“Top 10 Mistakes that Make Deals Go Bad” Series – Part 1

#10 Relying Solely on Seller’s Research

What a way to kick off our Top Ten Ways to Make a Deal Go Bad (for you, the rehabber, that is)! 

In any arms-length, investment real estate transaction, it should be assumed the buyer and seller of the real property are at complete and opposite odds with one another. 

  • Price is the just the beginning of the illustration.  The buyer wants the lowest possible price; the seller hopes to maximize profits (or cut their losses).  The seller should, it stands to reason, market the property in the best possible light and point out all the best features in an attempt to maximize selling price.  The buyer should be making the best possible, lowest cost deal for themselves in order to lower their cost basis and maximize future profits.

Buyers and seller opinion of condition is also at diametrically opposing views.  The seller will have the house in best possible condition, possibly covering up defects and hiding blemishes.  The rehab investor will want to peel back all layers to expose any flaws with the property and completely understand the scope of the work that needs to be done.

  • Seller information, such as comparable sales, tenants, neighbors, school information, etc., is not reliable and should be taken with a grain of salt.  In the current foreclosure environment, most properties are non-warranted, sold as is where is, and this point may not be relevant to the buyer.  However, anything offered up should be seen as an attempt by the seller to maximize selling price and should be vigorously vetted and verified before proceeding.

Remember the buyers golden rule: us versus them.  Act professionally but be diligent in your buying process and assume the seller’s motivation is not your own.

#9 Commingle Personal and Business Money and Debt

When running a business the line between business and personal regularly gets fuzzy. Underwriters HATE fuzzy.  If there is any vagueness to the situation they will always assume the worst. This is most pronounced when it comes to debts.  Business debt, even if on your personal credit report, needs to be only business debt and only paid from a business checking account. If this is NOT done then the business debt will be held against the useable income for loan approval. The best plan of action is to have accounts 100% dedicated to the business, only using them for business reasons, and have other accounts that are 100% personal. Good record keeping and proof of what is personal and what is business will increase your income useable for mortgage qualification, lower your debt ratio and make your CPA happy at the end of the year.

Co-mingling personal and business assets needs to be avoided also. Keep business accounts and personal accounts separate. Deposit all business income into the business account and then pay yourself with a check drawn on the business account. This accounting method places the income where it was derived and eliminates any fuzziness in debts, assets and income when your loan file gets reviewed for approval.

Top 10 Mistakes that Make Deals Go Bad


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.