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Articles for ‘Financial Considerations’

Using FHA 203k Loans To Rehab Your Short Sale or Foreclosure

Monday, December 6th, 2010 by Randy Whiting

There are a few common ways that I have seen an FHA 203k loan used.  Predominantly the clients I’ve worked with use this type of loan to purchase a property that either needs some general rehabbing throughout or to finish a job that was left incomplete for one reason or the other.  As rehab loans of any other type have virtually disappeared the FHA 203k loan has been on the tip of many buyer’s tongues lately.  The only challenge is that the type of property that would motivate a buyer to seek this type of loan typically ends up in a multi-offer situation; speaking in terms of my local market.  If you had a chance to read my short article on TheChicago77.com entitled, “Short Sale and Foreclosure Multi-Offer Strategy” or you have had any experience as a buyer or buyer’s agent attempting to purchase distressed properties then you already know that in a multi-offer situation an FHA 203k loan gets the lowest priority of any offer on the table.   For an in-depth explanation of why please visit the article mentioned above.  The long and short of it is that the FHA 203k loan has a huge amount of contingencies, outs, or reasons to fail before close, and that is very unattractive to a bank.  As banks are the ultimate decision makers in many distressed property sales it is their opinion that counts, and they want nothing more than the quickest close possible.

Clearing The Air

I’m sure there will be some of you reading this who have used an FHA 203k loan to buy a distressed property, and I do not mean to say it is impossible.  Local market conditions significantly impact the possibility that this loan will be accepted for the purchase of a distressed property.  For example, with most suburbs of Chicago and a few of the fringe neighborhoods of the city proper the competition is virtually nonexistent.  A bank attempting to sell a property in areas with low demand are often so desperate for any type of offer that on the slight chance that one comes it matters not what type of loan it is; they’ll pounce on it like a starving cat.

Back To Business

The purpose of this article is to illustrate an example that worked out very well for a buyer that I have been working with for quite some time.  As with many savvy investors my client was very particular about what he wanted in a property.  His goal was to find a distressed building, preferably a multi-unit, and convert it into a beautiful modern single family home for himself.   As such it took us quite some time to locate the perfect property.  When we finally did it was a gutted two unit that had little more than the bricks, the studs and a pile of rubble lining the floors.  With an asking price of around 180K it was ripe for the plucking.  When he asked me to put an offer in on the place, protocol demanded a pre-approval or proof of funds and I asked him for such.  A few moments later he forwarded me a pre-approval letter from his lender for an FHA 203k loan.  Knowing what I know about this type of loan and also about the desirability of this type of property to other investors I correctly surmised that a multi-offer situation was at hand.  Given a very small number of days on the market, there was little chance the seller of this property would jump on a 203K loan.  Instead, they would graciously acknowledge our offer and hold out for something more attractive; cash or a conventional loan offer with a low number of contingencies.  Given this, I called a couple lenders who I know that have their fingers on the pulse of the lending market and we came up with a solution.

The Challenge

Our challenge was how to make our offer stand out on top versus the others that were sure to come.  Knowing my client had enough cash to buy this property with some to spare, I asked him why he chose an FHA 203K loan.  He gave me the answer I was expecting, “I want to save my cash for the rehab.”  Knowing what we now know about the low desirability of this type of loan it was only natural that I council him on the unlikeliness that his offer would be considered.  As the ball was in my court to find a superior alternative I shared my discovery with him.

FHA 203K Refinance

Let me cut to the chase.  If you buy a property with cash there is no title seasoning requirements to re-finance the property with a 203K loan.  As such the refinance can happen immediately after purchase.  Combine that with the huge desirability of cash in the eyes of the seller and this significantly increases the likelihood of a win-win situation.

What If I Don’t Have Cash?

