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If I want to take out loans to buy real estate with the intention of renting it to cover the interest on the loans, what are the red flags that might prevent a bank from extending a loan to me?

Obviously, if I have filed for bankruptcy in the last 10 years, that would be a problem. However, do banks have other red flags, like pending litigation or things like that?

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    Lack of collateral and lack of a credible business plan mostly I imagine.
    – Robert Longson
    Feb 21, 2022 at 19:32
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    pending litigation would most certainly raise red flags. Similarly, your lack of income to cover the payments (excluding the income from the properties, since that is not at all guaranteed to ever exist), and of course many other random factors that may differ from bank to bank.
    – littleadv
    Feb 21, 2022 at 20:32
  • Taking out loans to buy rental real estate is called leverage, and you can make a lot of money this way. You can also lose a lot of money this way. Ask Dave Ramsey.
    – Glen Yates
    Feb 22, 2022 at 23:09
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    Convictions for financial crimes would likely be a red flag.
    – Laconic Droid
    Feb 22, 2022 at 23:53
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    To clarify: by "commercial real estate" you mean office space, warehouses, hotels, etc., true? We're not talking about renting out 1-4 unit residential properties, which in the US would typically just be non-occ home loans.
    – C8H10N4O2
    Feb 23, 2022 at 15:20

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It comes down to can you afford it.

Do you have enough money for the down payment? Do you have the income to pay off the loan?

If I want to take out loans to buy real estate with the intention of renting it to cover the interest on the loans,

They need to know you can afford more than the interest, they want you to pay off the loan.

Obviously, if I have filed for bankruptcy in the last 10 years, that would be a problem. However, do banks have other red flags, like pending litigation or things like that?

Failure to pay off previous loans will be enough to make them nervous. It doesn't have to go as far as bankruptcy.

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    "They want you to pay off the loan" is at least region dependent. For commercial real estate (where your income stream doesn't end at retirement) they might not care, particularly in perpetually low interest rate environments (e.g. Switzerland). LTV, sensitivity to interest rate charges, credit-worthiness, insurance on property, covenant (creditworthiness) of tenant, etc should also be included.
    – abligh
    Feb 22, 2022 at 5:33
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    This answer is generally incorrect for commercial loans where the focus is generally on whether the business plan is likely to generate enough revenues to cover the interest, rather than on whether the applicant can afford it out of their income (although the latter can be a secondary factor). E.g. in OP's case the bank will be looking to see (perhaps via a surveyor's report) whether or not the building will generate enough rent to satisfy their risk criteria, and whether it is worth enough money for them to recover the capital.
    – JBentley
    Feb 22, 2022 at 9:46
  • "they want you to pay off the loan": in the UK, where property tends to increase in value over time, one possible answer is "I will sell the property".
    – Steve Melnikoff
    Feb 23, 2022 at 14:38
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You didn't tag a jurisdiction, so I'll answer based on the UK.

For a commerical property loan, the primary factors will be:

  • Is the building worth enough to cover the loan plus an additional amount to account for risk? This is called the Loan To Value (LTV) ratio. Common LTVs are 50% for risky investments (e.g. buildings needing major redevelopment) and 75% - 80% for low-risk investments (buildings ready to be rented immediately). The buffer protects the bank in the event of reposession e.g. the market has crashed or big lossess are incurred due to a rapid sale.
  • Will the building generate enough rent to cover the repayments (interest only or interest + capital depending on the loan type) plus an additional amount to account for risk? The buffer protects the bank from rent shortfalls (e.g. non-payment, empty periods) and from interest rate rises.

These two factors will typically be assessed by instructing a surveyor to inspect the building and issue a valuation report.

Although those are the main considerations, a reposession is a last resort for a bank. The bank incurs significant costs both at the start of the loan (e.g. marketing, brokers fees, admin costs) and at reposession, and it wants the loan to proceed normally to the end of the term so that it can earn the expected profits from the interest payments. Therefore the bank will also consider a range of secondary issues even though the loan may make sense based purely on the valuation. Many of these vary between banks but almost all will consider:

  • Whether you've made any late payments or defaults to creditors in the past 3 - 6 years (e.g. banks, credit cards, mortgages, and in some cases services which you pay for in arrears such as utility bills or mobile phone contracts)
  • Whether or not you are registered to vote (a lack of which is seen as suspicious)
  • How many other loans you've applied for in the very recent past. Too many can indicate that you have financial difficulties or have been declined from other banks.
  • How much credit you have available to you and how much of that you have used. Too much can be a sign that you have over extended yourself financially. Too little means you haven't proven your ability to take and repay credit responsibly. For this reason, in the UK, it's recommended to have at least a credit card which you use modestly and pay off in full every month.
  • Whether you have any CCJs (County Court Judgments) from the past 6 years which you have failed to satisfy on time. If you've lost a case but paid on time, then you can have the records removed.
  • Whether you have an independent income. Typically the bank is not expecting you to be able to repay the loan interest out of your income, but it wants to ensure that (a) you are not depending on the investment income for your daily living i.e. you have independent means, and (b) that you can afford to pay the occasional monthly payment when necessary e.g. during empty periods.
  • Your history as an investor. Having an existing portfolio is helpful; being a first time investor may be unhelpful. The bank is concerned to know that you are competent.

In my personal experience, a bank never looks at pending litigation. It would be very difficult to even check this as there is no central database for undecided cases which the bank could consult.

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In all cases, the bank wants the same assurance: They want to know that they're going to get their money back, with interest. In the case of residential and personal loans, most of the risks are fairly obvious and relatively easy for both banks and consumers to reason about. Here are some example risks:

  • You might lose your job, for any number of reasons, or your existing income might be too low to meet the bank's expected repayment schedule (with interest).
  • A disaster might destroy or ruin the collateral.
  • You might incur (or already have) some other debt, and find yourself unable to pay for both.

It is relatively easy for banks to account for all of the above risks, and other risks associated with private lending, and come up with an interest rate that balances those risks appropriately with the rest of the bank's position. That's why they can just give you a magic number (the credit score) which summarizes most of this information. It's not perfect, but over large numbers of debtors, it averages out well enough for practical use.

In commercial lending, this is a great deal more complicated, because there are many more risks associated with commercial endeavors:

  • You might have a poor business plan that looks good on paper.
  • You might have a good business plan that you are unable to competently execute.
  • You might (unintentionally) violate some law or regulation, and the government might decide to shut you down.
  • As in the consumer case, you could incur additional debts; however, it is far more common for businesses to incur significant amounts of debt compared to individuals, and so this is much more complex to assess in practice.
  • You might do everything right (as far as anyone can tell), but the market just doesn't like your business and it fails anyway.

To roughly approximate these risks, banks will look to your experience running the business, or similar businesses in the past, as well as the amount of money in the company and the amount of debt it currently owes.

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The risk of a loan to the bank mainly consists of hard to predict contingencies. Usually a bank requires you to have enough income and collateral to make sure that the bank gets their money back, no matter what.

Some of the contingencies they might consider for a project like this:

  • What if people do not want to rent the apartments?
  • What if there are sudden extra maintenance costs?
  • What if the business owner faces personal problems, who takes over?

The bank is not in real estate business, they do not want to repossess the property or to sell it. If they are forced to, they'll do it as fast and least effort as possible, so the price they'll expect to get will be much lower than what you are paying for it.

For extreme cases, the bank may consider the loan altogether too risky. For other cases, they'll have requirements of extra collateral (such as your own home), smaller loan-to-value or extra co-signers.

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