The “Classic Real Estate” Investment Model Is Making a Comeback
One of the benefits of being a mortgage broker is that I have a front row seat to everything that is happening in the world of residential real estate and “small” business purpose real estate. By that I mean that I get to see what actual individuals and small business owners are doing in real time in terms of buying and selling homes and investing in properties. I find that very interesting.
One of the interesting developments that I have been noticing recently is what seems to be a shift from Fix and Flipping to what I call the Classic Real Estate model. Thanks to TV shows like “Flip or Flop” and “Flip That House,“ most people are familiar with the concept of fixing and flipping: you buy a house, renovate it to make it much nicer, and then you sell it at a higher price. You pocket the difference between the purchase price and the cost of renovation and the sales price. In recent years we haven’t been hearing much about the Classic Real Estate Model (explained below), but it’s what savvy investors have been doing for decades, if not much longer.
Fix and Flipping
Fix and flipping has been all the rage in recent years. Fix and flips are mainly done by building contractors and people who are experienced in the work of property renovation; in fact, one of the requirements of a Fix and Flip loan is that you know what you are doing in terms of renovation and have at least one person among the project’s partners who has executed at least three previous successful flips.
With fixing and flipping, timing is crucial. Holding the property during renovation costs money, because the property is usually acquired through a loan, and that loan charges interest (more interest than on a regular home loan). Also, if renovations take too long, the market can change. Property values can go down, and this can reduce or eat up the entire profit of the project when it is sold. Or worse, no one wants to buy the property at all.
What we’ve been seeing recently in both Southern California and Florida is that several of our fix and flip clients not getting the same (or any) profit on their projects compared to what was common several years ago. I am seeing several reasons for this:
The costs of renovation have gone up due to supply chain issues with raw materials. Also, renovations are taking longer because some of the materials now take longer to arrive after ordering.
Home prices have stopped rising; in some local areas, they have even gone down. It is now more difficult to find fix and flip projects that will make a profit after taking the higher cost of renovation materials into account. (As a rule of thumb, a fix and flip property should be purchased at about half the price you expect to sell it for after renovation.)
Higher mortgage rates (than three or four years ago) make it harder for people to purchase the property after renovation. This means that your pool of potential buyers is smaller (further depressing home prices). Not everyone has understood this new reality. Doing your due diligence before getting into a fix and flip project is more crucial than ever.
Classic Real Estate
“Classic Real Estate” investment is a model that has weathered the ages because it can persevere through any economy. In Classic Real Estate, you take out a mortgage loan to buy a property at a good price, you renovate it to increase its value and the rents you can get for it, and then you rent it out. The play is that you improve and then hold the property, and the tenants pay off your mortgage loan over time. In that way, you are using “other people’s money” to build your equity in real estate.
This is the totality of the model. If your property also appreciates in value, that is a bonus. But you don’t count on that. And that is why Classic Real Estate stands the test of time. If property values decrease, you simply hold the property and continue renting it out until property values increase again (and then you have the choice of selling or continuing to hold it even longer).
Because you don’t count on property appreciation, it is very important that you get the numbers right before your purchase a property. The rents of the property MUST be able to cover the total sum of the mortgage payments, maintenance and repairs, property taxes and insurance, and optional property management. Basically, the rents must cover all the expenses of holding and operating the property.
We have a number of clients and acquaintances who are applying this model very successfully, both in Southern California and in Florida. Many of these people are business owners who have a primary business in a field they are passionate about, and they use the excess profits from the business to invest in real estate rather than in the stock market.
And when a Fix and Flip project goes wrong, one of the options to save the day is often to refinance the property into a long-term loan, hold it and rent it, essentially turning the project into a Classic Real Estate model.
How to make Classic Real Estate work
In order for Classic Real Estate to work, the rents you can get for a property must have a specific relation to the property purchase price (and therefore the mortgage loan payments). It is important to get those numbers right and to have all your projected expenses worked out in detail before purchasing a property.
As a licensed and experienced California real estate broker, I can help you with the property valuation on California properties, and I can advise you on what to expect in terms of expenses and other aspect of managing a rental property. I can also recommend a real estate agent if needed. For Florida properties, I can give you general information about the Classic Real Estate model, and I can recommend a trustworthy Florida real estate agent to help you with valuations, if you need one.
For finding deals, I subscribe to a number of email lists that regularly send me deals on properties, both in California and Florida. I also continually keep an eye out for good deals from other sources in the course of my daily work. If you would like to be notified of deals that may be interesting to you, send me an email with the specific deal parameters that you are looking for, and I will send you a notification when I come across such properties.
On the loan side, there is a wonderful tool that has emerged in the last few years that I highly recommend for business owners and real estate investors. This loan program makes Classic Real Estate more doable than ever.