Here’s the good news for investors out there who want to take advantage of this scenario but don’t have enough capital to purchase with cash.  The FHA 203k refinance has the same title seasoning requirement (zero days) if you purchase with a conventional mortgage.  In other words, if you buy a property with a conventional loan, right after you close you can turn around and re-finance it with a FHA 203k loan allowing you to obtain extra money to do some rehabbing on the property.  So why not make the initial offer with an FHA 203k loan and why did I not recommend a conventional loan to my client and encourage him to save the cash for the rehab?  To get that answer I suggest you read my article on Multi-Offer Strategy.

Ciao for now!

Lease With Option To Buy/ Rent To Own

Monday, September 13th, 2010 by Randy Whiting and Gary Lucido

A Tutorial

Lease with option to buy (aka rent-to-own) is a viable solution for many sellers and buyers, yet it is largely under used. Browsing through the various real estate blogs there are many people asking questions that often go unanswered or receive the same type of safe/fluff answers every time. As we have navigated this process from start to finish and seen it work, We’d like to dissect this topic in hopes of shedding some light on a very viable method of transacting real estate.

A lease with option to buy is an agreement to lease a home with the option to buy it before a certain future date at an agreed upon price. This type of agreement is ideal for someone who is either not ready to buy because of a lack of assets or credit or a lack of desire to risk their assets or credit. Even though this is not a new concept it is largely under-developed and there are many things to consider for both sides of the transaction. We cannot stress enough that having an agent that is experienced in this type of transaction is something that should be strongly considered by both sides.

How much should the rent be?

The rent should reflect current market prices for comparable rental units plus additional amounts that may go towards purchase of the home or payment for the option. However, all three of these rent components are negotiable so this is a great reason to have an agent working with you who is experienced in this type of transaction. The key is for the seller to be appropriately compensated for taking the risk of future price depreciation while forfeiting all price appreciation to the buyer.

How much should the rent be increased to fund the future purchase?

As mentioned above, this is negotiable. Again, because this process is rarely used there is no standard or often used guideline to consult.  However, incorporating an extra amount into the rent to fund a future purchase amounts to nothing more than the seller operating a savings account for the benefit of the buyer. Does the seller really want to be in the banking business? And from the buyer’s perspective, how is this any different than the buyer starting a savings account and putting that extra money in there for an eventual purchase that doesn’t tie them to a particular unit? The only difference is that under this arrangement the buyer is “forced” to save money for their purchase. Interestingly, the Chicago Association of Realtors has a “Lease With Option To Purchase” rider that doesn’t even provide for such an accumulation fund.

How should the accumulation fund be managed until it’s time to buy?

There are a couple ways to go about this and it is largely affected by the profile of the seller. Is it huge profitable developer or a struggling couple that is trying to sell? First of all, if it was agreed that the monthly rent would be increased by a specific amount each month (above market price) and that amount would be put toward the eventual purchase, that money should be put into a separate escrow account by the landlord/seller until such a time as it will be used for the purchase or refunded to the buyer/renter. Another way this can be handled is for the landlord to keep a ledger to record the agreed upon amount so that when the time comes to purchase, the landlord will reduce the sale price on the home by the amount in the ledger. From experience this is the most common method, however a number of risks for the buyer present themselves. Namely when the time comes to sell will the landlord be able to sell the home at the reduced price? In addition, lack of funds for a down payment is a very common reason that buyers seek a lease with option and it is not necessarily the price of the home that is preventing them from buying. Often the amount of money accrued is a drop in the bucket when compared to the over all cost of the home and as such the highest impact of that money would be as down payment assistance for the buyer. If the landlord is not keeping the money in escrow, there is no guarantee that the landlord will be able to cough it up at the closing table.

At what point in the process should we agree on a purchase price?

