How Will You Finance Your Real Estate Investments?
Starting out, you’re likely struggling to picture how you’ll ever be able to afford real estate due to how expensive it can be. I don’t have the money! This is an excuse many people have as to why they haven’t invested in real estate yet.
Or maybe you’re confused by all the fancy terminology such as equity, debt, or leverage. You’re asking yourself “What is equity? What is debt? Should I invest in real estate using equity or debt or both?”
So I’m here to walk you through all the different options you have to finance an investment property so you can turn the idea of purchasing real estate into a reality.
For starters we need to get you understanding the difference between equity and debt as well as the uses of each.
Understanding Debt and Equity in Real Estate Investing
Defining Equity: the value of an asset less the value of liabilities tied to that asset, in other words equity is CASH you have in the asset or business. If you were to sell your house and pay off the mortgage balance, the cash remaining would be equity.
Defining Debt: Borrowing money from an outside source with the promise of paying back the borrowed amount, plus an agreed upon interest, at a later date
Equity is basically using all cash to purchase an investment property so that there is no debt and no default risk if the property sits vacant producing no income for a period of time.
- Real Estate Investing School: How to Retire on Passive Income
- How to Increase Your Income and Master Your Money (Saving, Investing, Taxes)
In terms of investors, you may wish to partner with equity investors who put up the cash to buy the property while you supply the knowledge, experience, and management of the investment.
The downside is they own a percentage of the business unlike a loan/debt.
Debt allows you to leverage other people’s money as well but for a fee, so that you can use less of your own capital and increase your return on investment. The interest paid on debt can be tax deductible helping to reduce your taxes paid.
When purchasing real estate you may use a combination of equity and debt to fund the cost of the asset (property).
Below is a list of types of Debt and Equity you can consider when funding properties.
Types of Equity:
- All Cash
- Your Cash
- Family or Friends Cash
- Private Investor Cash
Types of Debt:
- Conventional Bank Loan
- Commercial Bank Loan
- Portfolio Lender
- FHA Loan
- FHA 203(k) Loan
- Hard Money Lender
- Private Money Lender
- Seller Financing (land contract or lease option)
- Creative Financing
Many investors choose to pay all cash for an investment property. It makes investing transaction easier with no or few complications.
Time is of the essence in real estate and all cash offers can speed up the transaction timeline which makes them more appealing to sellers than buyers offering the seller an amount that will be bank financed.
In an all cash deal, cash usually isn’t actually used so don’t worry about taking home several $10,000 stacks like hip hop rappers do, waiting to take it with you in a duffel bag to closing.
In most cases, the buyer wires the money in from his bank account or writes a check to the seller.
Unfortunately, all cash is usually not possible for most beginning investors. Return on investment is also smaller when using all cash than if you were to use leverage in a deal. Let me explain:
Real Estate Investing Example:
Bob has $200,000 all cash to invest. He can choose to use that $200,000 to buy a house that will produce $2,000 per month in income or $24,000 per year. This equates to a 12% return-on-investment ($24,000/$200,000).
Bob could also instead use that $200,000 as a 20% down payment on 5 similar homes, each listed at $200,000.
He would put down $40,000 cash with a $160,000 mortgage on each. The cash flow would be approximately $600 each month per house, which is $3,000 per month each or $36,000 per year.
This equates to a 18% return-on-investment ($36,000 / $200,000) which is 50% better than buying just one home.
Conventional Bank Loan
Like the example above, most investors realize the returns are better with leverage and will make a down payment, financing the remainder on a mortgage.
This also allows them to buy more real estate than they have the money to afford, which you saw in the example when Bob bought $1,000,000 in real estate (5 homes at $200,000) using his $200,000 as a 20% down payment.
Most conventional mortgages will require you to make a down payment of at least 20% but with investment property they may set the bar higher at 25-30% depending on the lender.
Your typical home buyer who buys a house to live in as a personal resident is typically the client these conventional mortgage lenders work with. Investors will usually work with portfolio lenders, discussed next.
While most of the above options focus primarily on the residential side of loans, the world of commercial lending may also be viable option for your investing.
In fact, if you are looking to buy a property other than a one to four unit residential property, a commercial loan is probably exactly what you’ll be needing.
