why 1031

If I have 5 properties w/ 20K+ equity in each, and would like to put 100K down on a larger multifamily, wouldn’t it work just as well (better actually) to pull my 100k from equity loans to make the down payment instead of selling all 5 properties to raise the 100K through 1031 exchange? I’m saying this with the understanding that all 5 properties would still be at positive (though less) cash flow after the equity loans.

Will lenders not borrowed equity money as DP?

Could someone please explain to me what I’m missing with this line of reasoning?

Thanks.

A 1031 exchange has valid uses. The situation you describe can work as an exchange, though I wouldn’t think it would be an economical path to get $100K for a cash downpayment.

Five real estate settlements, five real estate commissions, and the 1031 exchange fee would eat into your equity. You might not find an exchange for such a small equity amount in each property cost effective. To complicate your situation, you have 180 days from the settlement date on the first relinquished property to complete the settlement on all five relinquished properties and to acquire the replacement property.

If you have found a lender that will allow 100% CLTV financing on an investment property with an equity loan, then go for it.

Dave,
thanks for the reply. I have never done a 1031X and didn’t even realize there were fees that would eat into my equity.

I guess my real question is - Will a lender let me use money from equity lines as down payment? If I can pull 100K from equity lines, would a commercial lender allow me to use that as 10% DP on a 1MM loan, or would they look at that 100K as borrowed funds and not allow it as down payment (saying I have nothing invested)?

Thanks

Commercial lending has a different set of rules than consumer residential mortgage lending.

A commercial loan officer will want your proposed purchase to generate enough cash flow to cover the loan payments. The loan officer will want to see that the Net Operating Income is at least 1.3 times your debt service (principal and interest). Next, the loan officer will probably only lend to a maximum of 80% of contract purchase price, meaning that you will have to have a 20% equity stake.

Additionally, expect your commercial loan to be amortized over 15 years at some interest rate such as prime plus one.

Thanks again Dave. Your answer brings me to my next question.

Assuming I cannot find a 90% commercial lender, which is my first choice, if the lender will lend 80% of contract purchase price, and I have 10% down, then the lender would allow my contract to include a 10% seller carry back?

Depends upon the lender, the strength of your financial statement, and the quality of the deal. If you have substantial assets (equity, net worth) underpinning your financial statement, you will have a better chance of having the commercial lender allow 10% seller financing.

However, not all commercial lenders allow a seller carryback. Those traditional institutional lenders that do allow the seller to participate in the financing, may limit the seller participation to only 5%.

You just have to shop your commercial loan sources to determine their lending criteria.

Dave,
As always, your help is very much appreciated. I’ve been visiting this site for about a year and a half, and actively investing for about a year now. During that time you and a few other very helpful people on this site have helped me with a lot of issues & questions. It’s great that there are people like you out there.

Thank you for the kind words.

In your area, try Fifth Third Bank and see what they will need to finance a deal as you have outlined.

A track record of successful deals will help bolster your credibility as a serious investor.

Let’s go back to the financing question for your proposed deal. Here is how the commercial loan officer will look at it.

First, the loan officer will want to see the operating expense details for the proposed property and a current rent roll. For the vacancy allowance, the loan officer will use either 5% or 10% depending upon your local market conditions. I have been told that Columbus is experiencing a soft rental market, so expect to use a 10% vacancy allowance.

Rental income at 100% occupancy will be computed from the current rent roll. Proforma (or projected rents) that are above the current rents will be rejected in favor of current actuals.

A 10% management expense will also be added to your operating costs. Don’t forget property taxes, hazard and liability insurance, cleaning and maintenance costs, grounds maintenance, trash removal, advertising, legal and leasing fees, utilities not paid by the tenants, and some reserve for replacements.

All your ownership and operating costs will be subtracted from your scheduled income minus an adjustment for vacancy allowance. The result will be your Net Operating Income (NOI).

Your NOI will be divided by 1.3 to determine your maximum permitted debt service. Once you have your debt service (monthly payment), use your financial calculator to plug in your interest rate and a 15 year loan term to calculate your maximum loan amount. If this loan amount is less than 80% of your proposed purchase price, then you will have to bring more down payment money to the settlement table. If this amount is greater than 80% of your purchase price, then your maximum loan amount will be reduced to 80% of your purchase price.

Lastly, the lender will inspect the property before approving any loan to insure that the property fits the lender’s property standards.

If you have followed this description of the process the commercial loan officer will use to “back into” the maximum allowable loan for your proposed purchase, I hope you see that the lender might not even approve 80% financing if your operating income is insufficient to support the debt service.

FYI, even though your loan is amortized over 15 years, the loan will be reviewed every five years. If the property still has strong financials, the lender will likely extend your loan for another five years. If the financials show signs of weakness (costs increasing faster than rents, declining NOI, higher vacancy rate, etc), the lender may call your note with a balloon payment due in 30 days.

By the way, here is another tidbit (though unrelated to your situation) I picked up from a commercial loan officer in the largest independent regional bank in my area. I was asking for a $1MM credit line. I have a long track record of success, a high net worth, and ample gross income from my rental properties. Because I have done such a good job at sheltering my income and paying little to zero income taxes, that was counted as a negative. The more income taxes I pay, the more money I might be allowed to get in a credit line. This loan officer also told me that his bank does not like to make “speculative” loans and does not freely give a real estate credit line. A much smaller regional bank has given me their maximum real estate credit line for the past three years based upon my track record, my credit score and my financial statement. The point of this story is that you just have to shop around.

Great Info Dave,

The bank having the option of calling the loan after 5 years is a scary thought! What if commercial rates go up from here and after 5 years say the rates have gone up by 3 points. What’s to keep the bank from deciding to call the loan just because they know they can get that money and get a better return for it? Coming up with the balance could be disastrous. How often have you encountered commerical loans being called early before their original maturity date? I’m debating about getting a Commerical loan but this one issue has caused a lot of concern for me.

Thanks!

I suppose you have no real protection against having your balloon called rather than having your loan extended. The lender may change their philosophy of lending and decide to get out of the particular niche loan business that you are in. The bank could be acquired by a larger lender who establishes different lending criteria.

However, if your loan is performing, you have made on time payments, and your fundamentals are strong and getting stronger, I doubt you have that much to really worry about.

If your loan does not get extended, refinance with another lender.