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?

[Bill Gulley]

I meant to look at who voted for the OP and mistakenly voted and there is no way I know of to retract it. Been away too long. Not that it is a really poor post, or that I disagree entirely, but there are flaws, especially where a few things are stated as if they are fact, while just opinions.

Using seller financing in any form is generally accomplished on a short term basis, but can be accomplished for more than 5 and 10 years, having done so hundreds of times.

A word of caution too, that omitting your obligations on a FNMA 1003 (loan application) would make it a fraudulent loan application. Your DTI ratio absolutely includes all financing obligations, even if the loan is made without recourse.

Those who have their name on a commercial loan (who have actually borrowed money at a bank) know that customary seller financing is very much like a portfolio loan with respect to the balloon requirement to the bank, the advantage is that usually a motivated seller will provide equity financing at or below that of the bank. The assumption of having to pay a premium on your deal for the financing is simply false. It is the private cash loan shark lenders that reach in your pockets. The call feature of sub-2s should be considered along the same lines as lightning striking twice in the same spot, it can and has happened, but about as likely. Having done hundreds of these, and reviewing thousands in seven different states, I have never seen a loan move directly to foreclosure as it would with a default in payment, when the original lender has barked, or the note holder, has gone this route. There has always been sufficient time to sell or refinance the property.

Avoiding the "wall" can be accomplished when your loan maturities (proper term) are managed. I suggest you line up your conventional deals first then move to seller financed deals, then move to the commercial arena. That is the way to begin your portfolio and move up. If you can't swing conventional financing, seller financing may be your only option, but make sure you can pull your deals together when they come due. If you can't do that, you are in the wrong RE strategy.

If you were a multi million dollar business entity we could develop an optimal leverage strategy as economic factors as that old opportunity cost could be better measured, but since you are not, it is a gut feeling, a shot in the dark and you'll usually need to take what you can as your options will always be limited. Just another way of saying that you can not inject all business financing ideas or concepts with small business, it is not practicle nor is it relevant to a small investor. Instead, strive to keep your portfolio flexible and have the abilty to move quickly in the market as conditions change. Stager the obligations that you have the best you can so that you don't have loans due at or about the same time. IMO, your seller financing, as a borrower, should always exceed 36 months (not 36, more than 36 to allow time to refinance depending on your situation) to 60 months, sometimes longer, depending how you structure your deals.

I know this sounded critical but it's not personal, it's that to dance around the bush just takes more time, effort and words typed, so sorry, I probably would not have said anything if I had not messed up. Now, I'm off to approve my awaiting colleague requests and answer my mail.