“How I Went From $0 Net Worth to Qualifying for $1M in Real Estate Financing in 2.5 Years
by Scott Trench | BiggerPockets.com”
By far one of the best written articles on beginner real estate investing! I believe this to be of the utmost importance for all investors getting started in real estate to follow this path. I too followed a similar path in building my portfolio and suggest you do the same! I hope you find motivation and inspiration in this article. – Joshua
“I just talked to a lender that prequalified me for over $1 million in financing. This is a conventional mortgage broker—not a friend, not a family member. This is a loan at the best rates available.
That’s $1 MILLION.
I don’t earn a ridiculously high salary, and I don’t have a tremendous amount of cash.
In this article, I want to talk about a reward that I did not foresee when I started investing in real estate. I want to talk about how I went from a position of approximately $0 in net worth just two and a half years ago to a position in which I am able to single-handedly purchase around a million dollars in real estate, right now, using conventional or even FHA financing.
For the foreseeable future, at least until I screw up badly or the economy collapses, I will have no problem getting access to real estate financing. This is in sharp contrast to most of my white-collar peers, for a reason that I will convey below. Please note that this article is written for investors who aspire to build real estate wealth while working a full-time job, not folks who are more on the “entrepreneurial” side of real estate investing, who fix and flip, rehab, or manage properties full-time.
See, the two things that hold most would-be part-time investors back from investing in real estate are their cash position and their access to financing.
In my opinion, accumulating cash is actually the easy part. I chose to do it by systematically saving my wage income of just under $50,000 per year (yes, after paying taxes on that income), working hard at my job and changing jobs to earn more money over the last few years, and investing passively in index funds. While that may sound hard to some people, the fact of the matter is that pretty much anyone who works a median income job in a city that isn’t LA, SFO, or NYC can give themselves a great shot at saving up the down payment on a rental property in under two to three years. It could take less than one year if they house hack, as I did here in Denver while earning less than $50,000 per year. For example, conventional lenders will typically only lend to first-time investors if the investor can bring 15-25% down (15% on a single family rental or a duplex and 25% on a triplex or quadplex). That’s $45,000-$75,000 in cash on a $300,000 property. That’s a challenge for many people, but not for a big saver with a few years in the workforce.
The Big Newbie Investor Issue: Access to Financing
The cash problem is solved simply through consistency and time. Again, it’s not the hard part; the hard part for many people is actually the access to financing. If you are a saver, you will eventually have no problem coming up with the cash to put 15% to 25% down on rentals with conventional financing. The real challenge you might run into is that your income isn’t high enough to qualify you for financing. The challenge is that most lenders won’t lend to folks to create an environment where their financing costs are more than 35% their income.
What does this mean in reality? Consider the following example:
Joey makes $85,000 per year and has $40,000 in lifetime savings outside of his retirement account. His lender tells him that this qualifies him for a maximum mortgage loan of approximately $400,000. The reason he is qualified for that amount, at maximum, is because the debt service, including principal, interest, taxes, and insurance, on a $400,000 loan is about $2,500 per month, or roughly 35% of his monthly paycheck.
So what does Joey do with this information? Well, he buys a $440,000 primary residence, putting roughly 10% down, and stretches himself to his absolute financial limits to live in the best home he could possibly purchase. Unfortunately, this wipes out his ability to save cash (a huge chunk of his paycheck goes to his mortgage), his current cash position (used for the downpayment), and his ability to get access to future financing (his debt to income ratio is maxed out, and lenders will no longer offer him credit)!
Fast forward a year or so, and Joey now decides that he would like to achieve early financial freedom in part through real estate investing. He goes to his lender, and his lender tells him this:
“I’m sorry, but you will need 15-25% in the form of a down payment AND enough income such that you can cover both your home mortgage AND the rental property’s mortgage. Because you have no history as a landlord, we cannot count any rental income towards your purchase. It may be quite some time before we can offer you a loan for a rental property.”
Joey is in a really bad position to begin investing in real estate. The reality of the situation is this:
If Joey wants to buy a second $400,000 property as a rental, he will need to accumulate $60,000 to $100,000 in cash AND increase his income to $140,000 -$155,000 per year in order to qualify for a loan.
Folks, this is the position that many BiggerPockets readers are starting in! They earn solid salaries, but have little cash accumulated and debts, like a mortgage, that inhibit their ability to borrow. Joey is forced to buy tiny rentals to get started, rentals that will have little impact on his overall financial position and that may not be available or desirable to him, depending on his location. These rentals will produce income and wealth that is insignificant relative to his wage income and are more likely to annoy him than encourage him. Unless Joey has equity in his home and is willing to leverage that to invest, he is a long way away from building significant passive income from real estate.
Related: The Tax Implications You MUST Understand Before House Hacking
The Less Painful Route to Bank-Financed Rentals
But, I, Scott Trench, have avoided this predicament.
How, you ask?
By buying my first home as a house hack.