Commercial loans typically have slightly higher interest rates and fees, as well as shorter terms and different qualifying standards.
In the world of residential lending, the income of the borrower is valued above almost every other area; commercial lending, however, is much more focused on the property instead.
The logic behind this is simple: if you own a ten million dollar apartment building and things go wrong, you aren’t going to be able to make that mortgage payment if you make $20,000 per year or $200,000 per year in personal income.
The commercial lender will still look at your income, credit, and other personal financial indicators, but only to gain a picture as to your skills financially.
What’s more important in the vast majority of cases is the amount of revenue a property generates.
Additionally, commercial lenders can often extend a “business line of credit” to finance flips or other investments.
Some investors are able to obtain a large “business line of credit,” which allows them access to cash for house flipping and other real estate ventures.
Getting Approved for Conventional and Commercial Loans
Loan Underwriters look at the following:
- Market Study
- Borrower’s Financials
- Borrower’s Credit
- Loan to Value Ratio
- Debt Coverage Ratio
The Loan-to-Value Ratio
Most lenders usually require that the loan amount being applied shall not exceed more than 75 to 80 percent of the value of the property.
Therefore, should a borrower default on such a loan, the property serving as security for the loan would have to decline in value by 20 to 25 percent from the date of closing before the outstanding loan balance owed to the lender would be jeopardized.
As a result, lenders tend to consider this range in the loan-to-value ratio to be important in underwriting.
The Debt Coverage Ratio
An additional underwriting benchmark widely used by lenders to limit default risk is the debt coverage ratio.
This ratio measures the extent that the NOI from the property is expected to exceed the mortgage payments.
The lender would like a sufficient cushion so that if the NOI becomes less than anticipated (e.g., from unexpected vacancy or a decline in rents), the borrower will still be able to make the mortgage payments without using personal funds.
The debt coverage ratio (DCR) is the ratio of NOI to the mortgage payment.
For example, the NOI projected in year 1 is $12,000 and the interest-only mortgage payment (debt service) is $8,000; these figures result in a debt coverage ratio of 1.50.
Lenders typically want the debt coverage ratio to be at least 1.20. In this way, the operating income could decline by as much as 20 percent before the mortgage payment is in jeopardy.
This 20 percent cushion is likely to be sufficient for most lenders.
To find the max debt service you can take on, divide the NOI by the desired debt coverage ratio.
For example, if the NOI is $100,000 and the bank requires a 1.25 DSCR, then your maximum debt service payment would be $80,000. This would likely qualify you for a 30 year loan of $1.2 to $1.3 million depending on the interest rate.
Portfolio lenders have less strict rules to adhere to than traditional conventional mortgage lenders, which usually makes this type of financing easier for many borrowers to qualify for, especially real estate investors and self-employed individuals.
The reason they have less strict guidelines is that portfolio lenders usually are making loans with their own money where as conventional lenders are using other people’s money to make loans such as Freddie Mac & Fannie Mae.
We discuss Freddie Mac more in our real estate FAQ page here.
Portfolio lenders are still banks but they usually don’t advertise themselves as portfolio lenders making it difficult to determine which banks are such.
You can find them through referrals and talking with other investors in your area. The most direct approach would be to simply pick up the phone and call each bank in your city and ask them if they are a portfolio lender.
The Federal Housing Administration (FHA) is a United States government program that insures mortgages for banks.
They don’t actually lend people money, they only insure the loan with the lenders against loss. FHA loans are given to consumers through FHA approved lenders.
These loans are typically meant for people who have less than perfect credit and to help homeowners who have been foreclosed upon or short sold their home in the past.
The benefit of the FHA loan is the low-down payment requirement: currently just 3.5%. This can help get you started much sooner, since you don’t need to save up 20%.
However, every blessing comes with a curse.
While the low down payments the FHA offers are great, the FHA does require an additional payment, called “Private Mortgage Insurance.”
This “PMI” insurance protects the lender and is required when the down payment on an FHA loan is less than 20%.
The extra PMI payment can make your monthly payment slightly higher, thus reducing your cash flow.
You’ll will pay an upfront mortgage insurance premium as well as an annual mortgage insurance premium that gets billed monthly, hence why your monthly payment will be higher.
