The Top 7 Ways To Finance Your Real Estate Adventures was written by a fellow blogger: Jaren Barnes. Jaren has a unique perspective as he is the lead acquisition specialist at a real estate investment company headquartered in San Francisco.
When Jimmy first invited me to guest post on this blog and to serve you, the audience here at RealEstateFinanceHQ, I was so blown away!
To think I could have anything to offer in regards to real estate finance beyond what Jimmy is already sharing was such an honor and honestly, kind of mind-blowing!
I want to sincerely thank you guys for having me on as a guest and I hope this post serves you well.
When deciding on what to share with you guys, I’ll be honest, I really ran into some serious writers block.
Real estate finance is such a crucial component of success in real estate investing that I truly wanted to give you guys something of value instead of the “normal” fluff that’s out there.
I kept thinking to myself, “If I was just starting out, what aspects of real estate finance would have benefited me the most in my journey?” and well, with a lot of research, time and corrections from the greatest editor in the world (my lovely wife) this post is the response to that question. I hope you enjoy!
Financing Real Estate: Why Borrow Money in the First Place?
Growing up, the conventional wisdom of my up-bringing was that all debt is ultimately evil. Period!
My dad was a huge believer in Dave Ramsey’s “Financial Peace University” which is a personal finance system that can pretty much be summed up in that if you can’t buy with cash, you ultimately can’t afford it, so don’t buy it!
In most cases this advice is very wise and I totally agree that our culture could really benefit from exercising better judgment when it comes to debt.
However, the only real exception to this rule (and Dave Ramsey actually says it in his course) is borrowing money in regards to real estate.
Real Estate is really the only asset that I’m aware of, that over time will always go up in value.
If you bought a house back in the 1970’s for $30,000, let’s say in Palo Alto, CA, (a city in my market) today it very easily could sell at $1.2 million or more.
This is an extreme example but it showcases what’s typical for real estate as an asset class, over the long-haul.
Property values go up!
You see, in my thinking, there is a difference between “debt” and what I call “leverage”. Ultimately they’re the same thing but one is birthed out of a mindset of stupidity and/or scarcity and the other is birthed out of a mindset of financial intelligence and long-term planning.
Debt is when you “need” a new sports car or top-of-the-line designer cloths just so that you can be the “cool kid” on the block and have all your friends and neighbors ooh-and-aww at your “stuff”.
It’s when you have 5 credit cards all maxed out on ordering pizza and chillin’ at the movies.
Hey, you deserve to live a good life right? So why not max out credit cards, you deserve it, right?
Debt in this regard, aimless, ongoing spending on short-term gratifications is not the smartest move.
Leverage on the other hand is when you have something you want to do on a massive scale, something that takes a lot of manpower and capital to accomplish and you decide it`s smarter to pay a little ongoingly over time for the power to accomplish that massive something right now.
For example, let’s say you want to launch a start-up software company (I live in Silicon Valley, work with me here) that requires a team of 50 people but you’re on limited funds. (For the sake of simplicity, we are just going to cover salaries, not other overhead expenses).
How could you afford to pay all those people when you haven’t actually launched the product to make income yet?
Well, let’s just say for the sake of simplicity that every one of those 50 people is salaried at $80,000 per year. That would mean for one year of operation, you’d need $4 million to cover the cost of your workers.
What are you going to do?
Well, if you borrow that $4 million, you can pay it back in small amounts over time, while attaining the ability to hire those 50 workers right away.
It’s like paying $5 a month to spend $100 dollars right now.
Through borrowing you can have access to the power of $4 million but you are only required to pay a small percentage of it.
This is leverage: the increase in force (empowerment) gained by using a lever (borrowed funds).
So to bring it back to real estate, if you use your own cash to invest with, you are actually limiting yourself to the amount of capital of your personal savings, whereas if you borrow funds to invest with, you’d actually empower yourself with the ability to do more deals, which ultimately means you can make more money.
