Top 10 Mistakes that Make Deals Go Bad

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Easy Money!

One of the mistakes that many rehab investors make is using consumer debt for business purposes because it is “Easy.”

On the surface, the lowest hanging fruit for a rehab investor is the credit card or Home Equity Line of Credit (“HELOC”). Often these consumer credit facilities are used for repairs and even purchases of real estate.  Why go through the hassle of gathering information and approaching lenders for a loan that they will charge points, fees and potentially higher interest on, when you already have or can easily obtain a credit card or HELOC? The short answer is that using consumer financing for business purposes does not work long term. In fact, it can be lethal for you as a business operator and a consumer.

ImageSpecifically, this “Easy” financing methodology can have a very negative impact on credit scores.  For entrepreneurs in the rehab investor market segment, where capital availability is a critical success factor, the credit score is your most valuable asset.  It must be protected.

A credit score is determined using five main methods of analysis, payment history, amount you owe, length of credit history, new credit, and type of credit.  Amount you owe or utilization is impacted the most by using consumer debt for business purposes.

Amount You Owe

The second largest impact on your credit score is the amount you owe in relation to the credit limit.  It is also known as the utilization rate.   If you have borrowed and are near or at your credit limit, this damages your score. In fact, any balance above 40% of the limit has a negative impact on the score.  This is important for rehabbers because financing rehab projects takes a great deal of capital, which will most likely exceed that ratio.  High unemployment and the decrease of home values have prompted many lenders and banks to cut credit limits in order to minimize risk, resulting in an immediate increase of utilization rates.

Why Does It Matter?

Utilization rate accounts for 30% of your credit score. According to FICO Score Simulator, maxing out your credit cards could drop your credit rating from 700 down to 590 or worse, assuming that you still pay your bills on time and all other factors remain positive. According to myFico, “Carrying extremely high balances on all of your revolving accounts (i.e. credit cards, equity, and personal lines of credit) makes you look ‘maxed out’ on your available credit. It is often considered a high-risk trait by lenders and the FICO score.” In short, lenders (and credit scorers) don’t like high balances.

Make sure you understand how a loan or line of credit is being reported to the credit agencies.  Many “Business” lines of credits and loans actually use the credit score of the business entity owner(s) and reports to the agencies.  This means it has the same impact as a consumer loan.

So how do credit-reporting agencies distinguish between a shopping spree and a rehab project?

Well, they don’t. It is hard to blame them, however. This is because they report on 190 million consumers. Extremely few of these 190 million people are rehabbers, so it is impossible for credit bureaus to track the difference between consuming and investing on credit cards. When you purchase and pay for improvements on a property with your credit card, the agency cannot distinguish between that luxurious vacations, extravagant jewelry, expensive clothes, and pricey dinners.

Why are these credit scores important? It can make the difference between being able to obtain a loan and getting denied. Also, even if your score only drops several points, it can result in higher interest rates.

Pennsylvania Real Estate – Title Insurance Price Change

Attention Pennsylvania Real Estate Investors, The Pennsylvania Department of Insurance has issued a change in the closing cost rates that will take effect on July 1, 2012. The department has agreed to a new price structure for title insurance that will allow for easier calculations for title insurance and will increase rates for title insurance. Note that if you are to close at the end of June but are delayed in to the month of July, you will be subjected to the higher rates.

For more information, read Jeff Geoghan’s “Watch out for changing title insurance rates” an article from Central Penn Business Journal

Your Most Important Asset

Most real estate investors are quick to answer the question, “What is your most important asset?” with the response “Real estate holdings.”  Others will mention cash reserves.  Working for an organization that caters to only rehab investors, and having completed thousands of deals, we can tell investors that the answer is their credit score!

Mortgage lenders, banks, utility companies, prospective employers, insurance companies, trade creditors, and more use credit scores.  A credit score can have a lasting impact on your ability to grow your real estate business in addition to other aspects of your personal and business endeavors.  Your credit score is your most valuable asset.  It must be protected and nurtured or it will cost you money and opportunities.

