, etc. etc. Keep in mind, I don’t get paid until the deal closes. So I have incentive to make the deal work as well.

Keep in mind that your closing date is going to be a moving target. Make sure that your vendor and the realtor are aware of this possibility. Why? If the appraisal comes in significantly lower, you may have to take a month to refinance something you already own or sell or find a partner with the extra cash.

If the environmental report doesn’t pass, how long will it take to remedy the problem (assuming it’s minor)? One month, two?

To give you some idea, I purchase a commercial deal many moons ago and it was the longest closing date I’ve ever had. It wasn’t a large building, but at every step of the way something came up. The appraiser got sick. The home inspector was delayed for some reason. The environmental guy took 3 weeks to get to the property and 6 weeks to write up the report. No contamination, but they did find a buried oil tank (empty). Lender didn’t like this, so I had to negotiate with the vendor to split the cost of removing. Got it removed and had to get the same environment guy to go back (another 3 week delay). They made an error in the number of samples collected and had to go back again.
We started with an August close date and ended up closing in February. I now try and avoid using the term “before the snow flies” when discussing commercial deals.