FHA loans are designed only for homeowners who are going to live in the property, so you cannot use an FHA-backed loan to buy a pure investment property.
However, you can take advantage of the exception to the rule that allows the FHA-financed home to have up to four separate units.
In other words, if you plan to live in one of the units, you could buy a duplex, triplex, or four-plex. This is a great strategy to employ in your business if your young and mobile.
How to Qualify for an FHA Loan:
- Employment history for the past 2 years
- Steady pay over those last 2 years of employment
- Minimum down payment of 3.5%
- Must have a valid social security number and be a resident of the U.S.
- The property must be inspected by an FHA appraiser and an FHA approved appraisal must be done.
- The mortgage payment each month shouldn’t exceed 30-32% of your gross monthly income but there is some flexibility there
- Total debt should not be more than 43% of your gross monthly income but there is some flexibility
- Credit score requirements vary by lender
- Foreclosure and Bankruptcy in the past will result in a waiting period and good credit
FHA 203K Loans
A sub-set of the FHA loan, the 203K loan is a loan that allows a homeowner to purchase a house that is in need of some rehab work and gives them the ability to finance those repairs or improvements into the loan itself.
Like the normal FHA loan, the 203K loan still allows for the low down payment requirement allowed by the FHA (currently just 3.5%)
This loan type is also applicable for duplexes, triplexes, and fourplexes, but maintains the same requirement for only being for “owner occupants” and comes with Private Mortgage Insurance demands for loans under 20%.
Real World Example:
Bob found a small duplex for $50,000 that he wants to move into, with plans to live in one half and rent the other half out. The property is in need of about $6,000 for new paint and carpet.
Bob is able to include that $6,000 into the cost of the loan and pay just a 3.5% down payment on the total amount for a total of $3,920 down.
Bob can now get the new paint and carpet (paid for by the loan), move into his renovated home, rent out the other half, and begin making cash flow and building wealth.
“Hard money” is financing that is obtained from private business or individual for the purpose of investing in real estate. While terms and styles change often, hard money has several defining characteristics:
- Loan is primarily based on the value of the property
- Shorter term lengths (due in 6 – 36 months)
- Higher than normal interest (8-15%)
- High loan “points” (fees to get the loan)
- Many hard money lenders do not require income verification
- Many hard money lenders don’t require credit references
- Does not show on your personal credit report
- Hard money can often fund a deal in just days
- Hard money lenders understand when the property needs rehab work
Hard money can be beneficial for short term loans and situations, but many investors who have used hard money lenders have been placed in tough situations when the short term loan ran out.
Use hard money with caution, making sure you have multiple exit strategies in place before taking out a hard money loan.
To find a hard money lender, try the following tips:
- Google It
- Ask a Real Estate Agent
- Ask a House Flipper
- Mortgage Broker
Private lending is great when you can’t obtain traditional financing from conventional and commercial lenders as discussed above. It’s also a good source of capital to use when you want to move faster and do more deals without the hassles of a bank and all the regulations surrounding bank capital.
What is Private Lending?
A private money loan is a loan that is given to a real estate investor by a private individual, and this loan is secured by real estate.
Private money lenders are given a first or second mortgage that secures their legal interest in the property and secures their investment.
When we have isolated a home that is well under market value, we give our private lenders an opportunity to fund the purchase and rehab of the home.
Through that process, the lender can yield extremely high interest rates – 4 or 5 times the rates they can get on bank CD’s and other traditional investment plans.
Private money is similar to hard money in many respects, but is usually distinguishable due to the relationship between the lender and the borrower.
Typically, with “private money,” the lender is not a professional lender like a hard money lender, but rather an individual looking to achieve higher returns on their cash.
Oftentimes, there is a close relationship with a private money lender ahead of time, and these lenders are often much less “business” oriented than hard money lenders.
Additionally, private 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 will lend you cash to buy property in exchange for a specific interest rate.
Their investment is secured by a promissory note or mortgage on the property which means if you don’t pay, they can foreclose and take the house (just like a bank, hard money, or most other loan types).
The interest rate given to a private lender is usually established up front and the money is lent for a specified period of time, anywhere from six months to thirty years.
What’s in it for the Private Lender/Investor?