Unlike our poor friend Joey, I do not have any trouble accumulating cash or getting access to future financing. I’ve saved thousands of dollars per month compared to folks like Joey for years by house hacking and having my tenants cover all of my mortgage. I have passive real estate income. I have cash AND access to financing, all I could want.
When I go to the lender, you know what he tells me?
“Mr. Trench, I see that you have a wage income of $______. This income qualifies you for a mortgage of hundreds of thousands of dollars on its own as an upper-middle-class wage-earner at a respectable corporation.
Additionally, in your case, your current mortgages do not count against this income because the payments, including principal, interest, taxes, and insurance, are wholly offset by the rents your current properties receive. In fact, because we allow 75% of the gross rents your properties command to count towards your income, your current properties actually increase your ability to borrow.
Let’s add an extra couple hundred thousand dollars to your purchasing power.
Oh, and Mr. Trench, I forgot to mention. Did you know that because you are landlord with two years of experience, verified by your tax returns, that you can actually use the expected rent from a future property to count towards your purchasing power? That’s right, if you buy a property with four units and each unit is estimated to command $1,500 in rent, we can tack on 75% of that rent (or $4,500 in monthly income) to help you qualify for a loan?
Let’s add yet another extra couple hundred thousand dollars to your purchasing power.”
My eyeballs exploded when I saw the amounts that my lender was willing to offer me for my next purchase(s). I can, right now, buy property at well over seven figures in value (using a combination of low-down-payment loans like FHA and 5% down conventional), assuming I house hack (move in and put down 3.5%-5% on one very expensive quadplex and purchase one much less expensive duplex or single family). Of course, I plan to remain conservative and am looking to purchase properties under $600,000 this year—but wow!
Financial Freedom the Easy Way
So, what’s the real difference between Joey and me in the eyes of the lender? The difference is I have two years of landlording experience and no debt with service that is not covered, with room to spare by the gross rents of my properties. You reach a real breakthrough point as a part-time investor when you get those first two years of rental history under your belt and are able to qualify for significantly more financing.
I, with my experience as a house hacker landlord, find it very easy to get a loan at a great interest rate. Shockingly easy. Joey will find it extremely difficult. My ability to buy real estate is perpetually increasing and is, at this point, basically limited only to what I can bring to the table in cash. Joey cannot get a loan without another co-signer, unless he can convince a private lender to give him money, likely on unfavorable commercial terms with high rates and origination fees. Joey is limited by both his cash and income. I am not. Joey may never get started and will have to fight very hard to get his business off the ground. I can offer on property worth more than Joey’s house every single year if I like.
The reason for my advantage is entirely due to the fact that I “put in my dues” for two years by house hacking instead of buying a primary residence with my first purchase. Had I not house hacked and used my first large loan to help me generate rental income, I might be in Joey’s position struggling to save and earn more. My first rental purchase would likely be years away and/or a very small property in a less-than-desirable area (unless I was willing to sell my home and start over by house hacking–unlikely if I was settled into my home). I would not believe myself to be “conservative” in looking to purchase property priced as high as $600,000. I would not have the option to purchase property approaching or exceeding seven figures in value.
This is not an argument against buying a nice home. I intend to buy a nice home one day. But that purchase is at least a few years away. I’ll buy the fancy home when my house hacking income can easily cover the mortgage payment. My argument is to delay the purchase of that first home, at least for two years, while one becomes a landlord the easy way, through house hacking. Or, at the very least, buy a home at a price point so conservative that you could easily buy two, and make a second property as a rental.
Related: Am I Missing Something, or Is Real Estate Investing Really Not That Hard?
Get the process started with a rental property that cash flows reasonably before buying a long-term primary residence at the upper bounds of your purchasing power. Put in your first year or two, and watch opportunities multiply in front of you. Do whatever you need to do to buy a solid rental property, large or small, and put yourself in a position where you can use the rent from your current and future purchases to help you out with your next purchase.
Then, when you have passive income, plenty of cash, and a proven track record, buy the nice home if desired.
If you can get started and set yourself up over the next few years such that you can save thousands of dollars per month and use your current and expected future rental income to purchase property, you may find real estate investing to be easy, fun, and automatic rather than something almost unattainable. Too many folks on BiggerPockets are spinning their wheels trying to get into real estate investing because they used up all of their purchasing power on a primary residence. In fact, the only set of circumstances that allows folks who buy their first homes to invest is when they experience a lot of appreciation on that home very quickly. That’s a big gamble to take, and that financial benefit would only be exaggerated if it were a rental property. If you do decide to max out on your first home purchase, you might find that financial freedom through real estate is decades farther away than it needs to be.
Looking to set yourself up for life as early as possible and enjoy time on your terms? Scott Trench’s new book Set for Life, slated for release April 23, 2017, is now available for pre-sale! Whether you’d like to “retire” from wage-paying work, become less dependent on your demanding nine-to-five, or simply spend time doing what you love, Set for Life will give you a plan to get there. This isn’t about saving up a nest egg. It’s not about setting aside money for a “rainy day.” Set for Life is an actionable guide that helps readers build the accessible wealth they need to achieve early financial freedom.”