Access to Loans

A credit score can make the difference between being able to obtain a loan and getting denied. Even if your score only drops several points, it can result in higher interest rates.  As far as lenders are concerned, lower credit scores equate with higher chances of delinquency, which translates into a higher risk premium on your loans or flat denial of your application. Delinquency is defined as any default, bankruptcy, non-payment or 30-days past due payment.

According to myFICO, a website dedicated to FICO Scores, the following are the delinquency rates for different categories of FICO Scores. A FICO Score is used to establish mortgage rates, car loans, and credit card terms. A FICO Score is devised based on credit history, and helps lenders appraise credit risk.

Assume for a moment that you are the lender and it is your money being lent.

Armed with the “Delinquency Rate” chart, to who would you lend? The answer is obviously that person with the higher credit score meaning lower probability of delinquency.  Who would you give the “best” rate to and who would get the “highest” rate?

Insurance Premiums

Yes, insurance companies use credit scores to determine if they will even provide insurance to a client, the types of coverages that they will make available, and the cost.  Insurance companies have thousands of historical data points and statistical evidence that shows a correlation with “Bad or Lower” credit scores and the probability that an insurance claim will be filed.  The insurance companies take the logical approach that if the probability of a claim being filed is high, then coverage will be denied or reduced and premiums will be raised.   This can occur even after you have an established relationship with a provider if your score drops.

Trade Creditors

Suppliers of building products and many utility companies use the credit score as the primary tool in evaluating whether they will extend credit and how much.   The alternative is to require cash payments or deposits for those products and services.

Building and growing a real estate business can be challenging and requires the management of many variables.   Managing the most important or valuable asset, the credit score, is something that you have control over.  Taking the necessary steps to preserve and increase the score will result in significant savings that can be reinvested in the business and provide access to premium loan and insurance products.

“You make your money when you buy the property!”

It took me several years to truly understand what “You make your money when you buy the property” meant.  After seeing my first real estate investor client successfully complete over 100 projects and make money on all of them, and hearing a similar mantra from other top notch investors, I began to understand.

There are basically five “variables” in the rehab real estate profit equation.

  • Purchase Price – What you pay for the property
  • Improvement Costs – What it costs to bring the property back to market condition
  • Soft Costs – Closing Fees, Loan Fees, Interest, Insurance, Taxes, Realtor Fees
  • Sales Price – What the property sells for

And it all equals…

  • Profit – What you put in your pocket once the property sells

The successful investors start with a target Profit figure and work backwards.   A Profit target can be a minimum dollar amount or a percentage.  In either case, they make sure there is wiggle room for unexpected negative changes in any of the other expense variables.  The percentage or dollar amount target can be influenced by factors like the investor’s experience, appetite for risk, neighborhood, and size of project or amount of improvements required.   It may take longer to find the right project that meets or exceeds your target, but that is much better than the alternative of cutting it too close and making little or no money or possibly taking a loss.

Since you do not know what the Sales Price will exactly be, the best way to estimate is to determine the market value of similar homes.  Sales Comparables or a “Subject To Appraisal” can provide this data.

Title Companies, Realtors, Insurance Agents, Lenders, and Auditor Sites can provide the information you need to determine a Soft Costs total.  Remember, that several of these Soft Cost items are impacted by the passing of time.  Taxes, Insurance and interest expense grow the longer the property is in your hands.   Use Days On Market (DOM) data to help you calculate those figures and it is not a bad idea to add a couple months to the average.

Improvement Costs can be obtained by getting 2 – 3 estimates for all the improvements required.  Additionally, walking the project with different contractors typically provides great ideas and different perspectives on what needs to be done and how.  If in doubt, spend the money for a professional inspector. 

We now have all of the required variables to calculate our maximum Purchase Price.

                Sales Price – Profit Target – Soft Costs – Improvements = Maximum Purchase Price.  

Now the negotiations begin.   The negative aspect of this approach is that it takes work, time and in most cases many offers. However, the positive is that you have dramatically increased your probability of a profitable project by “Making your money when you buy it!”