OK, I want to buy a building. What do I do first?

Call me. J/k. Sort of.

The first thing you need to do is take stock of your current position. Here is what you need to get started:

  • A decent credit score. FHA will loan down to a 580 score, but ideally you’d be north of 700.
  • A stable work history. The ideal loan applicant would have worked in the same job for 2+ years with stable or rising income which is reflected in his/her tax returns.
  • A bit of cash. Depending on where you want to buy, you’ll want at least $25,000 in the bank for a minimum of two months. FHA will allow you to get the money from someone as a gift, but you’ll be better off it’s been sitting in your account for two months before you even begin the loan process.

If you’re missing one or more of the above, don’t worry. Cash can cover up a lot of sins. If you can get together enough cash to put down 20-30% of the purchase price, you’re almost definitely going to be able to get a deal done, even with bad credit or a non-traditional employment history (though the terms of the loan won’t be optimal). If you do have all of the above, or if you have a bunch of cash, you’re ready to get started.

The next thing you need to do is determine what sort of property you’re looking for. For a first time buyer who fits the loan criteria, I strongly recommend an FHA mortgage, which means you’ll be limited to 2-4 units. My advice is to be open minded, but to favor 3-4 units over two. (If you already own property, or are going to be putting down 20-30%, go with more units, since you’re not getting the benefit of a high-leverage FHA loan anyway.)

Next, you want to determine where to look. All other things being equal, I recommend areas where the rents are increasing. Buying a building for a fair price with a fixed, 30 year mortgage in an area with increasing rents will turn your good investment into a home run without you having to do much. To find increasing rents, look for gentrifying areas (in LA, try Echo Park, Highland Park, etc.).

Finally, you want to find an experienced agent… hence my semi-joke above. I am sometimes guilty on this blog of making buying buildings seem easy. But you have to remember that buying a building with a mortgage is basically equivalent to doing a leveraged buy-out on a small business. Leverage (debt) magnifies outcomes. This means that, if you do a good deal, you do very well. But if you do a bad deal, you can do very badly. You wouldn’t do a leveraged buy-out without getting advice from someone who knows what they’re doing. Don’t make that mistake with an apartment building!

So find an agent you trust. Tell him/her what your resources are, what kind of building you’re looking for, and where. And listen very carefully to what he/she tells you. You’re probably 60-90 days away from buying your first cashflowing asset.

How much cash do you need to buy your first apartment building?

Not much, especially if you don’t already own real estate.

The federal government has a program called the FHA which provides banks with insurance in case a borrower defaults on his mortgage. Because of this insurance, banks are willing to loan up to 96.5% of the cost of a 2-4 unit building, as long as the borrower will actually live at the property.

In Los Angeles in 2012, FHA borrowers can borrow up to $934,000 for a duplex, $1,129,250 for a triplex and $1,403,400 for a fourplex. That means a borrower could put down as little as $51,000 and buy a $1.4MM fouplex.

Now, these loans come with strings attached. You need to have reasonable credit, a stable work history, and verifiable income. You also need to pay what’s called “private mortgage insurance”, which is an additional monthly fee that helps the government insure against borrowers with less than 20% equity in their properties defaulting.

Also, because of the way the numbers work, you need to make sure that you’re actually making a good deal. It’s no good to buy what you think is a cashflowing asset and then find out that it sucks money out of your pocket. This is where having an experienced agent helps.

But all that aside, I can tell you without a doubt that being able to buy an apartment building in this depressed market using 3.5% or 5% down with a fixed, 30 year mortgage is an amazing, amazing opportunity. I have a buyer I’m working with now who is in the process of buying an incredible duplex in Echo Park by putting down around $35,000.

What does that $35,000 get the buyer? A great place to live for the present with out of pocket expenses substantially less than what he would pay to rent the same unit, then, when he moves out, a cashflowing asset that will ensure that he retires with a sizeable nest egg, whatever else happens.

Do you have a stable job? Do you have reasonable credit? Do you have, or can you get access to $25,000-35,000? That, plus the willingness to take the leap is all you need to buy your first Los Angeles apartment building.

[Edit: Are you interested in getting started? Read this next post about how to proceed.]

Recourse vs. non-recourse

There is a major, major difference between recourse and non-recourse loans, as developers all over the country have found out to their distinct displeasure over the past few years.

A recourse loan is a loan where one or more of the borrowers agrees to personally pay back the loan, regardless of what happens to the property. If the loan payments are not made, the loan documents give the bank the right to go after the borrowers’ personal assets, like their houses or other assets. This makes recourse loans pretty safe from the bank’s perspective, and pretty dangerous from the borrower’s perspective. For example, say the neighborhood changes and, through no fault of the borrower, the rents go down, making the building unable to carry the mortgage. If the loan is recourse, that’s the borrower’s problem.

