Understanding lending nuances

Lenders and mortgage brokers are in the business of making loans. That’s how they make money. Their product is cash, and they make money by renting it to people and businesses that pay them the money back plus interest, which is the cost of renting the money. Money is a commodity just like anything else, and its availability and pricing are subject to an assortment of variables.

Lenders and mortgage brokers want to find you money for your next real estate purchase, but they’re not objective advisors to provide counsel for how much you should borrow. They’re trained to calculate the maximum that you may borrow. Don’t confuse this figure with the amount that you can truly afford or that fits best with your overall financial and personal situation. Because they only are paid when they make loans, many borrowers have learned the hard lesson that some lenders and mortgage brokers are willing to make any loan.

So why is getting a loan so difficult at times? Because lenders want to make loans to those investors who are a good credit risk and who they think have a high probability of repaying the loan in full plus the interest. This concern became more pronounced in the late 2000s/early 2010s as real estate prices fell and defaults and foreclosures escalated. The lender has costs of doing business and needs to make a profit. Because the money they lend often belongs to their depositors, lenders need to be careful and selective about the loans they make. (See Chapter 9 for more information on the necessity of a good credit rating when investing in real estate.)

On the upside, we’ve found that lenders can also serve a valuable role by preventing you from making serious mistakes. Particularly in overheated seller’s markets where prices are irrationally climbing with insufficient fundamental economic support, your lender and the required appraisal from a competent professional appraiser can keep you from getting caught up in a buy-at-any-price frenzy. (Of course, this isn’t always the case; look no further than the subprime loan debacle that came to light in the late 2000s.) In these markets, lenders tend to be a little more conservative, limiting loan amounts and requiring larger down payments. These factors provide the lender with additional protection should market prices fall, but they’re also a signal that the lender feels the loan exceeds the intrinsic value of the property that they’ll be stuck with if you default. Smaller loan offers with higher down payment requirements are a clue that you may be paying more than a property is worth or buying at the market’s peak.

Lenders require collateral to protect them if the borrower doesn’t make the debt service payments as required. Collateral is the real or personal property that’s pledged to secure a loan or mortgage. If the debt isn’t paid as agreed, the lender has the right to force the sale of the collateral to recover the outstanding principal and interest on the loan. Typically, the property being purchased is the pledged collateral for real estate loans or mortgages.

Building relationships with lenders

Relationships with lenders can take time to build, so begin looking for lenders that specialize in the types of properties within the geographic area that you have targeted. They can help you understand your financial qualifications or how much you can borrow before you begin your search for an investment property. Although lenders only make money by making loans and some lenders seem to be willing to lend money on any property at any price, the type of lender you should associate with is one who understands real estate cycles and your local real estate market. Not all lenders and mortgage brokers were hit by the subprime lending mess, and it does matter that you develop a relationship with a lender that’s likely to be there when you want to acquire additional properties.

When you get together with your lender or mortgage broker, provide your latest personal financial statement, which includes your income and expenses as well as your assets and liabilities and net worth. For the most part, the days of “no documentation” or “stated income” loans are over, but be wary if you see these loans being marketed again.

Always be truthful with your lender. One way to sabotage a relationship with a lender is to exaggerate or stretch the truth about your current financial situation or about the potential for your proposed property acquisition. Lenders require supporting documents for your income and assets and will obtain a current credit report. When you don’t oversell yourself or your proposed property, lenders are often more willing to work with you and even offer better terms.

Seeing the value of working with an agent

In many metropolitan areas, looking at the properties on a Multiple Listing Service (MLS) or in the newspaper or online listings isn’t enough. The best deals are often the ones that don’t make it into these sources. This is where the “insider information” from real estate sales agents can make you the bride and not the bridesmaid. (Of course, many brokers are themselves interested in investing in income producing properties, and they have the first chance at the best deals.)

