Appraisals May Stop You From Buying A Home

Earlier this month I was quickly on my way to closing on my third rental property when something unique happened: the appraisal came in for the purchase property.  That's not unique at all.  Obviously an appraisal has to be done so that the bank can justify their lending.  What was unique (to me) was that the appraisal of the purchase property, a 3 bedroom 2 bath home in the Memphis, TN area, came in significantly low.  Like $17K low.

The sales price was $87K and the property appraised at $60K.  It's bad news for you as the purchaser and borrower, on both ends, when an appraisal comes in too low.  For one, the company/wholesaler selling you the property will not agree to lowering the price of their property when it is so far to the low end.  Second, the bank will not budge at all in changing their new ceiling on your loan.  If it appraises at a certain amount, that's what the bank will finance at.  Instead of getting 20% of 87, I was now offered 20% of 60!  And I could not put in more of my own money to meet the selling company close to their sales price.

What are your options at this point?  In your favor you have the company not willing to sit on a property for too long.  Like you, they want to move quickly so that they are not carrying the note they have in their books for the property longer than they need to.  Option one is simply to go with another bank.  This was not what I wanted to hear.  My original loan was already in underwriting.  I had spent considerable time gathering all of the documents banks need to underwrite your loan (copies of income tax returns, W2's, bank statements, etc.).  Option two was to scrap the deal altogether.  I did not want to do this.  You may be asking, isn't there a continuing risk of another appraisal coming in low?  Yes!

I have worked with Meridian Pacific Properties on two other deals.  They are a reputable company and I trust their judgement.  They were sure the appraiser made a mistake, not taking recent comparables closer to the subject home into question.  Similarly, I have an interest in the property appraising higher as well.  I want to make sure what I am buying is worth the price.  We went with another bank.  Things are looking good right now.  I was lucky in that my paperwork was secure emailed to the new bank, so that I did not have to spend additional hours gathering and copying my financials again.

Here is the lesson I learned this time out:  

Appraisals are now independently done.  Banks do not have appraisers on staff.  Appraisals are ordered and the appraisers are selected randomly, and blindly.  This means you stand just as much of a chance of getting an appraiser with 1 year of work experience as one that has been on the job for 10 years!  



All this is due to new banking regulations.  You see, before the real estate bubble burst, appraisers were in cahoots with banks and sellers, getting steered into appraising properties at the list price or even slightly higher...NEVER lower than the list price for fear of losing business.  

Things have changed!  Appraisers are independent contractors now and they could care less on what you need.  They will do their appraisals with no repercussions, even if they are wrong!  Worse part, you can't ask for an experienced appraiser to go out to the home you want to buy.  You get who you get.

Bottom line: There is a new monkey wrench in the system when purchasing a property, whether you are buying to rent or reside in.  Good luck!

Real Estate Investing Metrics You Should Know

This post is also an addendum to “Negotiating is Not an Art form or Hidden Talent,” blog post, Thursday, March 20, 2014.

Why was I attempting to lower the asking price on an investment (rental) property in my negotiation with Meridian Pacific Properties?  

Simple, by reducing the asking price, in effect, I’m improving my cost basis, the amount of money I personally put into this investment.  You can also say that I was attempting to improve my Return On Investment (ROI).

What is ROI?  Simply put, ROI is,

Cash Flow (net income – loan payment) / Investment Basis

This will give you a ratio.  Multiply times 100 to get ROI as a percent.

There are only two parts to this equation as you can see.  Your goal as a real estate investor is to either improve your cash flow (better numerator) or lower your investment basis (smaller denominator) to improve your ROI percentage.

A lower sales price would mean I’d put less as a down payment.  I’ve recently signed the sales contract for the property in question.  On a later post, I’ll detail the deal.  I also plan on reviewing Meridian Pacific Properties for other investors.  My negotiation did Not lead to a lower sales price.  However, I got something just as good, if not better: they have agreed to tenant the property for more than what was listed on the property’s sale brochure!  In other words, I improved my cash flow situation.  

You need to be conservative as a landlord when it comes to raising rents.  Keep in line with the rental market where the property is located.  This will ensure that your property is tenanted long-term.  You may be wondering, isn’t tenanting the property your responsibility?  Not with Meridian.  Again, I’ll explain all of this on a later post.  For now, let’s see what other metrics are useful when analyzing a real estate deal.   

What’s an even better metric than ROI?  Enter Capitalization Rate.   

Cap rate = NOI (Net operating income: subtract all expenses this property will have except the loan payment) / Property Price.  

