Expert: Matt Heisler - 8/15/2007

Question
QUESTION: I currently owe $120,000 and pay mortgage on a $140,000 home and have been given an opportunity to buy an investment property for $500,000. It will be a property that I buy and a home builder will just be paying the mortgage and using it for an office. How would I go about financing something like that? Is it easier to finance an investment property than to buy a home? I only make $45,000 a year, so obviously I wouldn't be able to pay mortgages payments on that property. I would hold the property for 2 years while the builder built homes on the adjacent property. What do you think?

Thanks,

Andy

ANSWER: Hi Andy:

I advise all my investor clients that the biggest item to consider for investment property is cash flow.  Financing it isn't hard - just expensive.  You'd need an 80/20 loan, or something similar, since you haven't mentioned that you have any significant cash for a down payment.  The first loan is going to be at around 7, and the second around 10 or 12, and you're going to be looking at payments over $3500-4000 dollars a month - before taxes and escrows.  So what is the builder going to pay you for rent?  $5000?  $6000?  And how are you going to pay the mortgage when he leaves his lease?    By selling the property?  It's unlikely that you'll have made enough in appreciation to justify the risk.  

Basically, Andy, if you already know that you can't make mortgages on both properties, you need to be awfully sure that your expenses are covered.  In general, tenants aren't a good source of guaranteed income.  I would be careful with this arrangement.

Matt

---------- FOLLOW-UP ----------

QUESTION: The builder would pay the mortgage, whatever that would be. I guess this is a common practice when a builder builds a model home so they can put their assets and credit into building new homes. He thinks I can get the home for 10%-20% below market value(assume only 10%). I believe the original builder would be selling it and is currently on a construction loan with high interest. I will be selling the property when he has completed building homes in the area, which is about 2 years.
I probably need more information about this investment. The builder is a friend of mine and so this investment was brought up in conversation and he offered it to me and there was no formal write up of the whole deal.

Answer
Hi Andy:

Yes, I figured his goal was reduce his exposure, but if he's cutting it that close,  you need to understand that he could go belly-up - and you'd lose a friend and your good credit.

Friendship aside, let's talk some numbers:
1) If he sells it to you at 10% below market, what are your selling costs? Usually they are around 6%, so you're profit is only 4% over a two year period, or 2% annually.  That's a lot of risk for a very low return.
2) We are also assuming, of course, that the house sells the day he stops paying rent.  What if you have to carry the house for 2 months while it sells?  4 months?  That's 12-18K right there in profit gone.  Since we're looking at a total profit of 20K, I don't think you're being appropriately compensated for your risk.
3) Lastly, you'd need to set this up as an option-type deal, where the outcome depends on two seperate appraisals (or 3).  Something like "buyer gets the home at 90% of the average appraisal price as determined by 2 (or 3) licensed appraisers.  And you'd need a use-and-occupancy agreement.

I'm not sure where your builder is, but in my local market, finished homes are selling - not spec houses.  I don't know if I'd recommend this approach for him either - I think it's too expensive.  He'd be better off finishing one house at a time, quickly, then raising enough capital for a model home when the market improves.

I think there's a way to structure this so that it makes sense, but you'd need a lot more detail, and what probably would make sense for you, wouldn't make much sense for him.

Matt