By Douglas Katz – 01/12/23
So, you want to become a real estate investor and you need funding. This is a huge part of my job and any given day. I actually really enjoy being an on-ramp for new investors, but the downside is breaking the news that things, at least on the funding side, won’t work. Many aspiring investors would be well served by doing a little self-reflection and self-analysis before attempting to acquire and finance an investment property.
Firstly, I recommend new investors get in the right mindset before doing anything. What I mean by this is that they need to think like a lender. Lenders are about maximizing their profit and minimizing their risk. Exceptions or interpretation of subjective factors do not mesh well with their objectives, not to mention their ability to efficiently assign resources to their business. They, like you no doubt would, want solid borrowers with great projects. While this is not always achievable, lenders will work toward this end. YOU should go into the loan process knowing this, expecting this and preparing/acting in accordance with this assumption. In short, take some time to look objectively at the project and yourself, if you would not provide lender to a borrower like you on the project in question, why would a lender do it. Once in the right mindset, you can look critically to see if you and the property fit the bill. These are the table stakes that I refer to. The big ones here are credit, experience and assets.
Just because this is an investment property loan does not mean that credit scoring is disregarded. Like the residential business, credit scoring and credit history matter. While some programs go down to 600, most programs are limited to 620 and greater. I am going to sound like a hard-ass on this, but if you are below a 600, don’t bother with most lenders. I have spend more time than I like to recount explaining that there are rarely exceptions and, while they have a compelling story, the loan will not happen. Your score is your score. If it is inaccurate, I recommend getting it fixed. As a Certified Credit Repair Specialist myself, I can tell you that there are often opportunities to boost your score, but few lenders have the time and resources to help you with this. It is your credit and you should know the number and have a strategy to boost it, if possible, BEFORE you apply. We are only talking to getting to a between a 600 and 620. If this is impossible in your timeline, you should re-evaluate the viability from your own perspective.
One good piece of news here is that unlike much of the residential space, non-QM and hard money lenders often have programs that will take the highest credit score of all borrowers or owners of the entity under which you are borrowing. This is not always the case and is contrary to the residential market, which throws many people, including inexperienced investment financing lenders, for a loop. What it does man is that you could possibly find a partner with higher credit to strengthen your file. Again, this is not a guaranty, so some homework on the programs will be necessary.
Optimally, lenders do not want to lend to people who do not pay their bills and/or who have been through major derogatory credit occurrences. The same way that time heals all wounds, credit issues will disappear after a while as long as they are the exception of your credit behavior and not the norm. One issue is an event. Several credit issues are a trend. A credit report check full of problems is a reflection of either omission or commission with respect to your bills. Neither are good as the they point to you being financially inept, financially irresponsible or both. Either way, lenders will not want to be part of your history of unpaid creditors. If it is an event, own it and have a good letter of explanation ready. It will surely help and you will be asked.
While I am often on the receiving end of tirades by frustrated applicants who bemoan that their lack of experience is preventing them from getting experience, I understand the investor side. Research has shown that a successful track record is one of the best indicators of future success. If you think about this, it makes sense. They have likely made a lot of mistakes already and are, therefore, a lower risk for the lender. I want to stress that lack of or minimal experience is not technically a non-starter, but this means that more experience means better terms. What I do see is that many new investors with limited to no experience come up against less aggressive terms, such as lower leverage or higher rates, that will end up deep sixing the deal.
There are a few ways to minimize the impact of you are inexperienced. First, some programs will allow alternate verification for prospective borrowers. These are very specific and require documentation that you were involved at a high lever and that you were not just swinging a hammer. This can sometimes be excessive and I find few borrowers can meet the requirements. Mostly, I get borrowers who will tell me things like they were the general on a project, but that there is no paper trail, which will not work. Under this approach, I also include realtors and other real estate professionals who actually get decent consideration by many lenders to bump up the leverage, but do not expect a real estate license to put you in the same category as a veteran investor with a deal a quester for the last five years.
Additionally, like credit, you can leverage partners with more experience to improve the deal. Many , if not, most hard money and non-QM lenders will look at the borrower with the highest level of experience when evaluating an entity. Many inexperienced investors will bring on a partner to help them better qualify, but also to mentor. I often make the recommendation to my new investors who are having trouble qualifying to pursue this option.
While there are some 100% programs, most require some assets for reserves and other risk mitigators. It astounds me how often I get calls from prospective borrowers who do not have a pot to pee in who as asking for hundreds of thousands of dollars to acquire a new property. Like the credit evaluation, your assets tell a detailed story about you. If you have no savings, this tells a lender that you are either woefully bad at saving or going through a tough time. You can guess how lender feel about both of these. I am not saying that you need massive amounts of cash, but you should be able to meet any closing costs and reserves.
If assets are a problem, again a partner can resolve potential issues. Assets for the sake of investment deals are cumulative. As with the other components, a partner(s) can help. It is not uncommon for me to see family members or friends help aspiring investors as silent partners providing some financial support. As long as they are part of the borrowing entity, their assets can be applied to the deal. If that fails, there are some no document or limited document programs that can provide investors the ability to use non-documented funds for their deal, but expect higher costs and worse terms for these deals.
I know that the tone of this article could be deemed harsh, but I also feel that sometimes the cold hard facts are ore important than fluff and optimism. You do not want to learn these lessons when you have a deal on the table for a myriad of reasons. It is always best to fully evaluate your situation before and make any adjustments in advance of applying. As I said at the beginning, most lenders do not have time to mentor and coach you. They are appropriately focused on getting active deals done and keeping their clients happy. I would also add that arguing with a lender that they are wrong and that you are a better borrower than you are being given credit for rarely benefits anyone. In Part 2, I will provide guidance and tips regarding the property and/or project.