You want to be the first one contacted about the best properties coming on the market rather than one of many when everyone knows about the property as it is plastered across a dozen online listing services or the MLS. The MLS is a service created and maintained by real estate professionals per guidelines established by the National Association of Realtors (NAR). This service gathers all the local property listings into a single place so that purchasers may review all available properties from one source. The MLS also deals with commission splitting and other relations between agents.

For many years the MLS dominated the markets, but the Department of Justice filed an antitrust lawsuit that was settled with NAR in 2008, agreeing that other listing services would be given access to the same listings. Now there are several investment real estate listing services that are gaining market share and offering instant access to an incredible database of information on all types of properties, from single-family homes and condos to large commercial, industrial, and retail properties. Several of the most popular listing services for investment properties are Loopnet (www.loopnet.com), the Commercial Investment Multiple Listing Service (CIMLS; www.cimls.com), and CoStar (www.costar.com).

Grasping the implications of agency: Who the agent is working for

When you deal with a real estate agent, you need to know who she represents. Real estate investors need to understand the concepts of dual agency and single agency and the implications of each:

• Single agency: This is when an agent only represents the buyer or the seller. The other party either represents herself or is represented by an agent who doesn’t work for the same broker as the other agent. For example, a buyer’s agent only has a fiduciary relationship with the buyer. The buyer’s agent has a duty to promote the interests of the buyer and keep all information confidential unless legally required to disclose. The buyer’s interest should be first and foremost, and no information is passed to the seller without his knowledge other than that information that directly affects his ability to perform on the contract as written.

  We strongly recommend that you work with an agent who operates as a single agency representative. A lot of money is involved in income property transactions, and you want to have someone looking out for your interests, whether you’re buying or selling an investment property.

• Dual agency: A situation in which the same individual agent represents both the seller and the buyer or when two different agents representing the seller and buyer are from the same firm (with the same broker). With any transaction, each agent involved owes a fiduciary duty of loyalty to each client he represents, but this is nearly impossible for one agent who is representing both the buyer and seller in the same transaction (and difficult as well if two agents work for the same broker).

  Avoid the inherent conflict of interest found with dual agency and establish a relationship with a single agency agent who represents only your interests. Dual agency makes it extremely challenging for one agent, or two agents working for the same broker, to be loyal to clients with opposing interests. For example, an agent may hear confidential information from sellers about what their minimum acceptable price is, and the same agent or another agent from the same firm hears from buyers that they’re willing to pay more than what they first offered.

Agents, and especially their brokers, prefer dual agency — they generate more commissions by representing both sides of the transaction. That’s why many agents start out showing their clients only properties that are listed by their firms. However, this desire to capture a bigger share of the real estate commission has led to some serious conflicts of interest. Now most states either prohibit dual agency or at least require the agent to disclose the exact nature of the agency relationship prior to commencing the representation of a client by taking a listing, showing a property, or making an offer.

Getting a feel for compensation

Real estate agents are generally motivated to see the transaction go through because they’re compensated when a sale is made. Compensation for agents is typically calculated as a percentage of the sales price paid for a property. So the agents actually have an interest in the property going for a higher price. Commissions vary based on the property and the size of the transaction:

• Individual residential properties, such as single-family homes and condos, have commissions of 5 to 6 percent of the sales price.
• Small multifamily and commercial properties are often in the 3 to 5 percent range.
• Larger investment properties have commissions of 1 to 3 percent.
• Raw land (in its natural state with no grading, construction, or improvements) is usually at 10 percent, unless the acreage is large. Subdivided or finished developable lots in suburban areas typically draw a lower commission.

These commissions are typically split between the firm listing the property for sale and working with the seller and the agent representing the buyer. The actual proportion of the split varies, with the listing agent sometimes taking a smaller percentage than the buyer’s agent if the commissions aren’t evenly split. The commission actually is paid to the broker, and the agent receives his share based on his employment or commission agreement, which also often calls for the agent to cover some of his own expenses and overhead.