In the Chicago Association of Realtors “Lease With Option Rider” there are two choices (this may differ for your local association’s forms, please consult your agent):

“Tenant shall have the one-time right to purchase the Property (“Purchase Option”) for a purchase price equal to (strike one) $_______________________________ / the fair market value (“FMV”) of the Property at the time such Purchase Option is exercised (“Purchase Price”). (Strike the following sentence if it does not apply) The FMV of the Property shall be determined by Landlord and Tenant, in good faith, taking into consideration the purchase price for properties similar to the Property, located in the same geographic area as the Property, which have been purchased in the preceding nine months. “

There is a lot to consider here. When does the renter plan on converting himself or herself into a buyer? Will it be six months or two years? What does the housing market look like at the time of purchase? Is it stable, falling or experiencing growth? Either way there is risk involved for both parties.  In a standard option there is an agreed upon purchase price, the “strike price”, established at the point at which the option contract is entered into. It is this set price that creates the value of the option for the buyer. If there is merely an agreement to negotiate a fair market value at some point in the future then the option has absolutely no value whatsoever.  If the buyer ends up purchasing the property at fair market value in the future then they have forfeited any right to appreciation of the property up to that point in time.  What if the buyer and seller can’t agree upon a fair market value in the future? This essentially provides an out for the seller. In other words, the seller is not really obligated to sell the property and the buyer doesn’t really own an option.  The existence of this second alternative in the contract is really rather pointless. It creates a situation where the seller can’t sell the property to anyone else, but the buyer is not guaranteed that they will be able to purchase it for a price they consider reasonable.

As a seller, when should I ask for a pre-approval?

This is a tricky one because in many cases the reason people are looking for a lease with option is because they cannot yet qualify for a loan for one reason or the other. Our advice is this: With the assistance of a lender you or your agent are comfortable with, get the renter/buyer pre-qualified for the purchase amount you’ve negotiated and find out what it would take for them to be able to qualify. It could be increased assets or it could be credit clean up. Whatever the case may be, this will give them a clear picture of what their goals need to be in order to eventually purchase the home. This is also very important because this will give them a glimpse of what their monthly cost to own would be. A lot of first time home buyers have no idea what their mortgage, insurance, taxes, and assessments (for condos) will add up to. It may be that once they see what their monthly cost to own will be that they realize there is no way they would be able to ever buy this in the near future. The last thing a seller wants is to waste time renting their place when their goal is to attract a buyer. Getting the pre-approval done up front is also a good way for the seller to assess the risk of a given buyer. At the beginning this will serve as a credit check, which most landlords require anyway. If you see that the potential buyer has a 300 credit score and has never paid a bill on time, it may not be a good idea to tie your home up with that candidate. If you see that they are 800+ credit, never missed a payment, and the only thing preventing them from buying is a lack of down payment or lack of income, you may consider this to be less of a risk than the former example. Obviously the buyer will need to get re-approved once the purchase is close at hand.

Will the security deposit be handled separately from the earnest money?

We recommend that these two be handled separately. Through the Landlord Tenant Ordinance (LTO) the City of Chicago requires a lot from the landlord with respected to the security deposit and noncompliance comes with some very heavy penalties. That said, we feel that the seller acting the part of the landlord should adhere to the LTO and ask for earnest money if and when a purchase comes to fruition. This will reduce the liability to the landlord who is at significantly more risk than the potential buyer.

Should I keep my home for sale during the agreement?

Only if someone will buy it with the option attached. You gave the buyer/renter the right to buy the place and you can’t just ignore that fact. Again, consider the comfort level of the buyer. Do you think a buyer would go through all of this trouble with the possibility that the rug can be pulled out from underneath them at a moment’s notice? Plus a renter who is planning on buying this home may be very put out by having “potential buyers” traipsing through the home.

What happens if the home is foreclosed during our agreement?

This situation is largely effected by the type of agreement you had. If you are paying above market rent and having that money put into an escrow account, obviously you should have claim to that excess money. We recommend that you have some verbiage in your agreement that covers this possibility no matter how remote you think it may be.

Can section 8 vouchers be used in a rent-to-own home purchase?

