Someone (let’s call her Rachel) reached out to me to ask the following question: What’s the fastest way to increase my income in order to ensure that I can qualify for the mortgage to buy out my ex-husband’s share of the house when we finalize our divorce?
Rachel wants to remain in the house in order to minimize the disruption for the kids, however her income has been severely reduced for a variety of reasons and she needs to explore options. What should she do?
Thankfully, Rachel has a chunk of money set aside which she would like to invest in order to produce more income. She’s concerned that if she leaves the money where it is, she’ll tap into it to pay for living expenses and it will whittle away.
Rachel is temped to invest in real estate to produce an income but here’s the challenge: since she can’t qualify for a mortgage at the moment she would have to pay for the property in cash; no mortgage.
Here are my thoughts on her situation:
If I were in Rachel’s shoes, I would not invest in an income property at this time.
As much as we like to hate banks, they do serve a useful purpose by providing cash for large purchases. When you use a bank’s money to secure an investment property that will put money into your jeans, you take advantage of the power of leverage. That is, you are using the bank’s money to generate an income and growth, and maximize your Return on Investment. Leverage is key to making optimal use of your cash.
But what do you do if you’re stuck and you simply cannot get a mortgage on your own, as is Rachel’s case? Does real estate still make sense?
I would argue that it doesn’t in this case, at least not at this time. The are two primary issues: risk and immediate return.
Let’s look at the example above: Even if you pick a great property in a great area and you have the world’s most fabulous tenants, you are still not going to make enough money to declare sufficient income to qualify for a mortgage. In addition, the money you earn on a single property will not be enough to live on. Then there’s the issue of tenants.
Talk to anyone who has investment properties (note the use of plural here) and ask them about tenants. There is damage, stress and headaches. Dealing with tenants is rarely a walk in the park.
One of my investors on a Rent to Own deal has another property which he has had for several years now and in all of that time he has only had one tenant who has always paid the rent on time. He thinks this is the norm; select good people and you won’t have any problems.
Here’s what I said to him when he told me he has no trouble with tenants: “If you have not had issues with tenants, either you haven’t owned enough rental properties or you haven’t owned them long enough. Problems with tenants happen all the time. It’s great that you have had a perfect tenant for years, but that is definitely atypical.”
There is a process to finding and qualifying tenants, however the bottom line is that you cannot eliminate all the risk. Good people lie. People with strong credit histories and great jobs sometimes shirk their responsibilities. Honest-as-the-day-is-long-types will bail in the night. They stop paying rent and leave you with a mess to clean up. Thousands of dollars later you wonder what the hell happened.
As an investor you expect that and you plan for it. But if you’re desperate and you can’t afford damage and unpaid rent, that’s a problem.
Do I think investing in real estate is a good idea? Yes, absolutely. But you need to be ready for it – know what you’re doing and be prepared to deal with the financial ups and downs. You do not start making decent money right out of the gate; it takes time. Buy-and-hold real estate is a long game, not an overnight cash remedy.
Will a single investment property provide Rachel with the income she desperately needs? Not soon enough and not in great enough quantities to accomplish her goal.
Here’s what I would do in Rachel’s situation:
1. First I would invest a good chunk of the money in second mortgages using a seasoned mortgage broker who has a good reputation with respect to second mortgages. (You don’t care that he’s great at getting people first mortgages; you need to know that he knows what he’s doing with second mortgages.) There is risk here too so you need to know what you’re doing or be guided by someone who does. Beware of collateral mortgages if you’re a second mortgage investor. More on that in a future post.
To date the most consistent money I have made with my short-term investments has been through second mortgages. We are earning between 9% and 12% on our investments and since the payments come monthly or quarterly, they are a boost to cash flow. This is the best way that I know of to put cash in your jeans if you have some money to invest and you can’t qualify for a mortgage. When the investments have been in place long enough, the payments can also be counted as income for the purpose of qualifying for a mortgage.
The other advantage to second mortgages is that they can be sourced relatively quickly with the right connections. In this case Rachel is poised to move forward as she already has such a connection in place.
With the balance of the funds, I would put them in dividend-producing stocks if I didn’t want to touch the money for a long while. If I wanted to invest in real estate within a couple of years (which would be my preference), I would lock up the balance of the funds in short-term, fixed income vehicles like GICs.
2. Second, I would place all of my energy and focus on growing the income from my job or business. If Rachel is self-employed, she might ask how she can grow her top line via more clients, products or services. If running a business is a challenge as a solo parent, she might consider working for someone else to take the pressure off until she reorganizes her life. Or subcontract. Or do something else entirely from home. If she works for someone else, she might ask what she can do to obtain a raise or apply for a position with a stronger income.
Maximizing work income is the most likely path to accomplishing her goal of qualifying for her own mortgage. The key is to tap into her creativity and to remember that regardless how bad the situation is, there is always a way up and out.
3. Third, to ensure that I hold on to the house, I would turn to friends, colleagues or investors to work out a clever arrangement. In an ideal world, Rachel would find a co-signer whom she trusts to help her out until she gets back on her feet.
If however there isn’t anyone who can do that for her, here’s a quick thought: Bring in another party as a 50% joint owner for a limited time when she buys out her ex. The house value up to that point goes to Rachel and can be determined readily enough with a third party appraisal. Rachel sets up a deal with the Joint Venture partner whereby they will qualify for the mortgage and have a 50% ownership of the house. Rachel owns 50% and gets to live in it, taking care of all the utilities, repairs and maintenance. When Rachel is ready to qualify on her own, she buys out the investor and they get 50% of the appreciation and possibly also 50% of the mortgage pay down. The details can be worked out based on the appreciation rates for the zone in which Rachel’s house is located. If the appreciation is sufficient, then maybe she doesn’t need to throw in mortgage pay down as an incentive. She can also set a flexible term in which she has the option of buying out the investor every year, and does so as soon as she is able.
The attraction for the investor is that this is a no-cash deal with Rachel assuming full responsibility for maintenance and living costs. In the meantime the value of the asset is going up (assuming she lives in an area with positive appreciation). Rachel gets to stay in her house at no additional cost from a cash flow perspective. It’s a win-win approach.
Even if Rachel doesn’t like the details of what I’ve proposed, the point is that there is a way to be creative about retaining her house.
Later, when Rachel has recovered from the ordeal with her ex and when her income has become stable, she can purchase an investment property using the power of leverage.
Until then, I would learn as much as possible about real estate. Julie Broad’s book, “More Than Cashflow: The Real Risks & Rewards of Profitable Real Estate Investing” is a great place to start.
If you have any comments or ideas for Rachel, please add them below.
Until next time, Survive, Thrive & Grow.