Real estate commissions can be a significant cost factor for real estate investors. Most listing agreements acknowledge that commissions aren’t fixed by law and are negotiable. Traditionally, the seller “pays” the commission to the real estate agents involved in the transaction, although because the buyer is the one paying for the property, we say that both the buyer and seller ultimately pay for the agent’s commissions.

Real estate agents do add to the cost of purchasing property, but a good agent, like a good property manager, can justify the cost of her services by introducing you to properties that you would not otherwise have considered. A good agent earns her commissions in other ways as well — as a good negotiator and through her other marketplace knowledge.

Some real estate investors get a real estate license so that they can eliminate paying at least one-half of the real estate commission to agents. Be sure to disclose immediately to all parties in writing prior to entering into any transaction that you’re a licensed real estate agent. And at times, you’ll be able to use your sale’s or broker’s license to effectively reduce your transaction expenses and investment requirement by representing yourself in a transaction. This is particularly helpful when you’re looking to sell a property in a strong seller’s market.

But as a licensee you need to be very careful to follow all real estate disclosure laws about your licensing status to all parties in the transaction. Generally, a real estate agent is expected to have more knowledge in a real estate transaction than others without such credentials. Thus, you must be very careful when you act as an agent and a principal in a purchase or sale transaction.

Although you may often have superior knowledge of market values and opportunities in the marketplace, you need to make sure that you’re not self-dealing or taking advantage of insider information that would have a material impact on the value of the property. A real estate agent who buys properties for the long-term for his own account is not likely to be challenged, but such an individual who uses his knowledge to flip properties for a quick profit may be subject to claims by the seller that he withheld information. For example, you may find yourself named in a lawsuit if you bought a property at a low price when you knew that a new road was going to be built that would greatly enhance the property value in the next year or so.

Robert has seen many allegations against licensed real estate professionals who have been accused of self-dealing or failing to act properly in real estate transactions when they buy the property for an entity that they have a financial interest in or have a straw man or secret partner. This situation can happen even if you disclose your real estate license status and your financial interest in the buyer entity, but it is illegal and likely to be considered more egregious if you conceal this information from the seller. Agents have also been accused of illegal activity when they sell their own property (for example, as a tenants in common or triple net investment opportunity) at a much higher price than market value.

One example from Robert’s litigation consulting practice involved a real estate agent who advised an elderly owner to sell a residential rental fourplex where the apartments were contiguous but each rental unit was on a separate lot. The agent advised this unsophisticated owner to sell all four units as a single property to a business associate of the agent. Then the new owner turned around and within less than 12 months had sold each of the four individual properties separately at a gross profit of over $1 million. The agent clearly knew that real estate sold in smaller increments generates a higher overall value. The aggrieved elderly owner filed suit against the agent. The case settled, after both parties incurred significant legal costs, with the agent paying the elderly owner a significant sum with the understanding the owner wouldn’t file a complaint against the agent with the state real estate commission. But, the lawsuit is a public record and certainly had a negative impact on the agent’s reputation.

Finding a good broker or agent

The key to finding a good broker or agent to assist you in the purchase of investment real estate is to narrow the field down to those individuals who are the best. Look for folks with the following qualifications:

• Full-time professional: Because the commissions earned on the sale of a large income property can be so great, you’ll find that almost every broker or agent will claim that she can represent you. But you want to eliminate those brokers or agents who are greedy, incompetent, or simply mediocre. Although many part-time real estate professionals sell single-family homes and condos, you’ll quickly find that the most qualified real estate investment property agents are full-time.
• Expert in the geographic market and specific property type: Find someone who knows your market and the specific property type you’re seeking. This knowledge is especially important if you don’t live nearby. Avoid brokers who aren’t experts in your specific property type. For example, don’t use a broker who specializes in single-family homes and condominiums unless that’s your target market. Likewise, a commercial property broker is unlikely to have the best investment opportunities for your consideration with single-family investment property.