- Safe investment secured by real estate
- High returns on their money
- A predictable income stream
- No management costs
- No daily headaches with managing contractors or tenants
Why Private Lending is So Compelling?
- Passive income (minimal time involved)
- No dealing with tenants
- No manual labor renovating properties
- No dealing with unscrupulous contractors
- Option of Short-term or Long-term use of lenders money
- Sense of security that money will be coming back soon
- Secure collateral position in marketable and liquid real estate
- Borrowers do the HARD WORK of finding the collateral
- Borrowers put THEIR MONEY into lender’s collateral
- Borrowers put THEIR TIME and LABOR into lender’s collateral
- Borrower takes majority of the risk
- If lender must foreclose, lender makes even more money
- You make money while you are sleeping
- Profits can be tax free
- It is PROFITABLE with no cap on earning
What are Promissory Notes?
A promissory note is basically an IOU that contains the promise to repay the loan, as well as the terms for repayment. The note includes the:
- name(s) of the borrower
- property address
- interest rate (fixed or adjustable)
- late charge amount
- amount of the loan, and
- term (number of years).
Unlike a mortgage or deed of trust, the promissory note is not recorded in the county land records. The lender holds the promissory note while the loan is outstanding.
When the loan is fully paid off, the note will be marked as paid in full and returned to the borrower.
Bank financing is typically 15 years or 30 years in length.
Current bank mortgage rates are hovering at or below 3% for 15 year and 4% for 30 year loans in 2016.
As an investor you should know these rates when deciding the financing structure of your properties.
You can negotiate similar terms, 30 years & 4% interest with your private money lender but they’ll likely expect a higher rate of interest from you.
If you are trying to build relationships for private capital, developing credibility is a MUST.
Whether it’s through blogging about your real estate endeavors online, posting your real estate updates on Facebook, talking about real estate investing in casual conversation, or attending your local real estate investment club, you need to be visible.
Are you maximizing your visibility? Are you creating opportunities to highlight your investing experience to others?
You don’t need to be a braggart, but next time someone asks what’s new in your life, share a few details of your real estate endeavors. You never know what might transpire.
Owner Financing aka Seller Financing
Another great option for financing the purchase of a property is the owner of that property. Yes, the seller.
If the seller owns the property free and clear, meaning they have no debt on the property, then they may be willing to do seller financing and act as the bank for you.
You would negotiate an interest rate with the seller, the term of the loan, and any other details. Typically, a land contract is used as the contract between you and the seller.
The reason you want to find homeowners who own their property free and clear is due to a legal clause written into nearly every loan called the “Due on Sale” clause.
When the seller sells the home, they are required by this clause to pay back to balance of the loan immediately to the lender (bank).
If that amount can’t be repaid, the lender has the right to foreclose on the property and assume possession. If the home is free and clear, you don’t have to worry about the bank or anyone seizing ownership of the property.
On the reverse side, owner financing can also be a good tool for selling your properties in the future as well.
Why Would Someone Do Owner Financing?
If the owner of the home doesn’t need the cash right away, they may accept owner financing because it allows them to receive steady monthly payments over the life of the loan and it allows them to earn interest on that money they are loaning you.
If the seller is selling his/her home for $200,000 on seller financing, then they are really selling it for much more when you figure in all the interest they’ll receive plus the $200,000 principal.
Plus, as stated they may prefer steady monthly payments to live off of if they’re someone that doesn’t control their money well and fears spending it all if they received a bulk of cash upon sale in lump sum.
Home Equity Loans and Lines of Credit
A home equity loan is a loan on the equity you’ve built up in your primary residence or other properties.
You essentially get to tap into equity you already have in your property without having to sell the house to receive that money.
For example if you bought a house years ago for $80,000 cash and it’s value is now $100,000 due to appreciation, you would have $100,000 in equity to pull out of the house.
The bank may finance 90% loan to value though so you would receive 90% of the $100,000, giving you $90,000 in an equity loan to spend on your investment property purchase.
If you already had a $50,000 mortgage on your home, then you would be capped and could only borrow $40,000 as this would bring your total amount owed to the bank to $90,000.
Banks may offer different types of products such as a Home Equity Installment Loan (HEIL) or a Home Equity Line of Credit (HELOC). A loan and a line of credit are two different products.
The downside to using home equity loans is when the housing market goes down.
