A client who was recently introduced to us holds several cash-flowing properties in the Windsor market. He confidently put a firm offer on another Windsor property, assuming that he would be able to get the same type of financing he received in the past from his bank – 20 percent down, 30-year amortization at reasonably low rates – as his bank had provided pre-approval. Based on that combination of financing assumptions and pre-approval, his cash flow was going to be around $700 dollars per month using student rental as a cash flow-intensive strategy.
After taking the deal to his bank for financing, the deal was declined. The property was set to be rented by the room, and not too many banks are keen about lending on a student rental at attractive financing terms even if the client personally qualifies for a mortgage. Due to the potential for increased wear and tear, lenders may up the down payment requirement or charge higher rates to offset their risks of lending against such a property.
After we had assessed the client’s portfolio, it became apparent that his student rental deal would only qualify at a higher cost of capital at 35% down at higher rates. As a result, the higher cost of capital ate away into his projected cash flow.
The key takeaway from this story is that while you may have a property or strategy that looks amazing on paper from a cash flow standpoint, if you do not plan ahead and validate the financing you are able to get on that particular deal then you run the risk of facing a higher cost of capital late in the game that will devour a large chunk of the cash flow you had planned for.
To be clear, a pre-approval is not what I am referring to here. A pre-approval is just a quick way for a bank to tell you what you qualify for, subject to a series of often long conditions that have be met before it firms up into an actual approval. This is often where investors get tangled up: basing their cash flow or ROI projections on financing assumptions rather than the approved financing.
To avoid the unpleasant surprises brought on by needing to pump in more capital, and to ensure that the projected cash flow from a property will in fact materialize, here are three areas worth concentrating on when it comes to financing:
Create a financing road map
Planning financing goes beyond just getting a mortgage pre-approval. It entails speaking with your investor-friendly mortgage broker about all aspects relating to your finances and future deals and ironing out the following:
- How you derive your income
- What condition your credit is in
- Your down payment sources
- The deal’s structure – parties participating in the deal, corporations, Vendor Take Backs, etc.
- Your investment strategy – lenders look at each strategy differently when it comes to mortgage financing
- Your chosen market – some lenders shy away from lending in certain markets
- The size of your existing portfolio and the impact of that on future financing
The more proactive you are in planning the above with your mortgage broker, the more accurate you will be in assessing the cash flow and the more prepared you will be in terms of how to structure the deal to get the best financing possible.
Condition and location matter – a lot
Investors often underestimate the role a property plays in a mortgage’s approval and the mortgage terms they receive.
An example: Based on her finances, an investor qualifies with a certain group of lenders, but those lenders do not lend in certain locations. The property she has in mind looks amazing on paper in terms of cash flow, but because of her lenders’ predispositions and duty to protect their capital, the terms they propose may transform the deal from “no brainer” to “no thank you”.
Some properties’ cash flow numbers may look attractive because of their condition, primarily when the investor is purchasing below market value. Financing for such properties may be drastically different from the 20 percent/30-year package discussed earlier. Institutional lenders may shy away from such a property altogether, reduce their risk by asking the investor to inject a higher down payment or charge higher rates and fees. (On properties that are run down and/or in remote non-GTA locations, it is best to put in a financing condition and not go firm on the offer.)
It is crucial that you validate any financing assumptions associated with a property. Consult your mortgage advisor before you place an offer.
Consider your investment strategy
As per the earlier example, it is important for investors to be upfront with their mortgage broker regarding their plans for the property.
A property that needs renovations will require a different type of mortgage than a property that is turnkey. A property that is rented on a per room basis, like student rentals or a rooming house, will have to go to select lenders and will demand different terms compared to a property rented to a family. A rent-to-own deal will always be looked at differently by lenders compared to a regular turnkey rental.
As an investor, there are few things you should take for granted. Financing should not be one of them.
Dalia Barsoum, MBA Finance, is the president and principal broker at Streetwise Mortgages #12900. A multi award-winning mortgage broker, real estate investor and finance advisor with over 20 years’ experience in the banking sector, Dalia is also regular speaker and contributor on the topics of investing and financing. She is also the best-selling author of Canada’s #1 financing book: Canadian Real Estate Investor Financing: 7 Secrets to Getting All the Money You Want. Get in touch with Dalia for a complimentary portfolio consultation, or to discuss how to use RRSPs to invest, at firstname.lastname@example.org. More information is available at www.streetwisemortgages.com
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