Some real estate investment books advise you to contact every broker or real estate agent who targets your preferred geographic area. Although casting a bigger net has some inherent attraction, we recommend that you only work with one broker or agent at a time in a given market area.

Real estate agents can be a key source for new investment opportunities and general market information. This is where our advice about finding an experienced agent who specializes in the types of properties you’re looking for and knows the local market pays off. These agents know buyers and sellers and also possess contacts for other services and products that you need as your real estate investment portfolio expands.

After narrowing down the candidates, you can apply many standard screening techniques to pinpoint the top three that you should interview:

• Verify the professional’s license status: Nearly every state has an online broker and agent database. Confirm that their real estate license is current with no citations or disciplinary action for past or pending violations. Note that not all states will post pending violations but only adjudicated or resolved matters, so ask your agent directly in writing and have them respond in writing. If you’re using a real estate agent, check both the license status of the agent and her supervising broker. If the broker or agent has been disciplined by the state, inquire further to understand the relevance to your transaction. A suspension or temporary revocation of a license can be a serious issue — even if it was reinstated. The facts of the case may be material to your choice of a real estate professional.

• Check references: Get the names and phone numbers for at least three clients (in the geographical area where you’re seeking property) that the broker or agent has worked with in the past year. Investment real estate transactions tend to be fewer than owner-occupied property transactions, so speaking with three or more clients from the last year maximizes your chances of speaking with clients other than the agent’s all-time favorites.

  Don’t just ask for the references; you must call them. And don’t just ask generic questions about whether the client was happy with the broker or agent. Dig deeper — find an agent whom you can work with on investments that are critical to your long-term wealth-building goals. Ask questions about the types of properties and the geographic locations involved. Ask questions like, “Did the broker or agent assertively represent you and take charge of the transaction, or did you have to initiate conversations?”

Consider these traits when investigating potential brokers and agents as well:

• Willingness to communicate with you: The number-one complaint about real estate professionals is that they don’t keep their clients informed during transactions. You’re looking for someone with experience who isn’t necessarily the top producer, because you want someone who can take the time to communicate regularly with you.
• Interpersonal skills: A broker or agent needs to get along with you and with a whole host of others involved in a typical real estate deal: other agents, property sellers, inspectors, escrow officers or attorneys, lenders, and so on. An agent needs to know how to put your interests first without upsetting others.
• Negotiation skills: Putting a real estate deal together involves negotiation, so you want a broker or agent with negotiating skills and lots of experience in larger transactions. Is your agent going to exhaust all avenues to get you the best deal possible? Be sure to ask the agent’s former clients how the agent negotiated for them.
• Reputation for honesty, integrity, and patience: When it comes to the brokering of investment properties, the reputation of your representative can be critical. Just as you asked in writing about licensing violations, ask about any litigation. Most brokers with years of experience will get sued on occasion, but you want to know about the details so you can determine the validity of the claims. Brokers or agents with a track record of dealing fairly with their clients and their peers can greatly assist in gaining the cooperation of an adversarial seller. And gaining such cooperation is often needed to close a complicated transaction. Some strife is almost guaranteed when buying investment real estate — there are several opportunities where the transaction can unravel and only the trustworthiness, perseverance, and patience of the real estate professionals involved can keep the transaction on course.

Making the most of your agent

To get the best deals, timing is critical. You want your broker or agent to think of you first. To do this, you need to build a solid rapport with your agent, which you can do by building a track record of not wasting the time of your professional team. Because agents only get paid for deals they close, they’re not interested in investing time and energy with numerous potential buyers. They want serious buyers who will close the deal. Plus, if you garner a reputation of tying up properties and then renegotiating the deal or canceling the escrow, you’ll find that your offers won’t be accepted in the future. Sellers and their brokers don’t want to waste time with phantom buyers.

If you’re not interested in or not able to purchase a property at the time, let your agent know at once and explain your situation and thank him for thinking of you. A handwritten thank-you note or simple gift also lets him know that you appreciate his efforts — and keeps you at the top of his lists for the next opportunity.