Subject-To Purchases To Avoid “The Wall” When Growing Your Buy-And-Hold Portfolio

[Bryan Hancock]

There have been several threads recently about trying to grow portfolios past 4, 10, or X properties. It seems everyone has unique problems based on their credit, income, liquidity, leverage ratios, type of income, etc. so it is difficult to come up with a blueprint for growing a portfolio of property prudently over time. Many people seem to have to goal of acquiring as many units as they can using a systematized approach so I thought this is something worthy of exploring in a thread.

Private financing generally doesn’t work well for holding long-term assets. The money has to compete with fully-amortizing 30-year debt with government guarantees. Since this debt is so cheap and many non real estate investors don’t hit the FNMA “wall†for financing they can bid prices higher with cheaper debt and make the projects work. Many of these folks are also owner-occupants not seeking cash flow using the 50% rule of thumb. Many people simply don’t account for most of the costs of ownership and bid too much for the properties too. Private money should be viewed as a take-down tool if your goal is to keep the property on the books and grow wealth over time.

Subject-to purchases generally happen at a purchase price above what is necessary to cash flow. The seller doesn’t have enough equity to sell at a “fire sale†price and protect their credit. The seller also is motivated enough to trust an investor to use their credit in trade for exiting a bad situation. The trouble with subject-to purchases is that they limit your farming area for buy-and-hold purchases to a certain extent. You get a discount on the property and don’t have to qualify for additional financing, but you trade off a bit on purchase price because you aren’t buying at a fire sale price point.

For those with limited equity to spread around while you are building a portfolio, the following financing strategy may work:

Properties 1-4
For your first four properties you have all of your arrows in your quiver. You have 4 FNMA “bullets†that offer the cheapest level of financing possible. You also have subject-to purchases and private money for short-term financing that you can later refinance using portfolio financing, conventional financing, etc. These products are suitable for holding property long-term because they eliminate the interest rate and refinancing risk for other types of money. They also are not subject to call provisions like subject-to financing is.

Properties 5-10
Once you have used your 4 FNMA bullets there are extra requirements for conforming financing for properties five through ten. You generally need two years of experience and better documentation of income to continue qualifying for loans. You also need the right DTI, which is subject to the vagaries of how both “debt service†and “income†are accounted for on front-end and back-end ratios. Lenders generally count 75%ish of rent as “income†for this calculation from what I am told. I don’t think that subject-to purchases are included in the ratio calculation.

An alternative is to use short-term financing with subject-to purchases or private money that can later be refinanced once the constraining factor is removed. This could be either the experience or the DTI constraint.

Properties 10-X
After you pass the 10-property threshold you are really relegated to commercial financing with higher loan constants. In general, the rates will be comparable to conventional financing, but the amortization period will be shorter so that debt service will be higher.

I see subject-to purchases as a way to bypass some of the financing constraints imposed by FNMA or portfolio lenders. Acquiring new property needs to be balanced with staying liquid and not taking on too much debt too quickly. Can anyone think of a good metric to gauge the proper measures for leverage? What should one account for over time (DTI, 6 months liquid for all product, etc.) in their financial statements to make a compelling presentation to a lender so that they can continue to finance future purchases without being a loan gypsy? How have you handled this while growing your portfolio?

What modifications would you make to the loan sequencing strategy if you acquire commercial product in addition to the resi product?