During the housing bubble in 2006-2011 many homeowners were taking out 100%+ equity loans on their home and when home prices started falling they were suddenly underwater owing more to the bank than their property was worth.
Using home equity loans and lines of credit have multiple benefits over traditional loans, including:
- The banks don’t care what you do with the money
- You can make all cash offers on investment property because this loan is treated as equity/cash in your pocket same as if you sold the property to receive these funds.
- The IRS may give you tax breaks or incentives such as deducting the loan interest from your income taxes.
- Interest rates are typically lower because this loan is on your primary residence and has no ties to your investment purchase. Remember: investment loans are usually more expensive when dealing with banks.
You don’t have to take out the full amount allowed by the bank.
Maybe you only need to take out an equity loan big enough to give you the cash needed for a down payment on your investment property that will then allow you to use bank financing for the rest of the purchase price of the investment property.
Partnerships are great for combing resources of two people or multiple people to make a deal work.
For example, you may not have the capital when starting out and therefore need to form a partnership with someone who can provide the equity funding for the property you want to purchase.
There are many ways to construct an equity partnership.
You can split everything 50/50 to keep things simple or it can get more complex.
You might be asking why someone would put up 100% of the capital and accept to receive only 50% of the profits and the answer is that 50% of some deal is better than 100% of no deal.
Usually the investor agrees to this because they don’t have to do any of the work involved in the investment and simply act as the money provider.
You earn your 50% share in the profits by coordinating the management of the investment: finding the properties, negotiating with sellers, handling closing tasks to finalize the purchase, estimating renovation costs, hiring property managers or managing the property yourself, and more.
As an equity investor, there is more risk involved because unlike in private lending, the equity partner’s investment is not secured by a mortgage or promissory note, but by an operating agreement between the partners.
The equity investor isn’t guaranteed to see their money come back like they would with a loan.
If the property fails to perform and produce cash flow, the equity investor bites the bullet and loses money.
On the flip side, if the property does very well, they receive a percentage of the profits which can be far more money than if they were simply earning interest on a loan to you.
Equity partners take a higher risk than a private lender might, but in return, they have the potential of making significantly more when the investment is successful.
It’s quite common for beginning investors to partner up with a mentor or a family member or a friend who has experience investing in real estate.
Therefore, I though I would create a mini lesson on partnership agreements so that you have a quick outline of what to make sure is included in your contract when setting up a partnership with someone.
Your Partnership Agreement should include the following:
- Name of Partners
- Name of Partnership
- Location of Partnership
- Purposes of Partnership
- Duration of Partnership
- Allocation of Profits/Losses
- Capital Contributions
- Partner rights and responsibilities
- Dissolution Procedures
- Buyout provisions for death or withdrawal
Some additional tips to remember are be careful who you enter a partnership with.
If it’s with family and friends then make sure to keep business and personal life separate as things could go wrong on the business side that you may not want to affect your personal relationship with them.
If it’s someone you haven’t known very long such as a mentor or someone you met networking, make sure you’ve built a relationship with them first and can trust them.
You want to avoid litigation issues down the road between the two of you if things don’t go as planned or if your partner turns out to be a scam.
Overall, I expect you know who you’re dealing with and will make sound judgement calls when it comes to partnering up with someone so I won’t worry too much. Be safe, be smart, and go kick some tail building wealth in real estate!
ROTH IRAs, Life Insurance and Other Sources
There a multitude of other investment and savings products out there that you can use to invest in real estate.
While we don’t have the time to cover each of these in detail, be sure to speak to a qualified financial advisor about ways that you can use these products in your investing career.
After completing this guide, you now have many different ways to structure a real estate deal and negotiate the financing.
Not having money can no longer be an excuse to why you haven’t got started and bought your first property!
I’d love to hear any success stories if you’ve used any of these methods before to get your first deal! Feel free to share how you structured the real estate investment deal financing in order to acquire the property.
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- How Do You Make Money Investing in Real Estate?
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- 20 Reasons You Should Own Real Estate
- Can You Invest in Real Estate with a Full Time Job?
- 7 Questions to Ask Your Lender for Real Estate Financing
What to Do Next?
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- Grab our cheat sheet of 10 marketing strategies to get more property leads
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