The Magic Number for FHA Loans

12.

That’s the magic number for FHA loans on 2-4 uni apartment buildings. It stands for 12x the annual rents.

Why is 12x grm the magic number for FHA loans? 12x a building’s total annual rent (including the fair market value rent of the unit you will occupy) is basically the maximum price you can pay using an FHA loan and putting down 5% and still have the amount you pay out of pocket each month be equal to the fair market rental value of the unit you occupy.

Why is this important? Well, imagine you move out of your building a year after buying it. If you pay 12x the rent or less for your building, when you move out and rent your old unit to a new tenant, your building is at least breaking even (and, hopefully, paying you each month).

If you paid more than 12x the rent for the building, when you move out, you’ll still have to pay a few hundred a month for the pleasure of owning the building. That is most emphatically NOT what an apartment building is for. If you want to just speculate on the real estate market, go buy a single family home (with a different broker).

If you want to be in the apartment game to generate passive income, you want to use FHA if you can (because when the government is offering you free money, your answer should be “yes”). And if you’re going to use FHA, you need to pay less than 12x.

Why do deposits need to be sourced?

Today’s question is quick: “Why do deposits need to be sourced?”

I presume this question refers to the source of the downpayment for the purchase of a property. When you buy with a conventional loan (e.g. not an FHA loan), the bank lending you the money will very often want to know the source of the funds you are using for the downpayment.

Why? Remember that one of the ways banks think about risk in terms of the relationship between the value of the loan and the value of the property. They want to loan less than the full value of the property, mostly so that there is a cushion in case they have to take a property back. If they loaned $750k against a $1MM property, the thinking is that, even if you default and they have to foreclose, they just bought a $1MM property for $750k.

But there’s another reason banks like to keep the loan-to-value ratio (LTV) low. The lower the LTV, the more cash you, the buyer have to come up with. The more cash you have in the property, the more “skin” you have in the game. You’re much less likely to walk away from a deal into which you’ve poured your savings.

And now we come to the major reason for “sourcing”. If you got the funds to do the deal from someone else, either as a gift or a loan, walking away might mean a lot less to you than if it’s your own money. So, in order to protect their capital, banks try to make sure that the downpayment is, in fact, yours.

How to buy an apartment building when you don’t have income

Sometimes people come to me with the following problem: They have a bunch of cash, but they don’t have much (declared) income. They want to buy an apartment building but they don’t know how.

It turns out that it’s much easier to help these people buy 5+ unit buildings than it is to help them buy a 3-4 unit building. Why?

First, as discussed previously, 5+ unit buildings tend to be better deals, all things considered. Obviously, if you qualify for FHA, a 3-4 unit is great. But, if you already own property and therefore have to put down 25%, you’re better off going bigger; you get more for your money.

Second, lenders on commercial loans are much more interested in the asset than they are in the borrower. This means that, if the debt service coverage ratio works (usually they want to see 1.2 now), the bank doesn’t care that much about your reported income. After all, they’re expecting the rents to pay the mortgage. If, somehow, you screw that up, they get to take the building away from you at a price that’s 75% of what you paid… in other words, a good deal for them.

So, if you’re sitting there with a load of cash in the bank earning 0.25% and you want to do better, consider buying a larger building. At any reasonable price, you’re looking at probably 6-7% / year in cash, plus a bit more when you consider the fact that you’re paying down your loan.

Your good credit is incredibly important

In real estate, unless you have so much cash it’s coming out of your ears, your credit is perhaps your most important asset.

Late last year, I refinanced our 16 unit building on Reno St. When we bought the property in 2008, our interest rate was locked at 6.3% for three years. Because I hadn’t been back in the States for very long at that point, my parents had to be on the loan in order for us to get it. So, when the fixed rate period of three years expired, I wanted to refinance to take advantage of the new, lower interest rates and also to remove my parents from the loan.

We went through the whole process of assembling the relevant information regarding rents and expenses, speaking to banks, getting terms sheets, etc. The first bank we tried sent an appraiser who, after a thorough evaluation, valued the property at a level too low to get a large enough loan to refinance out the existing loan. (Remember, banks will only loan up to a certain percentage of the appraised value of the asset, so the value can limit the loan size.) Uh-oh.

Fortunately, the second bank we approached sent a more knowledgable appraiser (at least, from my perspective!) who pegged the value high enough to enable us to get the loan we needed. I was incredibly relieved, until…

The phone rang and my loan broker told me my credit score was 620, too low for the bank to make the loan. WHAM! Now, 620 isn’t the worst score in the world, but it’s pretty damn bad. I was shocked, because I’d never been late on any important bills. Panicking, I ordered my credit report to figure out what was going on.

Turns out some real mensch had opened a charge account at JC Penney in New York with my personal information, bought $163 worth of pots and pans and then (obviously) never paid the bill. After spending hours on the phone with customer service, it turned out that the easiest thing for me to do was to just pay the $163, after which they removed the negative information from my credit report, my score went back up to the mid 700s, and I closed the loan.

Lesson learned. I now use one of those credit monitoring services. And I’m an absolute Nazi about paying bills on time. Because, at the end of the day, getting a loan means asking an institution or person with whom you’ve had no previous relationship to trust you with hundreds of thousands or, in this case, millions of dollars. To make that happen, you need to be squeaky, squeaky clean.

Are LA apartment building prices entering a bubble?

Recently, prices for apartment buildings in Los Angeles have been increasing rapidly. 12 months ago, you could find buildings in improving neighborhoods for less than 10x annual gross rents. Now, the range is more like 10.5-11.5x for larger buildings and up to 14x for smaller buildings.

Inventory in all asset sizes is also very slim and anything priced reasonably is drawing large numbers of offers. Some clients I’m representing on a fourplex transaction in West LA won an auction by beating out 11 other offers, ending up at over 12x the annual rents. I just called on a duplex listed at $389,000 in Silver Lake and found out it went under contract at $470,000.

So the question has to be asked: Are we in a bubble?

Now, anyone who claims to be able to answer that question definitively is full of shit. Pricing is impacted by all kinds of variable which are very hard to predict, including interest rates, employment, the performance of the stock market, etc.(An aside: If you are able to predict any of those factors with any degree of certainty, you should be running a hedge-fund, not reading this piece.)

So the best we can do is look at the balance of the probabilities. Here’s why I don’t think we’re in a bubble:

  • Interest rates are going to stay low for a while. The Fed is actually looking at ways to stimulate the economy, because the employment numbers have been so low recently. So the odds that rates will rise seem low. (Rising rates would push prices down, because it would cost more to borrow money to buy buildings.)
  • The rental market is hot. We have a tenant breaking a lease on a $1500 one bed in a gentrifying but certainly not gentrified area. We put it on Craigslist and had 10 appointments scheduled that day. Stories like this abound.
  • Employment is bad but hopefully improving. There are still a ton of recent college grads sleeping on their friends’ couches or back at home with their parents. As they (eventually) get jobs, their first major expenditures will be on moving out and getting their own places.

If you do expect rents to continue rising and you don’t expect rates to increase, I think you have to conclude that we’re not in a bubble yet, because the underlying fundamentals of the apartment business (the rents) are improving and the means of financing acquisitions (debt) should remain cheap for some time.