The cap rate % is a hypothetical measure of what you’d get for your money IF you were to pay it outright, i.e., say: “screw financing!”  Will I ever pay for a rental

property outright?  Ha!  Over my dead body.  Why would I when I can employ leverage.

Why is the loan payment amount left out of the Net Operating Income calculation?  Why does it factor all of my expenses: taxes, property management fees, insurance, etc., but not what I have to pay monthly on the loan?  NOI is independent of debt service because this is a wild card.  A seller isn’t going to worry about your financing situation, and we can’t expect them to.  They will tell you, “this is what you can expect to have in net operating income, sir/madam,” and expect you to understand that they’re not factoring in what you’ll be paying on the loan.  Of course you’ll have to verify the numbers they give you for net income too!

Another way of improving your cash flow on a property is with more favorable financing.  Your job will be to get the best possible interest rate on your bank loan.  By the way, decent cap rates are anywhere from 8-12% range.

I love to calculate my Cash On Cash return for an investment property.  This is what investing is all about in my mind: putting as little down for a sweet return.  COC is directly related to what you put in at the start.

COC is, Cash Flow (yearly)/ Investment Basis.

Say you get a Real Estate deal that will generate $200 cash-flow/month.  You had to put 20% down + Closing Costs at the start.  The property price was $100K and it took $2K to close.  Your investment basis is $22K.  Take $200 cash flow x 12 months a year and you have, $2400.  $2400 / $22,000 is therefore your COC return.  In this case it would be 10.9%.  I like to compare my potential COC return with what I could potentially get in the stock market (8-10%).  

If my COC for a RE deal is less then 8%, I begin to doubt the investment.  (It could be worth it for you, especially if you don’t invest in equities).  You could certainly earn 8% in stocks, without doing as much work; however, you cannot view the return on your money from a RE deal with the same lens you’d use to view the return from investing in equities.  Why?

Real Estate has other advantages:

One, there is the factor of appreciation.  The property, if procured during a low in the market, stands a good chance of appreciating over time.  Your “out” will be better.  (You want to make your money when you buy, not when you sell) You cannot guarantee a property will appreciate, however.  

Two, with a rental property, you are building equity.  Your tenants pay down your mortgage.  Again, this helps on the sell side.  Finally, there are taxes.  If you’ve come to enjoy passive income from your rentals, you’ll enjoy it even more as you build your real estate portfolio, replacing salary (income from your job that is taxed at a higher rate) with income from your assets.  The tax consideration is huge!  As I state in my e-book: 

Common Core Money: Financial Literacy for

Educators and Other Professionals, taxes destroy wealth if not handled properly.  Real Estate is a great way of lowering your effective (vs. your marginal) tax rate.

In sum, 8% COC return may not be so bad in comparison to the return you could get with equities.  The stock price of one of your stocks could increase (appreciate) and if you hold it over a year, the gains when you sell will not be taxed as ordinary income.  But you can’t offset income from this investment with things like depreciation, property management fees, repairs, etc.  These are all real estate perks.  The only way to build equity with a stock is to buy more of it!

By the way, including equity, appreciation, and taxes, to the equation of ROI, creates what is known as Total ROI = Total Return / Investment Basis.

Review: Metrics for Analyzing a RE deal are: ROI, Cap Rate, and COC return.  Calculating these will require you to estimate your net income and cash flow as close to the actual as possible.  Good luck, my friends!

Common Core Money: Financial Literacy for Educators & Other Professionals--The Book!

This is not an April fools joke.  The book is finally here!  I checked my email this morning and found that my book cover designer, Donna Tlachac, Digital Arts and Media Teacher, had mailed.  She had the final draft image for me.  This is it:

I love that the elder version of the young man on the bottom left corner is grabbing the "O" in the word, "Core."    The idea to add the crossword puzzle and populate the rows and columns with words found inside the book, was also clever.  I like how she does a strike through the word, "Debt."  I think we all wish we could do this to our own debt statement, right?  There is layering as well on the left, as if the cover was a single page of a larger volume.  There is much to love about the cover of my book, and I could not be more pleased with the end product.  For you home publishers out there, take note, please have a professional do your book covers.  People like to say, "Don't judge a book by its cover."  Don't listen to these people.  Your book won't sell if you have a crappy cover.  Bottom line.  It won't matter what's inside, if you can't get a sale because people are put-off by a book's cover.

The book should be live tonight, 4/1/2014, on Amazon.  Available for Kindle/Kindle App.  Priced at $2.99.  Why so low?  This project was never about me making a ton of money.  I sincerely want to help people with their finances and retirement goals.  If I can make a little on the side, then great.  But I'd rather see you, reader, be successful, build wealth, and give to others when you have more to give.   Take care!