A non-recourse loan is one where the bank’s only choice, in the event of non-payment or other default by the borrower, is to take the property. In California, all residential loans (for properties of 1-4 units) are non-recourse by law. For larger properties of 5+ units, getting the bank to give you a non-recourse loan usually means paying the bank a slightly higher interest rate in exchange. In the example above, the borrower could theoretically walk away from the building, losing whatever downpayment he had but avoiding any additional penalty.

In my opinion, it is nearly always worth paying the premium to avoid recourse (so long as that premium is reasonably priced). Obviously, no borrower ever wants to default. For me, paying back all of the money I have ever borrowed is a point of pride and honor. But you never want to put yourself in a position where a deal going bad could cost your family their home or retirement savings.

One more thing to keep in mind: It’s incredibly important to pay close attention to the loan documents. Almost all non-recourse loans contain what are called “bad-boy carve-outs”. These are terms which mean that, if the borrower takes certain actions, the loan automatically changes from non-recourse to recourse. They’re called “bad boy carve-outs” because the actions they mean to prevent are things like lying on the loan applications, stealing rent money, failing to maintain the property, etc. So even if you have what you think is a non-recourse loan, be careful to continue to behave in an honorable way, lest problems with the asset rebound on you (which is what you were trying to avoid by going non-recourse in the first place!).

Debt service coverage ratio explained

Time for some more boring real estate math. I guess this is the blogging equivalent of eating your broccoli. I’ll make it quick and painless, I hope…

What is a debt service coverage ratio (DCSR)?

It is the result of dividing the annual net operating income of a building by the total annual debt service payments called for by a loan.

Banks use the DCSR as a test to determine how much money they can safely loan on a building.

Right now, the rule of thumb for apartment buildings of 5+ units is a DCSR of 1.25 or higher. That means that banks want you to have $1.25 in profit for each $1 in mortgage payment that you will be making. If the ratio is less than 1.25, then the banks will probably reduce the size of the loan they will offer you until the ratio hits 1.25.

Confused? Want more explanation? Let’s pick this concept apart:

  • “Net operating income” is a measure of the profitability of a building. You take the total annual rent and subtract all the expenses, including property taxes but not including any mortgage payments. This is the money that is available to pay a mortgage.
  • “Debt service payments” are what you pay the bank for a loan. You take the monthly payments over the course of a year and add them up to get the annual number.

When you divide the annual net operating income by the annual debt service, you get the DSCR. This number should be around 1.  If it’s less than 1, then there’s not enough income to support the proposed loan.

If DCSR is greater than 1, the building can probably support the loan. The higher the number, the safer the loan (because the more margin there is in case something goes wrong with the building and the profit decreases).

When you’re buying 2-4 unit buildings, the DCSR is not that important, because the lenders spend more time looking at you, the borrower, than they do looking at the property. But as you move up into 5+ unit buildings, and especially when you get into non-recourse loans, the bank is mostly interested in the asset, not you. DCSR is one of the key tests they use to determine whether to make a loan, and how much to loan.

[P.S. I’m meeting with a banker today to discuss a really large re-financing, so this post is particularly apropos. Wish me luck!]

Why I write this blog

You might be wondering: Why does this guy spend so much time writing about apartment buildings?

I think the financial crisis of the past few years has changed something fundamental about the relationship between young people and real estate, and I want to try to both explain that change, and help shape it and move it forward.

Before the crash, here’s how most people felt about real estate:

  • I want a big house on a big piece of property
  • I will work very hard at my job in order to afford to take out a big mortgage to afford this big house
  • While I own it, this big house will increase in value every year
  • Some day, I will sell my big house, take my profits and buy an even bigger one

Here’s what happened as a result: A lot of people ended up buried under huge mortgages, unable to sell, unable to re-finance, and facing years (maybe decades) of hard work in order to pay off loans on properties that will never be worth what they bought them for (at least, in real terms).

Sensible young people looking at this situation could come to two conclusions, both reasonable:

  1. I will never own property. It’s not worth the risk. There is value in the flexibility that renting provides. I will therefore rent. Or…
  2. I will own property, but it will be income property. I will slowly build an asset base, taking advantage of the low price of real estate, the availability of cheap debt, and the major subsidies that both the national and state tax codes provide to owners. Over time, as I save more money, I will buy more income property. And, eventually, one day, maybe 10-20 years from now, I will wake up to the fact that I have secured my family’s financial future.

I write this blog for the people who have reached conclusion two. If you are one of these people, or think you might be, get in touch.

I will help you learn for yourself how this whole thing works. And then, when you’re ready, I will help you buy your first income property. (Bonus: The whole thing is free, because, as a broker, I get paid by the sellers of property, not the buyers.)