Canadian Real Estate Wealth contributor, Peter Kinch explains the ways brokers can ensure their BFS investor clients can still get the financing they need
As a self-employed real estate investor, the Canadian mortgage lending environment will be more challenging in 2012 than it has been in past years, but sophisticated investors will learn that this can create opportunities for those who understand the rules and learn to work within them. While others continue to complain that things aren’t the way they ‘used to be’, savvy investors will be prepared to do a little more paperwork to get approvals. The key is to understand the position that the lender is in.
Given the global and political environment, lenders are not going to be open to clients who want to take shortcuts and provide the bare minimum when it comes to documentation. Statistically, self-employed real estate investors have been amongst the highest percentage of borrowers who default for Canadian banks over the past four years. So it should come as no surprise that lenders are going to scrutinize those files more than others. At the end of the day, banks want to mitigate their risk – real or perceived. Your job is to make sure your clients provide them with enough information that they can feel confident with the file and do not see them as a risk.
Prepare for more paperwork
The first thing a self-employed real estate investor will realize is that banks do not applaud you for having a ‘creative accountant’ who helped you to minimize your taxes by reducing your ‘verifiable income’ down to nothing. Congratulations, you now don’t have to pay taxes – but don’t turn around and expect to qualify for a mortgage. From a bank’s perspective there is a huge difference between a borrower buying a principal residence and a rental property. Again, the statistics bear the real truth. Statistically speaking, Canadian homeowners have less than a one per cent default rate on their mortgages – when it is owner-occupied. Conversely, the largest amount of fraud and default that lenders experience is with those mortgages that are arranged for investment purposes. As such, there are two sets of rules for mortgage borrowers – one for homeowners and one for investors.
Nowhere is this more evident than with the self-employed individual. Many banks are still willing to accept the fact that self-employed borrowers have a tendency to write-off as much as possible and therefore have a correlating low verifiable income. If it is for the purchase of an owner-occupied home, they will grant them a degree of flexibility and even allow a high-ratio mortgage at fully discounted rates based on ‘stated-income’ (if deemed to be reasonable).
However, if that same borrower were to go to the same bank to ask for a mortgage for a rental property purchase, the rules would be completely different. The mortgage for the rental property would now have to be ‘fully-income qualified.’ This poses a problem for the majority of self-employed borrowers – especially if you’ve only recently become self-employed. The majority of lenders define ‘verifiable’ income as a two-year average of line 150 on your tax return. Line 150 is the amount of ‘taxable’ income that is ‘net’ after all expenses. They will also ask for copies of your T1 General to determine the source of the income. For example, a lender will want to make sure that the income as stated on line 150 is derived from business income and not capital gains.
Selling real estate or cashing in RRSPs is not a sustainable source of income and will not be allowed. The lender will also ask to see the company financials to determine the revenue trend. Some owners pay themselves a healthy salary but do so at the expense of the bottom line. Banks will want to see that the company financials are strong and can sustain the income it is paying to the owner. Long gone are the days where you can simply give a lender a Notice of Assessment or a job letter that you’ve written yourself and tell them that should be sufficient. In today’s market that simply won’t do.
For investors who still hope to buy real estate but are finding it challenging to qualify for conventional mortgages, there are still a few unconventional options in today’s market. Home Trust, Equitable Trust, and Optimum Trust amongst others still offer ‘stated-income’ mortgages for self-employed borrowers who can show ‘reasonability’ of income. The maximum loan amount will only be 75 per cent. The interest rate will be about one to two per cent higher than fully discounted rates and there will be a 1 per cent lender’s fee. The cost is obviously higher, but still a cheaper alternative to having to bring in a joint-venture partner and give away 50 per cent of the deal just so they can help you qualify. In the end, you simply have to balance the cost versus the benefits.
If you are a self-employed real estate investor and you’re still concerned about how to qualify for mortgages in the current market environment, there is some good news. Everything mentioned in this article pertains to ‘residential mortgages.’ The easiest way to circumvent the strict rules surrounding the residential mortgage market is to simply shift your focus to multi-family purchases. If you buy a property with six units or more, you move into the ‘Commercial Sandbox’ and commercial mortgage rules are completely different than residential.
Among other things, in the commercial sandbox, the focus shifts from you, the borrower, and your verifiable income to the building and the amount of cash flow therein. Commercial financing has other issues and it is certainly not for everyone, but for the self-employed investor who is being inundated with negative headlines in today’s marketplace – this just may be the answer you were looking for. But until you decide which direction you’re going to go – don’t quit your day job (just yet).
This is an edited version of an article that appeared in Canadian Real Estate Wealth magazine, a KMI publication. Canadian Real Estate Wealth is available on newsstands. For more real estate investing news and tips, visit canadianrealestatemagazine.ca