The Debt Service Coverage Ratio Loan (DSCR)—turning Classic Real Estate into a serious investment strategy for the 21st century
When you buy a home to live in, lenders look at your income and some other factors to evaluate if you can afford the mortgage. In the world of commercial real estate on the other hand (such as large office buildings, apartment buildings, etc.), lenders look at the income of the property to determine if they want to give you a mortgage on the property. In addition, to qualify for a commercial real estate loan, you also needed to have a personal net worth equal to the value of the loan amount. In the past, there was nothing really in between a commercial loan and a residential loan.
Enter the “Debt Service Coverage Ratio Loan” (DSCR) for residential 1-4 unit properties. We will call these “residential DSCR loans.”
Somewhere in the last decade, someone came up with the idea of making that same concept as in the commercial real estate world, a loan that you qualify for through the income of the property want to buy, available to residential real estate investors.
As we saw above, for the Classic Real Estate play to work, the monthly rental income of the 1-4 unit residential property needs to cover the total monthly expenses involved in holding the property. And this is what the Debt Service Coverage Ratio loan is based on. The Debt Service Coverage Ratio is the degree (ratio) to which the monthly debt payments, which are defined as the mortgage payments plus the property taxes and insurance (called the “debt service”) are covered by the monthly rental income. If these two things are equal, then the coverage ratio is 1. If the monthly rental income is twice the monthly debts service, then this ratio is 2.
This is a revolutionary development in residential real estate investing, in that you need to show neither your personal net worth nor your personal income in order to get a mortgage on an investment rental property.
Some lenders will lend on a DSCR ratio of 1 and even lower. The best interest rate is obtained at a ratio of 1.25 and above, which is what we recommend. You can get a residential DSCR loan for up to about $3M per property, and there is no limit to the number of DSCR loans one person can take out.
To summarize, unlike a commercial real estate loan:
You do not need to have a net worth equal to the loan amount to qualify for a residential DSCR loan.
Interest rates are much lower for a residential DSCR loan than for a commercial real estate loan.
For the purpose of qualifying for a DSCR loan, the lender does not count property repairs, maintenance, etc as part of your monthly expenses—they only look at your monthly mortgage payment, property taxes and insurance. (We still recommend that you take ALL expenses into account, to safeguard your profitability.)
With residential DSCR loans, the property doesn’t even have to be currently occupied! If the property is vacant when you purchase it, the lender will send an appraiser to determine the “market rental income,” and they will use this as the rental income figure for loan qualification.
Unlike a mortgage loan for a primary residence:
You don’t need to show your personal income to qualify.
You don’t need to submit any tax returns as part of the application process.
The DSCR loan will not appear on your personal credit report.
The loan application process is faster and easier than when you buy a primary residence to live in.
The residential DSCR loan sits right in between a commercial loan and a mortgage for a primary residence in terms of interest rate, qualifications and requirements, but it actually has an easier and faster loan application process than both.
What you need to qualify for a Residential DSCR loan
There are a few things you need to qualify for a residential DSCR loan:
You have to already own a primary residence for at least 1 year
A credit score of at least 680
A down payment of at least 20% (though you will get a better interest rate with 30%)
As mentioned, the (appraised) rental income of the property you are looking to purchase needs to equal or exceed the lender’s Debt Service Coverage Ratio (this figure is usually at least “1,” but you will get a better interest rate if it is 1.25 or above).
There are a few additional rules about these loans depending on the specific lender, but these are the rough guidelines.
With continued inflation and some economic uncertainty on the horizon, building a portfolio of rental properties can be a good investment. Generally speaking, real estate has been a good investment throughout the ages as it tends to hold its value, isn’t easily confiscated, and shelter is a basic necessity of life no matter the economic conditions. Rental properties can also be a great retirement strategy, and they are a tangible asset that you can leave to your heirs.
Managing your properties
One thing to keep in mind is that managing rental properties does require work. It is not “passive income.” (If you are interested in purely passive income, check out our Residential Trust Deed Investments.) Additionally, even though to qualify for a DSCR loan you don’t need to factor in the cost of maintenance, repairs or property management, we recommend that you DO factor these in so that you are prepared if rents in your area (temporarily) take a downturn.
If you are going to be managing the property yourself, dealing with tenants is another topic that you need to be prepared for. The good news is that, today, there are a number of very affordable online software platforms that do much of the heavy lifting in terms of property management, including tenant screening, rent collection, maintenance requests and much more. We can help you with recommendations for these, and with advice on what to expect and how to be prepared when you take on rental property management.
If you are thinking about buying a rental property but would like advice or want to see the numbers for a particular scenario, feel free to schedule a Free Brainstorming Consultation. Being prepared in advance is the best way to go, and I will be happy to answer your questions even if you are still a long way from being ready to move forward!
