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Likewise, most of you are also aware that a mortgage may be put in place on the property. However, unlike non-IRA investment property loans, these mortgages are not the same as a typical rental property mortgage.
If you have used your IRA or other self-directed retirement plan to purchase an investment property, the mortgage loan you obtain must be NON-RECOURSE. What does this mean? A traditional loan provides for “recourse” to the borrower. In other words, if, for whatever reason, you don’t make the mortgage payment, the lender reserves the right to come after you personally for the balance of the loan.
The IRS will not allow you to personally guarantee a loan made in the name of your IRA. Therefore, all IRA mortgages must have no recourse, that is, they must be “NON”- RECOURSE to you. In simple English – the cash flow from the property must be sufficient to cover the mortgage payment and all expenses because the lender cannot come back to you for any shortfalls.
IRA property mortgages are not resold into the secondary market through the usual network of mortgage bankers, mortgage brokers and banks IRA property mortgages fall under the category of commercial loans. With a traditional mortgage, the lender may look at the rent and cash flow on the property, but the majority of their decision to give you a mortgage is based on your personal credit, personal income and your current debt load. Here, the property takes a back seat to your personal ability to repay the loan.
With commercial loans you, your credit, and your income take the back seat. The property’s cash flow is the major consideration. In fact, your credit and income may never even be addressed. So how does a lender underwrite an IRA mortgage? With the same methods they apply to apartment buildings, strip malls and office buildings. The lender will want to verify the ability of a property to generate sufficient cash to pay the mortgage, taxes and operating expenses.
This is a two-step process. First, the lender will look at certified copies of leases and operating expenses that have been obtained from the seller. The lender may also ask for certified copies of the seller’s tax returns. The lender will develop a picture of what typical annual operating expenses will be for the property. Rents may even be verified directly with the tenants. Once income and expenses are determined, credits and debits are applied to come up with a net operating income (NOI) figure.
Being the conservative group that they are, the banker will then order an appraisal on the property. The appraiser will determine the value of the property based upon two approaches. First is the usual “Market” Approach which looks at recent resale of comparable properties. Most investors are familiar with this appraisal method.
What is different is the second approach called the “income approach”. Here, the appraiser lets the lender know what the income and expenses are in the market for properties that are similar to the property that the lender is being asked to mortgage. This is why IRA mortgages have higher appraisal fees - because substantially more work is being asked of the appraiser.
The lender then analyzes both sets of figures—from the seller and from the appraiser—and will then calculate their own NOI. So far, the procedure is pretty straightforward.
The numbers “are doing the talking”. Lenders, always conservative beings, will want a cushion in the expenses to cover the “extraordinary” expenses should they become more “ordinary”. By this I mean…
This “cushion” is given the name DSCR – Debt Service Coverage Ratio (DSCR). Depending upon how quickly a property could be sold in the event of default or foreclosure, the lender will make sure that the “cushion” is larger rather than smaller. A property like a strip mall which could take months to sell would typically have a 25% cushion. In other words, a 10 to 25% cushion is left in the available cash after expenses and before the lender calculates the maximum mortgage for the property.
You now know what a Debt Service Coverage Ration of 1.10 to 1.25 is. The .10 to .25 is the cushion.
Let’s see a quick calculation:
A six flat is being sold for $300,000, has a net operating income of $1908.00/month. The lender uses a DSCR of 1.20 for a multi-family building. The net operating income (NOI) of $1908/month is divided by 1.20 which leaves you with a figure of $1590. This is the maximum
Again, the numbers, in the above scenario, are “doing all the talking”. This property would require the IRA to use $75,050 (25%) as a down payment.
So, here you have it. A peek behind the banker’s curtain in determining mortgage qualifications for IRA owned properties.
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