The answer according to the HUD website is yes, depending on your personal situation and the program that you are involved with. We advise you to consult the hud.gov website for details.

Do I have to sell my home at the end of the agreement?

Absolutely. That’s the whole idea behind an option and that’s what you are being paid for.

In Conclusion

With all of the different variables to consider it is clear why a lot of agents steer clear of this type of transaction. It is unfortunate that often the professionals that people turn to for advice are the ones that push them away from viable options due to lack of familiarity or out of sheer laziness (short sales are another example of this). In the end, rent-to-own has the potential to be a win-win situation for all parties involved. The buyer gets a chance to test out a home before buying it, continue to build credit, and an opportunity to put their money toward a home purchase prior to qualifying to do so. For sellers, they can have a renter in the short term to help alleviate some of the financial burden of their cost to own while cultivating this renter into a buyer. The situation can also be a very easy out for both parties. In a market where serious buyers are hard to come by, this has the potential to be an excellent compromise.

The Folly Of Timing The Housing Market

Wednesday, February 24th, 2010 by Gary Lucido

It’s hard enough to time investments. Finance theory says it’s impossible and there is plenty of evidence to prove that it can’t be done. So it should come as no surprise that timing a home purchase would be even more difficult.

As I’ve said before, I don’t think people should think of a home as an investment. If it were, it would be the only one that regularly springs leaks, begs for a makeover, and falls apart over the course of 30 years (maybe sooner depending upon your builder). Regardless of what the National Association of Realtors would like you to believe, a home is simply a lifestyle purchase, with some pretty hefty financial considerations. Therefore, the timing of when to buy a home should be largely influenced by lifestyle goals.

That doesn’t mean that there aren’t times when it’s prudent to wait for homes to “go on sale” – such as the last few years. But trying to pick the absolute bottom of the housing market is a fool’s errand. And it’s not just because you don’t know where the price of housing is going. You also have to figure in the impact of mortgage rates, which can have an even bigger impact on the cost of housing than the price of the house.

Let me demonstrate. Consider the purchase of a $500,000 home with 20% down and a 5.1% mortgage. Your monthly payment would be $2,171.80. However, if mortgage rates go up by 100 basis points to 6.1% then the price of the home would have to drop to $458,386 in order for you to have the same monthly payment with the same down payment. That’s an 8.3% price drop. So you have to ask yourself what is more likely at this stage: that housing prices will drop another 8.3% or that mortgage rates will go up by another 100 basis points? How about another 200 basis points?

Look at where Chicago housing prices are right now relative to their long term trend. I’m not saying that they are a steal but they are certainly fairly priced relative to where they have historically been. Now look at mortgage rates. Recently they have been at the lowest level in the past 50 years! I pulled the data below from the Federal Reserve and since that series doesn’t go past April, 1971 I estimated the prior data back to January, 1962 (light blue line) based upon the rate on 10 year treasuries. That estimate is a bit crude but the conclusion is still the same since 10 year treasuries are now at lower rates than they were in 1962.

Historic Mortgage Rates

Actual And Estimated 30 Year Fixed Rate Mortgage Rates

But what about this debate that rising interest rates will depress home prices? Well, let’s look at the period from the 60s to the 80s when 30 year rates went up from around 5% to 18%. According to the theory, during that period, home prices would have dropped by almost 52%! Well, they didn’t.

I’m trying to avoid repeating the realtor’s mantra of “now is the time to buy” because it really does sound lame and self-serving. However, the fact of the matter is that current conditions are extremely favorable for buying.

Will Rising Interest Rates Kill The Real Estate Market?

Monday, February 22nd, 2010 by Gary Lucido

Understanding the relationship between interest rates and home prices is particularly important now because most people believe that interest rates are heading up in the not-to-distant future. One might quite logically expect that when mortgage rates rise it depresses home prices. After all, most people determine the affordability of a home by looking at the monthly payment. In fact, buyers and their lenders usually target their price limit based upon how much they can afford to pay in principal, interest, taxes, and assessments, given their income. And the interest component of that equation is a big driver of the size of the payment. So when interest rates rise you would expect that all buyers would have to shift their expectations down scale and that this would depress home prices.