And because properties typically go up in value over time, the power you gain from leverage in obtaining real estate can really accelerate your growth of personal wealth!
So it is smart to use borrowed money to invest in real estate, but what now?
Good question! There are a number of different types of leverage available for those interested in investing in real estate and your first step is to learn which one makes sense for your style of investing.
To help you, I thought I’d go over some of the most common types of lending.
Though I am in no way claiming that the following list is all-inclusive, it definitely covers the basics to get you started.
1. Traditional Mortgage Loans
Typically these are loans given by banks and other financial institutions that require a minimum of 20% – 30% down.
There are a lot of different variations but for our purposes today, just think of these as the traditional 30-year fixed and all of it’s off-shoots.
Probably the most beneficial aspects of a traditional mortgage is the fact that they generally carry the lowest interest rates.
They can be a great tool for buy and hold investments in particular (if you run your numbers correctly of course), however, you are limited to the number of traditional loans you can hold in your name at a given time.
Equity for those who don’t know (this post is intended for everyone, so we can’t skip the basics) is the value of a piece of property after any debts that remain to be paid have been subtracted.
In other words, if you take out a 30-year fixed mortgage at a loan amount of $100,000 and over a few years you pay off $50,000 of the loan amount, then you’d have $50,000 in equity. If you were to sell the property, you’d profit $50,000… makes sense?
Two of the most common forms of this type of leverage are the Home Equity Installment Loan (HEIL) and the Home Equity Line of Credit (HELOC).
Typically when leveraging equity out of a pre-existing property, lenders will only let you borrow up to a certain percentage of the property’s value. It differs depending on the lender but it is possible to find lending percentages up to 90% of the property value, so be sure to do your due diligence when you search.
There are some pretty awesome upsides to leveraging equity versus that of a traditional mortgage that worth taking the time to mention.
For starters, there are some insane tax advantages like the ability to deduct the interest paid on the loan (I am not a CPA or attorney so seek one out to verify what I just said).
Secondly, you have complete control of the money when you leverage equity. In most cases if you take out a loan, there are limits on what you can spend it on. For example, a car loan can’t be used to buy a house and vice versa, but if you use home equity you could buy either/or, or both.
No one typically cares what you spend the money on!
This also means that you can then use equity as straight “cash” to make offers on new properties.
Cash offers are typically preferred to that of a traditional mortgaged-buyer because they don’t have to wait on the bank to transfer funds in order to close.
Another benefit is that equity leverage is known for having interest rates that are very, very low.
So it’s cheap to use!
My wife and I actually purchased a house in her home country of Kazakhstan using an equity line of credit on a house my grandmother left for our family and we only have to pay $500 a month on it!
Tip: Something you could try is to take out an equity loan and use small bits of it to fund down payments on several different traditional loans for multiple different properties.
Now that’s how to leverage like a boss!
Now to finish up, there are two different types of equity loans/lines that we should go over:
1. Fixed-Rate Loans
These provide a one-time, large lump-sum to the borrower, which is then repaid over a pre-determined period of time at an agreed interest rate amount. The payment amount and interest rate do not change, ever, over the entire lifetime of the loan.
2. Adjustable Interest Loans
These are loans that have an interest rate that fluctuates over time, meaning depending on whatever is happening in the loan market, the interest rate changes both positively and negatively.
According to Investopedia studies have shown that over time you are more likely to pay less interest overall with a variable rate loan.
It is important to note, however, that you need to be conscious of the amortization period of your loan because the longer it happens to be, the higher the impact the fluctuation will have on your payments.
Be sure to do your homework and determine what your investment goals are. If you’re flipping a house for example, getting an adjustable interest maybe a really good option compared to using it for a buy and hold investment because your hold time of the purchased property is a lot shorter.
3. Commercial Loans
If you exhaust your allowed amount of traditional mortgages or you purchase buy and hold investments with 5 or more units, you may have to adjust to using commercial loans.
