Real Estate Investment Financing
There is no such thing as ‘free’ real estate. However, one can craft the deals that you don’t pay anything out of pocket. One needs to understand different financing tools and have it in their tool belt. This will enable you to take out the most appropriate tool for the job. Below are some of the financing tools available.
This means that you are using your own money and from someone else - this is the easiest and fastest way of financing. This can be in the form of bank cashier’s check or wire transfer to the title company who then writes a check to the seller. Even though there are no complications, this is the not an option for most new investors. Additionally, the return on all cash deal will not be same as leveraged.
Case-1: Tom (inexperienced investor) invests his $100,000 to buy a house that produces 1,000 per month as cash flow. This is equal to $12,000 per year and 12% in terms of return-on-investment.
Case-2: John (experienced investor) uses $100,000 as a 20% down payment on 5 similar homes of $100k value. With $18,000 mortgage on each, the cash flow will be $300 per month per house. Total cash flow is $1,500 per month or $18,000 per year. This equates to 18% return-on-investment.
Case-2 (leveraged) is 50% better than Case-1 (all cash) from return-on-investment perspective.
This is the most common form of financing. One goes to bank and gets a mortgage based on one’s credit profile. Financing one’s investment property can produce significantly higher returns than paying all cash. That’s why a lot of investors would usually put down 20%-25% down payment and take on the mortgage. This option also provide the lowest interest rates.
However, this has it’s nuances and can get difficult for people to get if they don’t fit their requirement like one’s credit profile, current debt, number of properties owned etc. This is generally due to strict underwriting guidelines due to packing and selling of mortgage to government backed institutions like Fannie Mae and Freddie Mac to replenish their own funds. Banks don’t make money on interests but charges for loan servicing. Lastly, this is only for ‘finished’ properties so that they can take it back via foreclosure if it comes to that. However, investors like to add value by fixing the property and then sell/hold it which makes conventional financing difficult to obtain.
This is similar to conventional mortgage with a difference that they lend their own money instead of selling the mortgage to Fannie Mae and Freddie Mac. Since, it’s their own money, they are able to provide more flexible loan terms and qualifying standards. Oftentimes, these loan terms are less restrictive than conventional lender. These type of banks does make money on interest unlike traditional banks who makes money on servicing the loan and loan fees while Fannie Mae and Freddie Mac makes money on interest. These are generally smaller local community banks. It’s not necessarily easier or cheaper but more flexible and creative. A lot of terms depend on relationships.
The Federal Housing Administration (FHA) is a United States government program that insures mortgages for banks. This programs helps Americans to get their first home. The best benefit is the low down payment of 3.5% which helps people to get started much sooner, since they don’t have to save upto 20%. However, this program needs one to get ‘Private Mortgage Insurance’ to protect the lender and is required for the life of the loan. This requirement can make one’s monthly payment slightly higher, thus reducing the cash flow. These loans are only for homeowners who live in the property and cannot be used to buy a pure investment property. However, one can take advantage of FHA for a duplex/triplex/fourplex. It’s completely fair if an investor's occupy one unit and live in it while putting the rest on rent.
This is a subset of FHA loan which allows homeowner to purchase a house that is in need of some rehab work and provides the possibility of financing those repairs or improvements into the loan itself. This loan type if applicable for duplexes, triplexes and fourplexes but has the same requirements of ‘owner occupied’ and ‘private mortgage insurance’. This can be a perfect loan for a new investor who is trying to break into the investing game. There are some caveats to this type of loan - more red tape, lot more paperwork, slow lending process, use of FHA approved contractors for rehab work above 15k which must be completed within six months of loan closing, subject to maximum amount for the zip code etc.
Bob found a duplex for $150,000 that he wants to move into one half while renting out the other half. The property needs about $10,000 for new paint and carpet. Bob is able to include that into the cost of the loan and just pay a 3.5% down payment on the total amount for a total of $5,600 down. Bob can now get the cosmetic rehab of paint and carpet paid by the loan, move into his renovated home, rent out the other half and begin making cash flow.
Banks are not the only entities that can finance a property. In some cases, if you know what you are doing, the owner of the property you want to buy, can actually fund the property. The seller in this case carries the note and becomes the bank. In this case, investor will simply make monthly payments to them rather than the bank. Typically, the only time a property owner will do this for a person is if they don’t have any existing mortgage on it and they own it free and clear.