However, about a month ago one of my clients sent me a link to a BusinessWeek article on the impact of interest rates on home prices. In this article the author, who is the founder and president of Home Warranty of America, claims that the data just doesn’t support the notion that rising interest rates depress home prices. Although he doesn’t provide the direct analysis in his article he does provide links to several data sources so that you can do your own analysis. However, I would like to point out that this is not the first time I’ve heard this claim and I myself have glanced at the data before and found this to be true – especially in the late 70s and early 80s, which is the time period referenced by this author. During that time period home prices rose, despite interest rates that approached 18% ?!?!?! Or at least home prices didn’t decline like you would have expected.

Well, last week a spirited debate transpired on Cribchatter about this very topic. This has to be one of the longest threads in Cribchatter history with 234 comments. The people who argued that higher interest rates would push home prices down were initially arguing based upon the same logic I articulated above. However, eventually both sides of the debate started to link to various studies and articles that proved their point of view. Like most academic endeavors, when someone makes a career out of spending grant money they can prove anything they want so it’s not surprising that there are plenty of studies to support either side. Personally, I got a headache from following the debate, not to mention that it was full of insults.

However, I would like to point out a few things:

  • Many of the articles referenced as proof that higher interest rates depress housing prices were nothing more than opinion pieces, based upon financial logic, or were based upon anecdotal data. Hardly real studies. Nevertheless, several legitimate studies were referenced to support this thesis.
  • There could be several logical explanations as to why higher interest rates would not depress home prices as expected:
    • Buyers assume they can refinance at a lower rate in the future
    • Buyers have other financing alternatives, including adjustable rate mortgages and higher down payments. (I remember buying our first home in the summer of 1984 and an ARM was a no-brainer.)
    • Higher interest rates are usually associated with inflation and inflation pushes up housing prices
    • Buyers assume that if interest rates are higher now they will go down in the future and that will elevate home prices
    • When rates go up buyers shift their focus to the lower end of the spectrum but demand at every price level is replaced by demand shifting down from a higher price level – except of course as you get to the higher levels there isn’t as much replacement demand as exiting demand
    • When rates go up buyers simply allocate more of their income to interest payments.

For further reading you may want to check out some of the referenced studies and one that I have been meaning to read for a while:

  • What Moves Housing Markets – demonstrates that interest rates do not affect home prices. “…our results provide evidence that changes in risk-free interest rates may not have done much to change housing valuations over the 1975 to 2007 period.”
  • The Effect of Real Rates of Interest on Housing Prices – demonstrates that real interest rates do affect home prices. “This ebb and flow of real interest rates appears to explain market price levels.”
  • Assessing the Role of Income and Interest Rates in Determining House Prices – demonstrates that interest rates do affect home prices. “Our results support the existence of a long-run relationship between actual house prices and the amount individuals can borrow.”
  • Why do House Prices Fall? – demonstrates that interest rates do not affect home prices. “Interest rates appear to play a relatively minor direct role, though they may play an important indirect role.”

Villa Taj Update

Monday, February 8th, 2010 by Sari Levy

Last October, I wrote about an outrageous mansion, Villa Taj in Burr Ridge.  Since then I have obtained some interesting tidbits of updated information.

  • The auction reserve price was $12 million dollars – the auction failed
  • The current broker thinks the place could be sold for scrap for a mere $6mm
  • The seller isn’t entertaining any potential buyers who can’t back up their interest with a $10mm documented net worth

While the cooperating commission is  not published my guess is about 1.0-1.5% on a sales price  around $10mm, which of course, we’d split with you if we represented you in the transaction. When I first wrote about this home, I thought it would sell for north of $12mm.  My optimism has diminished.

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