LLCs and Residential Mortgage Financing

LLC or not?  There's a parade of gurus and booksellers urging us constantly to form trusts, LLCs, offshore partnerships and pay them for their kits to do it. All of these have their place, but the easiest way to achieve our protection goals is to hold all rental property in one or more LLCs.

It sounds cheap and easy, but as with many other critical factors in real estate, the question is TIMING!

When is the right time to quitclaim our property into an LLC?

The answer to this critical question has to do with how banks lend to investors. There are generally two types of purchase money mortgage loans written in today's markets:

1. Residential conforming loans

- Lowest interest rates available (currently about 4.5-5%)

- 30 year terms

- Fixed interest rate for entire term of loan

- 20% down

- Lender will generally only write these loans for an investor purchasing property in their personal name

- Limit 10 per person

2. Commercial loans

- Higher interest rates (the lowest I've seen lately is 5.5%)

- Usually 20-25 year terms

- Sometimes a bank will offer a fixed rate, but most are 5/1 ARM (adjustable rate)

- Lender has the flexibility to write a loan in the name of any entity, including an LLC

- Usually 25% down or more

Usually the lender has plans to sell off residential loans into the residential secondary mortgage market (hence why they are "conforming" to the standards of the market). In contrast, the lender usually plans to hold a commercial loan in its own investment portfolio for the term of the loan. So usually you'll only see smaller banks writing commercial loans - my first one came from a bank who primarily lent to the Amish!

Purchase agreement. So whose name is going on the purchase and sale agreement - your own, or your LLC's? The answer is whether you want to end up with a residential conforming loan or a commercial loan. Since the residential conforming loan offers favorable terms, we definitely want to use all of these loans for our ten most expensive properties. 

The due on sale clause. Many investors will buy in their own name with a residential conforming mortgage and then quitclaim the property into their LLC's name. It is a widespread practice. A note about this: it's not without risk. Every residential conforming mortgage has a due on sale clause which gives the lender the right to foreclose if title has transferred. Quitclaiming a property from one's personal name to an LLC triggers this clause, but the lender doesn't have to do anything. In this market, most banks are happy to have a performing loan at all, so they likely aren't going to foreclose simply because an investor quitclaimed the property into a wholly-owned LLC. In the event that interest rates double, however, it's possible that banks might go hunting for defaults on low-interest fixed loans -- and you might be forced to refinance. At this time, it's a non-issue, but it's always something to keep in mind.

Cash out refinancing. One strategy is to buy with cash or a commercial loan and then later refinance into a residential conforming loan, pulling cash out of that property. This strategy works best when buying a house that needs substantial rehab. The problem you'll run into here is seasoning. A lender is going to require you to hold a property in your personal name for 6 to 12 months before refinancing. This means that you can't simply deed the property from your LLC's name to your personal name the day before closing the refi. (Sometimes banks will write a HELOC without a seasoning period - more on this in a future post). So in order to execute this strategy properly, you'll have to have some idea as to what your plans are in 12 months.

Portfolio loans. Once you hold more than 5-10 properties, you'll want to find a commercial lender who is able to combine multiple properties onto a single mortgage. The seasoning period will likely still apply, and commercial loan terms will apply, but potentially you can seek financing for an unlimited number of properties based solely on their valuation and cashflow.

Wrapping up. Try your best to find a bank that will write commercial loans for your properties, even if you don't plan to get one right now. It's useful for planning purposes to have a contact at that bank to pick his or her brain about the requirements. And as always, have a 12-month plan in mind!

How to get a bank to loan you cash

We detailed the traditional types of financing available to residential property investors in an earlier post. To recap, when you're about to sign a purchase agreement, it's important to consider whether you want the property to be titled in the LLC's name or your own personal name. Generally, it boils down to this:

LLC - Commercial mortgage
Personal name - Residential conforming mortgage.

90% of banks will not write a mortgage for an LLC, period. This is because they cannot sell the mortgage on the secondary market. The key to getting a commercial loan is to find a bank that is a portfolio lender; that is, a bank that holds and services its own loans for the entire term. These banks have the ability to be more flexible with its lending standards, as opposed to Big Behemoth Bank, which makes a cottage industry from churning out conforming FHA loans on single-family houses, dumping them to Fannie Mae on a regular basis to raise capital.

Planning for success. Here are some of the relevant questions to ask yourself when trying to determine what kind of financing you should seek:

1. Does this property need substantial rehab?

If you're putting more than $25,000 into a property, you might want to consider planning for a cash-out refinance into a residential conforming loan. Call your lender of choice, find out what their seasoning rules are, and mark your calendar for when you'll be able to do a cash out refinance. Follow their rules - hold title in your personal name for as long as they instruct you to - and be prompt about submitting that mortgage application.

A local bank in my area does a purchase-rehab loan with commercial terms. You send your rehab estimates and purchase contract, and they add them up and lend you 75% of the balance. These can be tremendous tools to streamline your business.

2. Is the purchase price less than $70,000?

Most banks won't write residential conforming loans with a principal of less than $50,000. It's difficult to find banks who will do otherwise, and you might be forced to go commercial here. In addition, closing costs tend to be fixed - between $1500 and $4000 - and borrowing less than $50,000 means that your total APR is going to be upwards of 7%, and most people would rather not borrow money at that rate.

3. Is this property one of the highest-priced property I plan to have in my portfolio?

If your potential purchase is going to be one of your more expensive acquisitions, you may want to consider a residential conforming mortgage as your endgame, since the favorable interest rate will have a larger impact on your ROI.

4. Do I plan to own more than 10 properties in 12 months?

If you're planning to ramp up your purchase activity by the time the seasoning period is up, you might not need to worry about what kind of mortgage you're seeking at this stage because you can refinance into a blanket mortgage from a small lender. If you're working in an area with low-priced properties, it might be advisable to plan to do this in order to keep closing costs low.