A couple of differences between residential and commercial loans:
1. The amortization period (time to pay of your loan amount) is typically shorter for commercial. 15-20 year schedules are the most normal. This naturally causes the amount of interest and amount paid every month to increase, so you’ll need to make sure your numbers are adjusted accordingly.
2. The interest rates and fees are higher on the commercial side.
3. In residential, how much income you have has a heavy impact on the likeliness of your approval for a loan. In commercial, it’s more about the actually investment property and how much revenue the property generates.
Also, be aware that commercial lenders can lend out what’s known as a “business line of credit” for ongoing investment usage, like fixing and flipping houses for example.
How sweet would it be to have access to a huge amount of money for both purchase and rehab that you don’t have to put in work to raise?
I think it’d be pretty sweet…
4. Portfolio Lenders
In most cases when banks and other financial institutions provide traditional mortgage loans, they actually pull the funds from other investment parties. This translates to some pretty strict underwriting guidelines for loan qualification because they’re dealing with other people’s money as well as government regulations and oversight.
There are, however, some smaller banks and credit unions known as portfolio lenders who only loan out of their own funds internally.
Since the money they’re lending is all in-house, they can be more flexible on terms and qualifying standards which can be really beneficial!
The more deals you do, the harder using traditional financing gets, so portfolio lenders that can work with you are great to have in your network.
Now, most of the time, financial institutions that are set up as portfolio lenders don’t advertise themselves, so you’ll need to find out about them through referrals by other investors or do some calling around to local banks in your area to find them.
5. Owner Financing
Sometimes you don’t actually need a financial institution to gain leverage for investing in real estate. In certain cases, the current owner of the property you want to purchase can actually fund the investment.
To put it simply instead of paying the bank monthly payments, you’d simply pay the prior owner monthly payments. He, in essence, would become the bank/lender.
Normally this structure only makes sense if the prior owner doesn’t carry any more debt on the property.
There is an option to structure something called a “subject to”, where you take over the pre-existing loan, however, because of something called the “Due on Sale” clause which is incorporated in almost every loan, under a “subject to” transaction the bank technically has the right to call the note due, meaning you’ll have to pay the loan amount in full or face foreclosure.
Owner Financing can be a great way to continue investing when all traditional modes of financing have been maxed out.
6. Hard/Private Money
Hard and private money in financing that comes from a private individual or business. It’s typically structured solely for investment purposes.
The main differences between the two are that hard money typically is a little bit more expensive and comes from someone who structures their lending as an ongoing business, whereas private money typically comes from friends and/or relatives who are just interested in making a little return on their money.
Hard money typically has more guidelines and rules whereas with private money lending pricing and what-not is structured a lot more case-by-case.
Typically, these loans are expensive (8-15%) and have shorter terms (6 months to 3 years) but they don’t require standard qualification guidelines used by common financial institutions.
Also, hard money lenders usually have great insight in terms of analyzing investment properties (because if they lend you money on a bad deal they end up losing as well) which can be a very helpful guide for people who are just starting out.
Both hard money and private money is structured to be a short-term loan for a short-term situation.
Using it otherwise can lead into some really sticky situations.
There was one time while I was out door knocking pre-foreclosures where I actually came across an investor who was losing his home because he (stupidly) decided to use hard money to purchase it. Don’t do that!
7. Retirement-Saving Sources:
The last type of leverage source we will cover is retirement-saving sources. I can’t really go into detail on all that you can do because I’m not a CPA and don’t have the legal credentials to give advice on this type of stuff, but long story short, there is a way to use a self-directed Roth-IRA and other investment vehicles to invest in real estate. Get in touch with the right professionals and see how you can pimp-your-retirement!
I hope you found this post helpful. I know if I was given an outline of the different financing options out there, it would have really saved me some trouble along the way, so I hope it does that for you.
Before I go, is there any particular question you may have regarding financing sources? If so, leave a comment below and I’ll do what I can to help out!
I hope you enjoyed all of these different way’s of financing your real estate adventures.