If the seller does have another loan, and then sells the home to you, the seller’s loan must be paid back immediately or can face foreclosure. This is due to a legal clause ‘due on sale’ clause which is written into nearly every loan. This clause gives the former lender the right to call the note due immediately if they want. Investors can choose to ignore this clause and still purchase ‘subject to’ the other loan and keep making payments to the original lender.
This is a type of financing obtained from private business or individual for the purpose of investing in real estate. There are different terms and styles based on whom you talk to but generally has following characteristics:
Shorter term lengths (generally 6 months)
Higher interest rate (8-15%)
High loan ‘points’ (fees to get the loan)
Loan is based on value of the property and how good the deal is
Many hard money lenders don’t require credit references or income verification
This loan doesn’t show up on personal credit report
Fast - can fund the deal in days
This can be a beneficial for short term loans and situations but many investors have been placed in tough situations when the short term loan ran out. One should have multiple exit strategies before taking out a hard money loan.
This is similar to hard money but with a fundamental difference that this is based on personal relationship. These are not professional lenders but friends, family and associates who are looking to achieve higher returns on their cash. This type of money usually has fewer fees and points and the term length can be negotiated more easily to serve the best interest of both parties.
Private lenders can let you borrow their money in exchange of specific interest rate. Their investment gets secured by a promissory note or mortgage on the property which means if the investor doesn’t pay them back, private lenders can foreclose and take the house.
There are no set hard rules for this type of capital. A private lender can also have an equity stake in the profit of fix and flip instead of getting a fixed rate of return or can have both. Raising the capital by this means requires developing a Credibility.
Home Equity Lines of Credit (HELOC)
Investors can tap into the equity in their own home and purchase rental properties. There are many different products such as Home Equity Installment Loan (HEIL) or Home Equity Line of Credit (HELOC). Instead of getting through the hassle of conventional mortgage for an investment property with its stipulations, one can instead take out a HELOC on their own home to pay for the property.
There are many benefits to this form of financing:
Loan is based on the value of primary residence and not the newly purchased property. This means that the lender doesn’t care what the intent is with the money and won’t even look at the new property or its condition. They do care about your ability to pay it back.
One can use HELOC to put in ‘cash’ offers on new properties which gives investor a leg up during price negotiations with the buyer.
The interest rate is generally very low compared to hard money or private money as it is secured by one’s primary residence.
Bob wants to buy an investment property for $100,000 but doesn’t have any down payment saved up. He does have his primary residence which is worth $150,000 and owes $75,000 on it. This means he has an equity of $75,000. He opens up a $20,000 home equity loan on his primary residence to fund the down payment and then get a conventional mortgage from the bank for the remaining $80,000.
One can create partnership with folks who have cash and helps finance the property. The partnership can be structured in different ways - use partner for down payment alone or to finance the whole property. This would be called an equity partner and there are no set rules for this type of partnership. However, each deal requires its own analysis of how the deal will be put together, who makes the decisions, and how profits will be split at the end.
The equity partner may have an active or passive role depending upon how the deal is structured and operating agreement written. Unlike a private lender, an equity partner does not receive an agreed upon interest rate on their money. Instead, they receive only a percentage of what the property generates. Equity partner can make or lose money depending upon how the deal proceeds. In general, equity partner takes a higher risk than a private lender might, but also have the potential of making significantly more when the investment is successful. Another difference with private lender is that the equity partners investment is not secured by a mortgage or promissory note but by an operating agreement between the partners.
If one is looking for a property bigger than four units (quadplex), they cannot get residential side of loans and will need a commercial loan. Commercial Loans have different qualifying standards and typically have slightly higher interest rates and fees. The value of the property is focused on this type of loan compared to the income of borrower as in residential lending.
RE Entrepreneur Group Community
We are a group of entrepreneurial real estate investors who bring knowledge, expertise and financing to the table and do deals with the team members. After vetting the deal properly, one can collaborate financially or via their special skill set (example Architect, RE Agent, Contractor, Engineer, Banker etc) and all profit from it and do more deals together than a single person could have done.